Issue #21

An interview with Joe on-the-Street.

Barnes Capital: Stocks were recently at all time highs. Most commodities are at all-time highs. Oil was over $90/barrel last week. Van Gogh paintings are selling for $10-$50 Million. Now Real Estate has busted, down 20%, but that’s after its 10-year sprint that created more wealth for more Americans than any other society has ever known. Joe on-the-Street: on the well heeled street want’s to know: Where should I save and invest my money?

Joe on-the-Street: Where should I put my money? Stocks, CD’s, Real Estate?

Barnes Capital (BC): Stocks are near all time highs?

Joe on-the-Street: Yes.

BC: What about your other costs? Are they at all time highs?

Joe on-the-Street: Why yes, most of them are.

BC: Gas?

Joe on-the-Street: Yes, it’s $3.50 a gallon.

BC: Dog Food?

Joe on-the-Street: No idea, it’s like $40 a bag.

BC: Food? Milk? Bread?

Joe on-the-Street: Hmm, my average Costco receipt has climbed $100.

BC: Plumbing?

Joe on-the-Street: What?

BC: How much did your recent plumbing repairs cost?

Joe on-the-Street: Well, let’s see, last summer we had all the faucets replaced, 4 faucets total, for $850. You see we got a discount off the regular price of $250 a faucet.

BC: Did that include the faucet.

Joe on-the-Street: No, just the install.

BC: Movies?

Joe on-the-Street: We went last Saturday with the kids, 4 tickets with hot dogs and popcorn ran $74.00

BC: Do you see the problem? Your costs are skyrocketing! We haven’t even talked about the other two killers: Health Care and Education costs. The point is, as the price of everything is going up, so will stocks. Inflation is running, depending on the authority, at something between 5% and 10% annually. I am not an economist, I won’t measure all the data, but just take a second to think about the recent increases in prices that you yourself have witnessed. A piece of redwood lumbar costs $40 bucks at the lumbar yard.”

Let’s Look at more examples:
Other examples A gallon of

	1970 prices	2007 prices
A gallon of milk	$0.66	$2
Loaf of bread	$0.40	$2.50
Postage Stamp	$0.10	$0.41
Gallon of Gas	$0.32	$3.25
California House	$30,000	$600,000

If the cost of most goods and services is going up, then all else being equal, the fractional ownership in corporate America ought to be rising to the same degree.
If inflation is running 10%, then stocks can climb 10%, without actually getting more expensive.

However, historically there is a correlation between rising inflation and stumbling stock prices. That’s a concern. Historically, stocks have traded down in periods of rising inflation (think the 1970s); because the stock is discounted by expected value of future cash flow. If inflation is high, than the value of future cash flow is lower because each new dollar isn’t worth as much. Think of it, a dollar in 1977 bought you a matinee movie ticket; today it only buys you 1/6th of a movie ticket.

Why? Because of inflation, so a company that is producing a dollar in 2007 of earnings per share is probably worth 6x as much as a company that produces $1 of EPS in thirty years from now.

Joe on-the-Street: “But if stocks across the world are outperforming, in a period of rising inflationary pressures, what gives? And it seems this weeks events indicate there is actually a lot of deflationary pressures from the housing bust.

BC: That’s what makes it tricky, we’ve got contradictions. Let’s explore one of the reasons for the contradictions.

BC: Let’s say you are an oil sheik. Your CFO reports that you will have $400 million in cash in the next 3 months after all taxes and capital projects and expenses have been paid.
“What do you do with the money?”

Joe on-the-Street: Put it in the bank?

BC: What Bank, you’re in Iran, do you want it in the local banks there?

Joe on-the-Street: I guess not, the government might nationalize them.

BC: Right. What currency do you want that money in?

Joe on-the-Street: I’m not sure, why don’t you just run through a bunch of my options if I am this Oil Sheik with an extra $400 million.

BC: Okay, great idea, let’s do just that:

Question: What does one do with an extra 400 Million?

