Instead of boring everyone with more discussion about the fiscal cliff, I thought I would take an opportunity to provide some insight into how investment professionals actually find investment opportunities and the difference between investing and speculating. Apple provides us with that wonderful opportunity.

Apple is one of, if not the most, successful companies in the world. Over the last five years they have grown earnings at a rate of 62.2 percent per year, and that is during the “Great Recession.” Imagine what they could have done in a good economy. They have the hottest smart phone on the market, the number one tablet computer and on and on.

There is a cliché on Wall Street that says great companies make lousy stocks. The reason for that is because most great companies have all their greatness priced into their stock. Usually great companies sell at large premiums to the market in terms of their price-to-earnings ratio. For example in 2004 when it was clear that eBay would be a successful survivor of the tech bubble, they sold at a price that was in excess of 100 times their current earnings. eBay has done well as a company, much as expected, and their stock is currently selling at around $50 per share, a full $7 per share less than their 2004 peak. Great company, lousy stock.

Many people assume the same is true for Apple, but they simply are not looking at the reality. Apple is currently selling for 12 times its earnings. To put that in perspective, the S&P 500 sells at almost 17 times its earnings. In other words the price for an average company today is 17 times earnings, but one of the greatest companies on the planet sells for considerably less? How could that be?

Part of the answer is in investor psychology. While Apple’s stock is cheap by just about any measure, it looks expensive because Apple has not split their stock. Apple hit its peak of a little over $700 per share earlier this year and a lot of smaller investors get nervous about that large of a price tag, after all what stock is worth $700? This is a classic case of perception trumping reality. The share price is a mere accounting function, determined by how many shares the company wishes to have outstanding. Apple could have split the shares 10 for 1 and every shareholder who held one share at $700 would now hold ten at $70. The reality is the same – the same percentage ownership of the company, the same total value. However, had Apple split its stock and the price tag appeared to be $70 vs. $700 I would wager that the stock would have jumped significantly. After all a company like Apple should be trading at a large premium to the market, not its current discount.

As it was the stock peaked at $705 and has been in a downturn ever since. This started most likely because of simple profit-taking; Apple’s stock sold for as low as $380 per share just a year ago, so some investors were sitting on hefty gains. No doubt this activity was exaggerated by the threat of higher taxes on investment gains next year. Then the “technical analyst” started talking about how awful Apple’s chart looks and the fall continued. For those who are not familiar, technical analysis sounds very sophisticated but it is nothing but the tracking of prices to attempt to find patterns which indicate the future direction of prices. Academics hold technical analysis in approximately the same level of regard with which they hold witch doctory. It has a dubious record as there are no actual investors who credit long records of success to its practice, but it does one thing well: it turns investors into speculators, making otherwise rational people buy and sell stocks like riverboat gamblers. That is good for business, which is why almost all technical analysts work for Wall Street firms. There is no such thing as a buy-side technical analyst.

The technical witch doctors are assisted in scaring people by Apple’s stock price. The drop from a $700 price to a $500 price is much more compelling on CNBC than a stock that dropped from $70 to $50. Of course in reality those are the same thing and the stock that dropped from that level can get back there just as quickly, but the perception of investor fear is far greater with higher numbers.

In the meantime, as Apple’s stock price drops the company itself is doing fantastically. Just this past weekend they announced selling two million iPhone 5s in China on the day of its launch; the most optimistic analyst we saw thought they would sell four million in the first quarter and they did half that the first day. They still have lines around the world for their products and they have a brand loyalty that is second to none.

Speculating is guessing which way a stock’s price will go next week and I would guess that technical analysis is as good at doing that as any other similar method – the magic 8 ball, darts, dice, etc. Investing, on the other hand, is about buying things of value at a good price and waiting patiently for the value to be recognized. Benjamin Graham defined investing as follows, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.” That safety of principal was found in what he called the margin of safety, which is the difference between an investment’s actual value and the price. We calculate Apple’s actual value at more than $1,000 per share, assuming 18 percent growth over the next few years, down from the 62percent growth they have had over the last five years. Don’t just take our word for it; many sell-side analysts have price targets ranging from $800 to $900 per share. That is a huge margin of safety.

Of course we could be wrong; there is always risk in investing. Apple may suffer a complete collapse like other companies of the past, but if that possibility – however remote – did not exist, then the opportunity would not exist. The thing about margin of safety is that it is at its highest precisely when the perception is the opposite, otherwise the price would not be so low and the margin would not exist.

Owning Apple directly is not appropriate for everyone. We do own it in many clients’ portfolios and it is a large holding of several mutual funds, so most of our retirement clients have indirect ownership. That is not the point here. The point is to start to learn what an investment opportunity looks like when it happens. Apple is it.

Chuck Osborne, CFA
Managing Director

~Investing, Speculating, and Apple

Happily we go straight to the cliff. Will we go over it? If so, will we go way over, or will we just dip into January to get that dropping sensation in our stomachs before pulling the parachute cord?

