Sticking To Your Convictions As A Value Investor Is Hard, Just Ask Whitney Tilson About Netflix

Back in December, Whitney Tilson, a fairly well known value investor with T2 Partners, published a letter outlining a compelling bear case for Netflix (NFLX), a stock he was shorting at around $180 per share. After seeing the position go against him, Tilson was feeling pressure from his clients. After all, shorting a high-flying technology company with a cult-like following, as it is soaring in value, can be a tough psychological exercise. Tilson's argument for betting against Netflix was clear, concise, and thorough. He boiled it down to this, in his December piece entitled Why We're Short Netflix:

"We don't think there are any easy answers for Netflix. It is already having to pay much more for streaming content and may soon have to pay for bandwidth usage as well, which will result in both margin compression (Netflix's margins are currently double Amazon's) and also increased prices to its customers, which will slow growth.

Under this scenario, Netflix will continue to be a profitable and growing company, but not nearly profitable and rapidly growing enough to justify today's stock price, which is why we believe it will fall dramatically over the next year."

The main bearish argument seemed reasonable at the time; customers were moving away from DVD by mail and towards streaming content. In order to secure content for their streaming library, Netflix would have to pay more than in the past, when they could just buy a DVD once and send it out to dozens of customers. But at the time subscribers were signing up at a record pace and were highly satisfied.

In February Tilson threw in the towel. The stock had continued its ascent, rising to $220. Again, Tilson went public with his changed view, writing a letter called Why We Covered Our Netflix Short. The bulls loved the fact that Tilson was admitting defeat. The stock continued soaring and hit an all-time high of $304 in July. Tilson summed up his reasoning as follows:

Our short thesis was predicated on the following stream of logic:

1) Netflix's future depends on its streaming video business (rather than its traditional DVD-by-mail business);

2) The company's streaming library is weak, which would lead to customer dissatisfaction and declining usage;

3) This would either cause subscriber growth to wither or force Netflix to pay large amounts to license more content, which would compress margins and profits;

4) Either of these two outcomes would crush the share price.

We are no longer convinced that #2 and #3 are true.

This was interesting because very little in the way of fundamentals had changed at that time. Tilson cited three reasons why he was doubting his earlier bearish thesis:

1) The company reported a very strong quarter that weakened key pillars of our investment thesis, especially as it relates to margins;

2) We conducted a survey, completed by more than 500 Netflix subscribers, that showed significantly higher satisfaction with and usage of Netflix's streaming service than we anticipated (the results of our survey are posted; and

3) Our article generated a great deal of feedback, including an open letter from Netflix's CEO, Reed Hastings, some of which caused us to question a number of our assumptions.

In hindsight these reasons seem even more suspect than they did at the time, but it is worth pointing out the mistakes anyway so value investors can learn from each other.

First, Tilson cited that Netflix reported a strong fourth quarter. Tilson's bearish view was never predicated on Netflix blowing the next quarter. It was the longer term trend of rising content costs, which would give Netflix two choices; maintain a weak streaming library and risk losing customers, or pay up for strong content and be forced to either raise prices (which would hurt subscriber growth and reduce profitability) or keep prices steady and lose profitability that way. The fact that Netflix reported one strong quarter really didn't make a dent in the bearish thesis.

Second, Tilson surveyed 500 Netflix customers and found they were quite happy with the service. Again, his thesis didn't claim that current customers were unhappy (after all, they were signing up in droves in part because streaming was free with your subscription at the time). Rather, it was about the future and how those customers would react if Netflix had to either raise prices or offer less in the way of viewing choices.

Third, and this one was perhaps the most bizarre, Tilson was evidently persuaded by Netflix's own CEO, Reed Hastings. I find this one odd because I have never seen a CEO on TV or elsewhere who was publicly negative about their company's prospects, regardless of how good or bad things were going at the time. In fact, many investors believe it is a huge red flag when CEOs of public companies take time to personally rebuff bearish claims from short sellers. Hastings did just that, responding to Tilson's short case with a letter of his own that suggested that he cover his short immediately. Generally speaking, the fact that the CEO of a company you are short thinks you are wrong is not a good reason to cover your short.