10 Options

Option 1: Put it in a bank, lend it to other corporations.
This strategy will earn about 5-6% annually, with low risk. The problem is that if inflation really is 10%, a 6% return is actually a -4% real return. And if the currency you put it in declines, you’re your real return is even less. Since 2002 the US Dollar has depreciated an average of 4% every year against the world currency market. Remember Insight #14 Staying even . . . it isn’t easy.

Option 2: Put it in US Government Bonds.
Short-term, this strategy is the lowest risk. Expected returns of 4-5%. But Government bonds are subject to interest rate risk (rising interest rates because bond prices to go down. And the dollar can go down too.

On the flip side, buying government bonds and helps keep U.S. interest rates lower. By buying US Bonds, our Sheik is indirectly adding purchasing power and demand to his U.S. consumers, by helping to ensure higher demand for oil, and higher prices (and hence higher future cash flow to his oil operations). This is the rationale behind China’s massive purchases of US. Government Bonds.

Option 3: Get fancy.
Hire a couple investment consultants to find the best Hedge Fund managers. Pay those hedge funds a 2% annual fee, plus 20% of your investment return as a bonus. Expected return: “Who knows”, probably 12% less fees, so about 8-9% net return. Risk Level: higher than bonds, with maybe more, maybe less, uncertainty compared to stocks.

Option 4: Buy the world’s best companies.
(In other words: “Buy Stocks”) As a fractional owner of these companies, particularly US multi-national firms, your investments participate in global growth, there is no danger of civil unrest, seizure of your property. The managements generally are competent, and the barriers to entry for many of these companies, are the strongest in the world (procter & gamble, Citibank, Caterpillar, Johnson & Johnson, American Express, United Technologies, What’s more, these companies are enjoying good pricing pressure, and there is a lot more money out there facing the same situation, where to put the excess cash flow…

Joe on-the-Street: So what other alternatives does our Sheik have?

Option 5: Buy Gold
Downside: it pays no interest or dividend.
Upside: Gold is considered real wealth. It can’t be depreciated away like a paper currency, because there is no gold-mine that can be run like the treasury printing presses can. Since you can’t create Gold out of thin air, and nobody found a way to make alchemy work, Gold should maintain it’s value over time, through inflation, deflation, war, recession etc.

Option 6: Buy Local Stocks
Downside: your in the Middle East, the local companies are not-trustworthy, and the governments aren’t to be completely trusted either.

Option 7: Local Bonds
Downside: see local stock issues, plus interest rate risk

Option 8: Real Estate
Upside: this is usually good over the long term, but maintenance and upkeep costs can be high. And if it is raw land, that is non-interest rate bearing, and suspectible to legal and other liabilities.

Option 9: Expand your business:
Buy other operating companies,
Downside: this is a lot of work, with all kinds of operational risks.

Option 10: Buy Large Cap stocks
These entities are durable, returns over time should average return on equity of the entities, which provides for an inflation/interest rate hedge. Rising asset values stabilize the status quo, provide increasing leverage for a finance-based economy, and pay a 2-4% yield in many cases.

Joe on-the-Street: So what should I do?

BC: Invest a portion of your income every month. Work with an Investment Advisor who thinks outside the box, and is not compensated by commissions, but rather by a percentage of Assets. Compound your savings, reduce your debt, max-out your Roth IRA contributions, and don’t worry.

Summary
The last 4 months have been more volatile. But the long term trends that we have identified through out the year are playing out. Looking forward we expect equities to continue to climb a wall of worry. We are focused on good dividend payers and we continue to believe that diversified portfolios should include commodity and precious metals exposure. We continue to believe that fixed income securities are priced for very modest returns. We do however like the medium maturity municipal bonds for high net worth client portfolios due to their relatively high after tax returns.

The likelihood of a recession has grown in recent months, but we still believe that with Fed interest rate cuts, a real recession will be avoided, inflation will continue, and diversified clients with tangible assets and shareholder friendly dividend large cap stocks will be rewarded with real increases in wealth over the next few years.

Enjoying the Autumn air,
Daniel A. Barnes, CFA

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503.

This entry was posted on Wednesday, October 31st, 2007 at 12:24 am and is filed under Insight Newsletter. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.