The fiscal cliff is all anyone talks about these days. The market seems confident that a deal will be done. I’m not sure why, as nothing that has been shared in public has been very reassuring. One theory is that politicians are actually not in a hurry because the market has not signaled desperation. That leads to some interesting circular reasoning: the markets stay relatively calm, putting faith in politicians who end up doing nothing because they have faith that the market would signal a real need to act.

Perhaps even more puzzling is the fact that consumer sentiment is at a five-year high. I saw a projection from one economist who believes unemployment will go to 11 percent if we go over the cliff, and of course as we wrote last time, the first effect of the cliff will be increased taxes out of consumers’ January paychecks. Consumers also seem to be going all-in on our government coming to a solution, and I fear their faith will be one more excuse for our politicians to delay. If the consumers aren’t worrying, then why should politicians?

It certainly is a curious time. The market did begin to act as we thought it should immediately after the election, then it decided to go up nearly 4 percent over Thanksgiving. Usually moves like that are ignored by investors because it was on anemic volume over a holiday week, and one assumes the professionals will be back at work the next week and will correct that false optimism. Thus far that has not happened.

Most of the talking heads have been saying that they believe the market will pop big when a deal is announced in Washington. We think that is probably true, but what happens if a deal is not forthcoming? It appears that option is not even being considered. We think this phenomenon presents one of those binary moments when only one of two things is going to happen: a deal will get done and the market will go up dramatically, or a deal won’t get done and the market will drop dramatically. We prefer to err on the safe side of that bet.

Either way we will get beyond the cliff and when we do, there are beginning to be some bright spots. Housing is truly improving and the economy grew faster than originally believed in the third quarter. Economic weakness in Europe has had one silver lining in that reduced demand for commodities has eased the pain at the pump for many consumers. Earnings growth in the third quarter has settled to -0.9 percent, according to FactSet, which ends an eleven-quarter streak for positive growth, but this is better than the almost 3 percent drop that was expected. Revenues, on the other hand, did disappoint with 59 percent of companies missing estimates, so don’t get too excited just yet. Still it feels like it has been a long time since there has been anything positive to talk about so I am seizing the moment.

The bottom line is that all eyes are on Washington until we either go over the cliff or come to an agreement. It is time to be nimble and hope Santa brings us something good for Christmas and not a lump of coal.

One final note. Our political class is, by and large, more opportunistic than idealistic. Of course there are exceptions, but for most politicians the unwillingness to compromise comes not from core values but from the knowledge that doing so will be used against them when they run for re-election. If you really want our leaders to work together, which requires compromise on both sides, then you might consider letting your elected officials know that by shooting them an email or phone call. If you do so and they follow that lead, then we should do everything in our power to make sure that they don’t get punished for it in the next election. Food for thought.

Chuck Osborne, CFA
Managing Director

~Someone Must Know Something I Don’t

Are we headed over the “fiscal cliff” or will our politicians come to an agreement? Your guess is as good as ours, but as there is at least some chance we could go over the cliff, we should spend some time understanding what that would actually mean.

The first impact that most of us will feel from the fall is the loss of the so-called “payroll tax holiday.” For those who don’t follow every tax we pay very closely, the payroll tax is probably better known to you as FICA, or your Social Security and Medicare contributions. For the past few years we have been contributing 2 percent less than we are supposed to into these entitlement programs. Abby Phillips, in an article for ABC News online, says this will mean on average an extra $672 in taxes for people making between $40,000 and $65,000 per year. For higher wage earners it will mean on average an extra $1,135 in taxes.

The second blow comes from income tax hikes, which will impact tax withholdings with the first paycheck of the New Year. Of course it has been well-publicized that the top rate will go from the current 35 percent to 39.6 percent, but in addition, just about everyone will see about a 3 percent increase. Phillips estimates that the average earner in the country making between $40,000 and $65,000 will see an increase of $888 in income taxes. Add that to the payroll tax increase and you are talking about an increase of $1,560.00 for the average American, which will begin to hit paychecks in January.

After these initial blows we will see the impact of the taxing of investments. Dividends will be taxed at ordinary income instead of the current 15 percent rate. Remember dividends are corporate income that has already been taxed at the corporate rate, so this additional tax is icing on the cake for Uncle Sam. This means that for every corporate dollar earned and paid as dividends, the shareholder in the top tax bracket will receive approximately $0.39. Add to that the new health care tax and it drops even further.

Long-term capital gains tax will go up as well, from 15 percent to 20 percent plus the 3.8 percent health care tax. This is one that makes little sense. Capital gains represent voluntary income; one must sell an asset in order to realize a capital gain. If people believe the rate is too high they simply refuse to sell. Warren Buffett assures us that this is not the case, but he is mistaken. Warren will not change his investing behavior, nor will any of his professional investing friends. We will not change either, but that is because rational investors are not going to allow the tail to wag the dog. I have written newsletters on this subject, and for good reason: most retail investors are not rational, and a known tax hit is too hard for them to stomach regardless of how much better other investment options may appear. Others are actually being rational because the capital gain would not only create a tax hit on their investment return, but actually would put them in a higher tax bracket, or worse yet, subject them to the Alternative Minimum Tax (AMT).