And so we had a situation where Tilson's short thesis appeared sound, albeit unresolved, but the stock price kept soaring and he was feeling heat for the position, which was losing money. Then, just a few months later, Netflix decided to raise their prices and customers canceled in droves. Tilson's bearish thesis proved exactly correct, but he no longer had the short bet to capitalize on it.

Today in pre-market trading Netflix stock is down about 30% to $83 per share after forecasting higher than expected customer cancellations, lower than expected fourth quarter profits, and operating losses during the first half of 2012 due to higher content costs, slowing subscriber growth, and expenses for the company's expansion into the U.K. and Ireland. Analysts were expecting Netflix to earn $6 per share in 2012 and in July investors were willing to pay 50 times that figure for the stock. Now it is unclear if Netflix will even be profitable in 2012 after forecasting losses for the first "few quarters" of next year.

This is a perfect example of why value investing is a tougher investment strategy to implement than many realize, but offers tremendous opportunity to outperform. By definition you have to take a contrarian view; either going long a stock that people don't like, or shorting a stock that everyone loves. The bottom line is that your analysis is what is important. If you do your homework and get it right, the market will reward you. It may take more than a quarter or two, but you need to stick to your convictions unless there is extremely solid evidence that you are wrong. In this case, Tilson's bearish thesis was never really debunked by the CEO's defensive posture or the fact that customers were satisfied when they were getting streaming content for free. In hindsight, Tilson understood the outlook for Netflix better than the company's own CEO. However, both are likely feeling very uneasy this morning.

Interestingly, the question now may be whether there is a point at which Netflix stock becomes too cheap and warrants consideration on the long side. I suspect the answer is yes, though probably not quite yet. If the stock keeps falling and we see $60 or $70 per share, maybe the time will be right for value investors like Tilson to go against the crowd again and buy the stock when everybody hates it.

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

UPDATE: 3:00PM ET on 10/25

The WSJ is reporting that Tilson initiated a small long position in Netflix this morning:

Mr. Tilson tells us in an e-mail that he bought the stock this morning after it tumbled 35%:"It's been frustrating to see our original investment thesis validated, yet not profit from it. It certainly highlights the importance of getting the timing right and maintaining your conviction even when the market moves against you. The core of our short thesis was always Netflix's high valuation. In light of the stock's collapse, we now think it's cheap and today established a small long position. We hope it gets cheaper so we can add to it."

Should Investors Revisit Sears Holdings Now That Eddie Lampert Appears To Be Shifting Strategies?

Longtime readers of this blog are familiar with my history with Sears Holdings (SHLD) and its predecessor, Kmart. A brief summary goes something like this.

Hedge fund manager Eddie Lampert loaded up on the debt of Kmart for pennies on the dollar as it fell into bankruptcy (nobody else wanted to come anywhere near the stuff). When the struggling retailer emerged post-restructuring, Lampert owned a majority stake and began cutting costs and reduced the company's focus on competing with Wal-Mart on price (a losing proposition). The changes worked. Kmart was making money again and the stock soared from $15 to $100 before anyone really knew what had happened. Lampert merged Kmart with Sears in 2005 and investors cheered the move, imagining the magic he could work with strong brands and valuable real estate. Investors assumed he would close money-losing stores, sell off real estate to other retailers, ink deals to sell proprietary products (Kenmore appliances and Craftsman tools) in other chains, and use the cash flow to buyback stock and make acquisitions to diversify the company away from Kmart and Sears, which were clearly dying a slow death. Sears Holdings stock hit a high of $195 in 2007, for a gain of 1,200% in just four years.

