As I wrote in “Don’t Be Fooled: Get Short Now”, the euro is not that different from Enron, WorldCom or the Madoff fund. All of these organizations were able to pretend they were profitable or solvent long after they were insolvent.
Now markets are finally acknowledging the intractability of the Euro debacle. Part of this acknowledgement also means coming to terms with structural decline in global productivity created by fiscal and monetary policies that espoused wastefulness over quite a long time.
Markets have finally begun to acknowledge that interest rates, when kept too low for too long, undermine long-term economic growth potential instead of boosting it.
Economic growth forecasts are being lowered around the world. Worse, forecasts of a recovery are few and far between. It is as if the world is finally accepting the mess we are in.
The worst is not behind us, but it will be soon. As bad as things are, they are, on the margin getting better.
Acknowledging problems means they can be, albeit slowly, addressed. One could argue that Greece, Italy, Ireland, France and Spain are now being forced to engage greater economic change than anytime in centuries.
The dismal financial reality of not being able to pay the bills forces politicians address the unpopular need to change long-standing policies that are simply not sustainable.
The gradual change in economic behavior being forced on the troubled countries in Europe is likely to have a much more lasting effect than sudden change, which would almost certainly be viewed as cruel and oppressive. The populations that endured the change would likely resent it and revert back to their old ways as soon as they could.
Under the slow, gradual approach where authorities give them every chance to avoid change, they gently prove that they have no choice. They gently prove that their previously chosen approach is an abject failure. In so doing, they pave the way for long-term structural changes that will lead to superior capital allocation over the long-run.
A similar trend is making waves in the U.S. Several states are engaging in pro-growth austerity: cutting taxes and spending at the same time. Many of these states were forced into this action by mounting entitlement and pension liabilities on top of budget deficits. States like Wisconsin, Ohio and others are seeing rather impressive economic results from clawing back on promises to unions they could not keep and cutting taxes at the same time
I see the mounting successes of pro-growth austerity laying the groundwork for an end to profligate fiscal policy – similar to how the Arab spring signals an end to authoritarian political regimes. Increasingly, other forms of economy are held accountable to the capitalistic standard, among the most prosperous in the world. If they do not perform at comparable levels, unrest is likely to follow.
For stock pickers, the current volatile environment is like a forge that steels the commitment to true value and melts away the temptation to run with momentum.
To survive the Euro crisis and the coming slow-growth environment, one must exercise great diligence in stock picking. The easy money days are coming to an end, and, now, we will see who has done their diligence.
Here is what my diligence led me to buy and short.
My fund owns Apple [s: AAPL], and I remain amazed that so few have focused on the most important driver of its stock price: the company’s 270% return on invested capital (ROIC). As detailed in “Apple Bears Have It Wrong”, Apple represents the best of corporate America because of its elite level of profitability. Apple generated enough cash flow to pay off its original investors 2.7 times in 2011.
At the same time, the stock is cheap and implies astonishingly low profit growth. At $570/share, the current valuation suggests that Apple will grow its NOPAT by only 30% In fiscal year 2012. Consensus for EPS growth is over 60% this year (2012) and around 15% for 2013. If Apple grows its NOPAT by 15%, compounded annually, for 3 years, the stock is worth north of $700.
I also like Exxon Mobil [s: XOM] and ConocoPhillips [s: COP], which like AAPL gets get my Very Attractive rating because of their positive and rising economic earnings and cheap valuations. Both stocks offer excellent risk/reward because of their excellent cash flows and the low expectations in their stocks prices. At $82/share, the expectations in XOM’s stock price imply the company’s after-tax cash flow (NOPAT) will permanently decline by over 40%. For COP at $51.30/share, the stock price implies the company’s NOPAT will permanently decline by nearly 70%. With valuations so low, investors have little to lose and lots to gain in these stocks.
Stocks to avoid or short are Delta Airlines [s: DAL] and US Steel [s: X]. Both of these stocks are sensitive to an anemic economic environment and are saddled with huge pension and debt liabilities. In “Bail Out of DAL”, I point out that an accounting loophole allows DAL to minimize the impact of its mounting pension liabilities on earnings. In addition, $26 billion in pension and debt liabilities means equity investors are at the end of a long line of stakeholders hoping for cash flows.
US Steel is in a similar situation except that it has yet to report an annual profit in recent history. Sure, 2012 started out pretty well, but I think few expect the rest of the year to be as good as 2012. Most economists are predicting 2013 GDP will be lower than this year’s. US Steel also has serious pension and debt liabilities. The pension issues are not apparent in EPS because of an accounting loophole. As detailed here, X boosted its 2011 earnings by increasing its expected return on plan assets assumption for its pensions to 7.79%, up from 7.75% in 2010, higher than 90% of all companies. Its pensions are underfunded by $5.2 billion. More details on X’s pension issues are here.
Disclosure: I own XOM, AAPL and COP. I am short DAL and X. I receive no compensation to write about any specific stock, sector or theme.