A Challenging Global Outlook for the Next 50 Years

The above is never something I would venture to take a stab at, but GMO's Jeremy Grantham has made a name for himself by making bold predictions about the future. His latest quarterly letter, entitled "On the Road to Zero Growth" is one of his best, in my opinion. A highly recommended read if you are interested in a 16-page article characterized by a lot of economic jargon. Granted, it makes a lot of sense and was written by someone who has been right an awful lot over his multi-decade investment career. Just thought I would share the link. Enjoy!

Chipotle: A Lesson in High P/E Investing

Shares of Chipotle Mexican Grill (CMG) are falling more than 90 dollars today after reporting second quarter earnings last night. Revenue rose 21%, with earnings soaring 61%, beating estimates of $2.30 per share by an impressive 26 cents. However, light sales figures (same store sales of 8% versus expectations of double digits) are causing a huge sell-off today. This is a perfect example of what can go wrong when investors rush into stocks that are very expensive relative to their overall profitability. Any hiccup results in a violent decline. And this really isn't a hiccup except relative to lofty expectations. If you simply read the press release and ignored the analyst estimates, you would conclude the company is absolutely printing money at its restaurants. Unit-level margins approaching 30% are pretty much unheard of in the industry.

The problem is that prior to today's drop, CMG stock traded for a stunning 59 times trailing earnings. Even using this year's projections gets you to a P/E of 45x, more than 3x the S&P 500 multiple. Even a meaningful earnings beat can't help investors with the bar set so high. Today could very well be a buying opportunity if one believes in the long term growth story at CMG, however, with the P/E still sitting around 34 on 2012 earnings, it is definitely not cheap enough for value investors to get interested.

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Full Disclosure: No position in CMG 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

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. :) 

Sokol's Lubrizol Trades Sure Look Illegal, And Buffett Needs To Change Berkshire Hathaway's Internal Trading Policies Immediately

I would not go as far as some people have and suggest that Warren Buffett's Berkshire Hathaway has lost its way, but there have certainly been some developments in recent months that should give people pause. First, a young, unknown investor is named as one of Buffett's likely successors, and now we learn that one of the firm's most highly regarded internal candidates has resigned from the company over what appears to possibly be insider trading accusations.

After looking at the timeline of events surrounding Berkshire's discussion to acquire Lubrizol (announced March 14th) and Sokol's trading in the stock while he was serving as the point person for those talks, it is hard to argue that Sokol's trades are not illegal. Not only that, it appears that Berkshire Hathaway has no internal controls regarding how managers trade stocks they may have inside information about, which is also troubling. Although it is reasonable to assume that high level people at the company should know what would fall under insider trading and what would not, given the fact that Berkshire's main source of growth is through acquisitions, the firm should have a specific personal trading policy in place for all of its employees. If anything, to avoid situations like this, where it appears that Sokol made a big mistake and Buffett is pretty much defending him by saying he didn't see anything wrong with the trades.

So why is it most likely insider trading? According to a timeline of the Lubrizol deal compiled by the Wall Street Journal, Sokol met on behalf of Berkshire Hathaway, with their investment bankers (Citigroup), on December 13th. At this meeting the two parties discussed a list of 18 companies that the bankers had put together as a possible deal targets for Berkshire and Sokol told Citigroup that Lubrizol was the only company on the list that he found interesting.  Sokol also told them to contact Lubrizol's management to inform them of Berkshire's interest in exploring a possible deal.

At that point it should be obvious to anyone, including Sokol, that he and the bankers are in possession of material, non-public information. Sokol has decided that Berkshire Hathaway would like to explore the possibility of buying Lubrizol and he has instructed his bankers to inform Lubrizol of their interest. It is painfully clear that a deal could result from these discussions, and only a few people are aware of these private plans. Now remember, this meeting occurred on December 13th.

So when did Sokol first buy Lubrizol stock for his personal account? On December 14th. Seriously? Seriously. Sokol bought 2,300 shares of the stock the day after telling Citigroup to call them and express interest in a deal. Interestingly, Sokol sold those shares on December 21st. He didn't wait very long to buy them back though. During the first week of January Sokol bought 96,060 shares of Lubrizol. Lubrizol's board met to discuss the interest from Berkshire Hathaway on January 6th and Sokol met with Lubrizol's CEO face-to-face on January 25. The deal was approved on March 13th and announced March 14th. The purchase price was 30% above where Sokol bought the stock for his own account.

Not only is Sokol going to have trouble on his hands here, but Buffett's reputation is also on the line. Even though Warren didn't know about these trades as they were happening, the very fact that Sokol is allowed to trade in the same companies that he is looking at as possible acquisition targets for Berkshire Hathaway (and at the same time!) screams of lax oversight.

Large Brokerage Firm Recommendations Performing Poorly, Again

Another piece of data supporting the idea of contrarian investing, this time from Bloomberg.

The money quote:"

Companies in the Standard & Poor's 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest "buy" recommendations gained 165 percent, according to data compiled by Bloomberg. Now, bank favorites include retailers and restaurant chains, the industry that did best in last year's rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits."

Least Surprising Prediction for 2011: Wall Street Strategists See Market Rally of 10%

According to data compiled by Bloomberg from twelve of Wall Street's largest investment banks, strategists expect the S&P 500 index to rise by about 10% next year, which would mark the third straight year of double-digit gains for U.S. stocks. Their figures, based on operating earnings in the low 90's for the broad index, equate to a year-end P/E of about 15 times, in-line with the market's historical average.

Investors well-versed in market history may not feel like these predictions are all that interesting. After all, the market averages a 14-15 P/E ratio over the long term, and the mean return for the S&P 500 since it was created is about 10% per year. These Wall Streeters are clearly not going out on a limb with these estimates, which is hardly surprising given their nature to hedge their bets in an effort to protect their jobs (by rarely differing very much from the consensus view).

Since consensus viewpoints typically will not make us money, it is helpful to think about whether the odds are that the market does better or worse than these predictions. Personally, I would guess the odds are better that we see single digit returns in 2011, as opposed to a better-than-expected gain. I say that because P/E ratios are unlikely to rise given that interest rates are headed higher. Couple that with the fact that analysts consistently overestimate forward earnings growth (by a factor of nearly 2 times). A long term study by the consulting firm McKinsey has found that long-term earnings at public companies grow by about 6% per year on average, versus projections by industry analysts of 10-12% heading into any given year.

All in all, U.S. stocks are far from overvalued, but with strong earnings growth in 2011 already expected and a ceiling on multiples seemingly close by, returns in the year ahead should be decent but not fantastic, especially given that we are coming off two above-average years in a row for the U.S. stock market.