Then something strange happened. Those grand ideas never materialized. People close to Lampert were convinced that was the route he would take, based on his experience and philosophy, but he never came out and said it himself. Investors had resorted to blind faith. While Lampert has closed some stores and sold off some real estate, the total store count has actually risen from 3,800 to over 4,000. Lampert cut costs and bought back stock (shares outstanding have fallen from 165 million to 107 million) but he has spent most of his time trying to turn around the retail operations. Couple that flawed strategy with an economy that went bust (the Sears deal closed in the heat of the housing bubble) and profits at Sears Holdings have plummeted. Despite the 35% reduction in shares outstanding, earnings per share dropped like a rock from $9 in 2006 to $1 in 2010. Like many others, upon realizing faith alone was not enough, I sold the last of my Sears stock in 2008 after it had dropped back down to the $100 area. Sure I had a huge profit from the early Kmart days, but the potential for Sears Holdings was just too great to be squandered.

So why rehash the past when readers could get all of that information just be reading all of the posts I penned back then about Sears Holdings? Because it appears Lampert might finally be getting his act together and not putting all of his eggs in the "make Kmart and Sears popular again" basket. It started last year with some subtle moves like splitting up the company into smaller divisions (including one for brands and one for real estate). Then the company reached a deal to sell Craftsman products in Ace Hardware stores (a much better idea than just putting them in Kmart stores). None of these moves were big but maybe they indicated a larger shift in strategy.

This year we have seen further movement in that direction. Sears has announced plans to spin off its Orchard Supply hardware store business into a separate public company. Craftsman tools can now be found in Costco stores and indications are that Kenmore appliances might be next. Diehard batteries are now going to be sold in 129 Meijer stores across the country. Floor space is now available for other retailers to lease within most of the company's existing 4,000 Kmart and Sears locations. In Greensboro, North Carolina, for instance, there is a Whole Foods Market store located inside of a Sears. For the first time since the Kmart/Sears merged closed in early 2005 we are seeing signs that Sears Holdings might finally be focused on extracting value from the company's assets in ways other than trying to turn back the retail industry's clock several decades. As a result, it makes sense to keep close eyes on the company's stock once again.

Caution should be advised here, however. Annual revenue at Sears Holdings, while down from $54 billion in 2005, is still formidable at about $43 billion. Selling a few screwdrivers here and leasing some floor space there won't have a huge impact on their financial results. However, one can certainly see the potential if these efforts prove successful and are adopted in widespread form across not only the company's 4,000 stores, but within other retailers' four walls as well. It is too early to predict a turnaround, but the stock price is not factoring in much of this strategy shift, if indeed it is real and sustainable. After dropping from $195 in 2007 to $100 in 2008, Sears Holdings stock has been cut in half again over the last 18 months and now fetches just $55 per share. If we see these moves start to bear fruit on the income statement, the bull market for the stock just may well resume after a five-year hiatus.

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

Buffett, Of All People, Should Know It Hurts Shareholders to Telegraph Buybacks Ahead of Time

One of my pet peeves is how frequently public companies announce stock buyback programs before they buy a single share. If you are buying back your stock because you believe it is undervalued, and you know that announcing your intentions is going to give a boost to the stock, you are essentially screwing over your shareholders. Why pay more than you have to for the shares you want to repurchase? Today we learned that Berkshire Hathaway (BRKa /BRKb) has authorized share buybacks at prices up to 110% of book value. I am kicking myself because I took a hard look at this stock last week, concluded it was very attractive, but didn't rush in to buy any. After all, what catalyst near-term could possibly boost the stock that much in a volatile market? Well, a telegraphed buyback program is about the only thing. And today the "B" shares are up nearly $5, or 7%, to just under $71 per share. They looked good at $66, but much less so now.

Isn't Buffett smarter than this? If he could have bought the stock at $66 why put out a press release and drive your potential cost basis up so much? Skeptics will say he has no intention of actually buying the stock... that it is just a way to give the stock a boost without committing any capital. Perhaps this will prove true (Buffett thought hard about it decade ago but never actually bought any) but I hope not. The stock really is cheap, and Buffett of all people knows this. I cannot figure out why he wouldn't buy the stock first, and then announce the amount purchased and price paid. That too would give the stock a jolt to the upside, but it would actually benefit shareholders too. This announcement really seems silly. Other companies do it all the time, but I expect more from Buffett.

Some might argue that disclosing the buyback authorization is a Reg FD issue but I would respectfully disagree. Reg FD is supposed to protect certain investors from getting information earlier than others, thereby providing a level playing field for everyone. Failing to disclose the buyback plan ahead of time does nothing to give anyone a leg up on others. In fact, it treats everyone equally (nobody learns of the plan) and beneficially (all shareholders profit from the accretive nature of the repurchases, which were done at the lowest price possible).

We will see if Berkshire stock holds today's 7% gain. If it does and Buffett doesn't buy any shares, not only will this announcement have been a waste of time, but more importantly, he will have balked at a great opportunity to make money for Berkshire shareholders.

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

Dell: The Anti-Hewlett-Packard?

Following up to yesterday's post on the outright ridiculous valuation being assigned to shares of Hewlett-Packard (HPQ) these days, it is worth playing devil's advocate and exploring the merits of anti-H-P plays if you believe they will have a hard time convincing its customers that it finally is on the right track. Dell (DELL) should be the primary beneficiary if enterprise customers seek out new vendors, so it would be a perfect way to play the continued demise of H-P.

How does that stock look? Very, very cheap. At $14 per share, Dell fetches about 8 times earnings. But if you dig deeper the stock is even cheaper. Dell has about $10 billion of net cash on the balance sheet, which equates to $5 per share. So investors are really only paying about $9 a share for Dell's operations, which generate north of $60 billion in annual revenue. With about $5.5 billion in trailing twelve-month EBITDA and an enterprise value of about $16.5 billion, Dell currently trades at 3 times cash flow. Heck, that is not that much more than H-P (2.5 times). Both of these stocks may make a lot of sense at current prices.

Full Disclosure: Long shares of HPQ at the time of writing but positions may change at any time

Hewlett-Packard Revisited: Lowest Tech Valuation in 20 Years

You can bet that there will be a Harvard Business School case study written about the last year in the board room at PC hardware giant Hewlett-Packard (HPQ). A little over a year ago I wrote that I thought the stock was pretty cheap after falling to $38 from a high of $55 per share. Mark Hurd, a cost-cutting guru praised by investors, had just been fired as CEO and the company later filled that position with Leo Apothekar, the former CEO of software-focused SAP, a job he held for about seven months before being ousted. At the time Wall Street was reeling from Hurd's exit and given that H-P is the largest hardware company in the world, most everyone wondered why the Board hired Apothekar of all people. At $38 each, the stock fetched only 8.4 times earnings per share of $4.50, about as low as large tech company valuations ever get. Sure, Apothekar was unproven and hardly an inspiring hire, but unless the company's business really was about to fall off a cliff, there appeared to be minimal downside risk given the single-digit multiple. Or so it seemed.

Here we are a year later and the H-P story has been downright bizarre. Apothekar was fired last night and replaced by former eBay CEO Meg Whitman. If you thought hiring Apothekar, a software guy, was an odd choice for the world's leading hardware company, Whitman's career experiences at eBay, Hasbro, Proctor and Gamble, Disney, Stride Rite, and FTD.com is certainly questionable. Not surprisingly, H-P stock fetches $22 today, the lowest level since 2005 and less than five times earnings. According to an analyst that covers H-P who was on CNBC this morning, a large cap tech stock has not traded at that price in more than two decades.

From an investor's perspective, the most interesting thing is that H-P's business has not actually fallen apart, as the stock price would have you believe. Earnings per share for the current fiscal year will likely grow about 5% to $4.80, on flat revenue. So while large technology companies never usually trade for less than 7-8 times earnings, today Hewlett-Packard trades at 4.6 times earnings, which is simply unheard of. To me, that doesn't make any sense unless H-P's business crashes. And if that didn't happen over the last year, I am not sure it is a wise bet that it will happen now. After all, Apothekar's strategic decisions seem to be correct (focus on growing software and services, dump unprofitable tablet hardware that is bleeding hundreds of millions of dollars, etc), even when the leadership and communication to Wall Street and customers was unclear, inconsistent, and confusing.

So where do I stand on Hewlett-Packard stock now, with clients sitting on a loss over the last year? Given that the company remains a major player that is extremely profitable and trades at a valuation not seen in decades in the technology space, I am strongly considering doubling down here. There may not be many catalysts short term to get the stock higher, unless Whitman was to inject strong leadership and clear priorities quickly, but earnings would have to collapse from here to justify anything near a $22 stock price longer term. The selling pressure in recent months appears to be capitulation from investors who are fed up with the sheer incompetence of the prior board of directors, rather than significant weakness in the underlying businesses at H-P.

Assuming that management can't get much worse going forward (seems reasonable), there is little reason to think H-P won't fetch at least a 7-8 P/E in the intermediate term (a higher multiple is certainly possible --- the stock fetched 10 times earnings under Hurd --- but at this point conservative assumptions seem prudent). That would imply significant share price upside even without earnings growth (though I do think EPS growth is coming --- it will be +5% this year even after all that has happened). There are just too many ways to get a higher stock price from here, even without making optimistic assumptions.

In summary, the last year has been brutal for the company and its stockholders, but at its current valuation, the stock price just doesn't make much sense, based on what we know today.

Full Disclosure: Long shares of Hewlett-Packard at the time of writing, but positions may change at any time

Europe's Woes Crushing U.S. Stocks, Creating Longer Term Opportunities

You can certainly argue whether the TARP program was a good idea or not, but you cannot accuse the U.S. government of dragging their feet. They took decisive action, injected much-needed capital into the banking sector, brought confidence back into the system, and the end result was a well capitalized banking industry and a profit on the U.S. taxpayer's $700 billion investment. Unfortunately, the powers that be in Europe are taking their good ol' time to take meaningful action. Greece may be the size of Ohio, as I have repeatedly reminded investors, but as long as the markets freak out about it anyway, strong action must be taken to settle the financial markets down. We have yet to see that (hence the market's continued concern this morning), but let's keep our fingers crossed that we are getting closer.

In the meantime, there are plenty of strong companies that are being dragged down by this prolonged bailout process. Not surprisingly, most of these opportunities are in the financial sector, but in many ways are not directly in the middle of the European crisis but rather only marginally impacted. In my view, a perfect example is Aflac (AFL), the supplemental health and life insurance company whose two largest markets are Japan and the United States. As you can see from the chart below, shares of Aflac have been crushed from $59 to $33, a 44% drop from earlier in the year.

Now Aflac is not exactly the first company that comes to mind when you think about the European debt crisis. So why the huge sell-off in the stock? As a large insurance company, Aflac collects premiums from its customers and invests that capital to earn income until it needs to pay out claims. Aflac's investment portfolio amounts to a relatively large $90 billion. When investing that much money, and doing so in mostly shorter term fixed income securities, an insurance company will own a little bit of everything, and that includes debt of European countries. And therein lies the problem for the stock in 2011.

Aflac has already sold all of its Greece exposure and over the next year or so will de-risk its holdings in the other smaller European countries that people are worried about (Italy, Portugal, etc). Of course, most of Aflac's investments are outside of the troubled European countries and their underlying business is very strong. But in times of stress investors focus only on the negatives, and if any losses at all are possible from Europe, that will drive the stock down quickly.

Given the health of Aflac's business, any losses should be more than manageable. The company right now is earning more than $6 per share. At $33 per share, that puts the stock's P/E at 5.5. Such territory is nothing new for Aflac stock. During the U.S. sub-prime crisis Aflac stock also got killed, dropping from $68 in early 2008 to $10 in early 2009. The company's sub-prime exposure back then also proved to be very manageable (most of the losses were marked-to-market and never actually realized) and the stock soared nearly 500% over the following two years. I have little reason to think this time around will be much different in terms of how the company can weather the storm in the financial markets and the European debt crisis.

Full Disclosure: No position in AFL at the time of writing, but clients of Peridot Capital have owned the stock in recent years and may again in the near future

Let's Face It, Given All That Has Happened Lately, A Market Correction Makes Sense

In a few short days I leave town for a two-week vacation (interesting timing I know, but it has been planned for months and therefore not market-related) but before I leave these volatile markets behind for some refreshing time away I think a few comments are in order. As I write this the Dow is down 400 points to below 11,500 and the S&P 500 index has now dropped 11% from its 2011 high. In the days of computer-driven trading stock market moves are more pronounced and happen faster than ever before, so it is important to keep things in perspective.

First, given everything that has happened in Europe this year, coupled with our own ugly debt ceiling political debate in Washington DC, it is completely reasonable to have a stock market correction. I would even go a step further and say it was a bit odd that the market held up so well prior to last week's debt ceiling dealings. Historically the U.S. stock market has corrected (by 10% or more) about once per year. The last one we had was a 17% drop in 2010 during the initial Greece debt woes. That we have another one now in 2011 is not only predictable based on history, but especially when we factor in everything going on lately financially, economically, and politically. Let's keep the market swoon of the last week or two in context.

From an economic standpoint, investors need to realize we really are in a new paradigm. The U.S. economy was goosed up by debt, both at the consumer level (credit bubble) and at the government level (tax cuts along with increased spending). As a result, we have to see both groups de-lever their balance sheets. Consumers are reducing debt and saving more, and many don't have jobs. The government is now beginning to cut back as well. Consumer spending represents 70% of U.S. GDP and government spending, at $3.6 trillion per year, makes up another 25%. Corporations are the only bright spot in today's landscape, with record earnings and stellar balance sheets, but their spending is only the remaining 5% of GDP. With both consumers and government agencies cutting back, a slowing economy and lackluster job growth are all but assured.

So are we headed back into a late 2008, early 2009 situation for both the economy and financial markets? While anything is possible, we probably should not make such an assumption. A slowing economy (say, 1-2% GDP growth) is far better than what we had at the depths of the financial crisis with 700,000 jobs being lost per month, negative GDP of several percentage points, and runs on the country's largest banks. The 2008-2009 time period did not reflect a normal recession (which would last 6-9 months and be relatively mild). It was far worse this time and those events typically only happen once per generation, not once every few years.

The best case scenario short term is that the markets calm down and we meander along with 1-2% growth. Not good, but not horrific either. Could we slip back into a garden-variety recession due to government cutbacks, 9% unemployment, and a deteriorating economy in Europe? Sure, but that would likely result in a more typical 20% stock market decline over several quarters, not a 50-60% drubbing. And keep in mind we are already down 11% in a few short trading sessions.

What does this mean for the stock market longer term? Well, believe it or not, there are reasons for optimism once investors calm down and we really get a sense of what we are dealing with. With slow economic growth interest rates are going to stay near all-time lows. Buyers of government bonds today are accepting 2.5% per year in interest for a 10-year bond. Savings accounts pay 1% if you are lucky. The S&P 500 stock index pays a 2% dividend and many stocks pay 3% or more. Given the financial backdrop for U.S. corporations relative to the U.S. government, which do you think is a better investment; lending the government money for 10 years at 2.5% or buying McDonalds stock and collecting a 2.9% annual dividend? Investment capital will find its way to the best opportunities and even with slow growth along with the possibility of a double-dip recession, U.S. stocks will look attractive relative to other asset classes.

As a result, I think there are reasons to believe the current market correction is going to wind up being much more normal than the 2008-2009 period. With interest rates and government finances where they are, equity prices can easily justify a 12-14 P/E ratio. Maybe stock market players before the last week or two were just hoping we could escape all of this unscathed, despite the fact that market history shows that is rarely the case. In any event, while I am looking forward to spending some time away from the markets, I am not overly concerned about this week's market action, especially in the context of global events lately. My hope is that by the time I return markets have calmed down and we can revisit how to play the upcoming 2012 presidential election cycle, even though that thought alone makes me want to take far more than two weeks off. :) 

Link: Apple Now Has More Cash Than The U.S. Government

Courtesy of Business Insider:  

http://www.businessinsider.com/apple-has-more-cash-on-hand-than-the-us-government-2011-7 

E*Trade's Largest Shareholder Pushes for a Sale, Company Hires Bankers to Explore Options

It has only been about three and a half months since I wrote about E*Trade Financial and the strong possibility that at some point the company is sold at a large premium to the then stock price of around $15 per share. Although it makes sense for the company to let its legacy loan book runoff as much as possible before exploring a sale, Citadel, with its 10% stake, urged E*Trade to sell themselves last week. The company has hired Morgan Stanley to looks at its options (though it did the same thing last year and decided to wait), and maybe not coincidentally, TD Ameritrade (long thought to be the most natural acquirer of E*Trade) has a previously scheduled board meeting this week during which buying E*Trade will surely be discussed.

My original post pegged E*Trade's value at between $22 and $27 per share and I stand by that range. E*Trade's loan book continues to runoff as expected and loan losses and delinquencies continue to trend lower every quarter (second quarter earnings were reported last week and delinquent loans fell to $1.4 billion from over $2 billion a year ago). After digging into the details of that mortgage exposure, a buyer such as Ameritrade should realize that there is very little there that should scare them out of making an offer. I don't know if a fair offer will come this year (buyers will obviously try to lowball an offer and point to the loan book as the reason why) but even if management stands by their plan from last year of waiting out a couple more years, investors will only get more for their shares. Any offer not at least in the mid 20's probably isn't in the best interests of shareholders at this time. Nonetheless, this story could get very interesting in the next few months so stay tuned.

Full Disclosure: Long shares of E*Trade at the time of writing, but positions may change at any time

Spending AND Taxes Got Us Into This Mess, And Only BOTH Can Get Us Out

Since we are right in the heat of the debt ceiling/budget deficit debate, I made a point to devote a section of my July quarterly client letter to the topic, but I also wanted to share some of that publicly as well. As old as these arguments back and forth in Washington are getting, they are important issues for our economic and financial futures. To try and boil it down to something (relatively) simple, below are two graphs I created to help people visualize exactly how we got into this deficit mess, and more importantly, the only way we can get out.

The first chart shows tax collections and government spending, as a percentage of GDP, in fiscal 2001 (the last year we had a balanced budget in the U.S.) compared with the projections for fiscal 2012 (which begins on October 1st of this year).

You can clearly see how we have gone from a surplus of 1% of GDP to a deficit of 7% of GDP; taxes went down by 4% of GDP and spending went up by 4% of GDP. If there was ever a question of whether the federal government has a spending problem or a taxation problem, this should end that debate. We have both, and each has contributed equally to our budget deficit woes over the course of the last decade.

To counter one of the most common rebuttals to this conclusion (that taxes are too high) consider that federal taxes (payroll taxes, income taxes, gift and estate taxes, etc) today are at their lowest point since 1950 (again, as a percentage of GDP). In order to balance the budget, we need to close an annual deficit of $1.4 trillion, the product of $3.6 trillion in spending versus just $2.2 trillion in tax collections. If we do not raise taxes at all, government spending would have to be cut by that $1.4 trillion figure, which would be a cut of 40% (and is impossible).

The second chart below shows the sources of our budget deficit, by comparing our finances in 2001 to those that the CBO projects for fiscal 2012. It shows in another way how increased spending and tax cuts are equally responsible for the fiscal problem we have, but it goes a step further by showing that nearly half of the increase on the spending side is due to huge increases in defense spending (which has more than doubled since 2001, from $300 billion in 2001 to $700 billion today).

So not only do we have to get taxes up and cut spending, but we have to cut defense spending meaningfully within that context. If we don't increase taxes and we don't cut defense spending, a balanced budget would require we cut the non-defense portion of the government's budget by a whopping 50% (again, impossible).

If you weren't ticked off at the childish crap going on now on Capitol Hill, you probably should be after reviewing these numbers. The solution to the problem is easy to identify if you want to be honest about it. But without even admitting to that in public, how will our politicians ever actually solve the problem? A depressing thought indeed.