In addition to the tax hikes government spending will be cut, especially spending on national defense. The sum of it all points to lower spending by consumers due to lower take-home pay, coupled by less effective distribution of capital as investors will be less willing to realize gains for tax reasons. This will hurt retailers and small businesses the worst, followed by companies with government contracts. In other words: recession here we come.

This all could be at least partially avoided with political compromise, and there have been some positive signals from Congress in that regard. However, until an actual deal is crafted, the cliff remains a possibility. Our best guess is that a stop-gap solution is found followed by more comprehensive tax reform in 2013. That would be much better and at least alleviate the immediate hit on consumers, but it still creates a difficult environment for business leaders to make future plans. Economic activity is likely to be slow in the beginning of 2013 even in the best case scenario.

This brings us to our national holiday. These are difficult times but we still have much for which to be thankful. As is our tradition here is my list.

1. I am thankful that the United States of America is, with all of our issues, still the best place to live and invest within the developed world.

2. I am thankful that I can still run a half marathon even if it does take a little longer than it did when I was in my twenties.

3. I am thankful for my family, immediate and extended.

4. Of course I am still grateful for Mama’s pumpkin cheesecake and my loose-fitting pants that make the enjoyment of said cheesecake possible.

5. Last but certainly not least, I am thankful for you, our clients and friends of the firm. Your trust in Iron Capital is our greatest asset and we value you every day of the year.

Happy Thanksgiving!

Chuck Osborne, CFA
Managing Director

~Over The Cliff?

My guess is that there is only one positive outcome all Americans can agree on as a result of last night’s election: no more political ads…until the next time anyway. Now that all the theatrics are over it is time to get back to reality.

I was surprised last night not to hear any exit polling on whether voters are aware of the looming fiscal cliff. I am not suggesting that awareness would have necessarily changed anything, I am just curious – after all, I am an analyst at heart. I hope voters are aware, because it is serious and it must be dealt with immediately.

It may come as a surprise for Americans to wake up today and realize that there have been things happening in the world during the last few weeks other than storms and elections. GDP growth came in at 2 percent, which was better than expected. Unfortunately when one digs into the numbers you see that 0.72 percent of that growth was due to increased government spending, mostly a 13 percent jump in military spending, which looks to me like stockpiling ahead of the draconian cuts coming from the fiscal cliff. That leaves real GDP growth at approximately 1.3 percent, which is still better than we expected but extremely weak, and if I am correct will mean a drop in future military spending as this stockpile of supplies is drawn down even if the fiscal cliff is avoided.

Yesterday the pharmaceutical benefit company Express Scripts reported earnings. They beat expectations but cautioned analysts that next year’s earnings estimates are too aggressive, citing the weak economy when pressed for rationale. Analysts seemed legitimately surprised, and the stock got hammered. What seems strange to me is that sense of surprise; we get the same data as everyone else, and I don’t understand how people do not recognize the lack of economic activity.

Perhaps it is the housing data, which is the one true bright spot in the economy. However, some are behaving as though housing is going to now return to 2005 levels, and that is not going to happen.

Consumers are also more optimistic, although consumer sentiment is almost always a backward-looking indicator: consumers are usually the happiest when the economy has peaked, meaning that things have been relatively good but are about to get much worse. Likewise they are the saddest when the economy bottoms, meaning things have been bad but are actually about to improve. In other words, consumers are almost always wrong. Today I believe that is doubly true, because it is hard to understand optimism in the face of an enormous tax increase. My guess is that most Americans simply have not realized that their take-home pay is about to get significantly reduced come January 1 if nothing is done to avert the fiscal cliff. Either that or they are very optimistic that our leaders will reach a compromise by year-end.

Don’t get me wrong, I hope that optimism is well-placed. However, in my business it pays to hope for the best but plan for the worst. Investing is about making decisions today about the future, which is by definition unknowable. As a result we must deal in the world of probabilities. There must be some probability that no compromise is to be had and that we will indeed go over the cliff. This brings us to last night. The irony is that after billions of dollars spent on ads we are all glad to never see again, we have sent basically the exact same split government back to Washington. The guys who could not agree on anything for two years are now the ones we trust to avoid fiscal disaster. I fear the probability of going over the cliff has been greatly increased.

Beyond the fiscal cliff there is hope. Long-term valuations are reasonable and that is ultimately what drives results, but we must get over this cliff. Caution remains in order.

Chuck Osborne, CFA
Managing Director

~Now What?

What should we think about last week’s jobs report? As I am sure most of you have heard by now the official unemployment rate is finally below 8 percent at 7.8 percent, according to the Department of Labor’s Bureau of Labor Statistics. Since the release of the report the talking heads on CNBC have become screaming heads, and people such as the former Chairman and CEO of GE, Jack Welch, have accused the Administration of fudging the number for political reasons.

For the record, I do not believe there is any grand conspiracy to fudge the numbers. The problem with conspiracy theories is that they assume two things: competency and the ability to keep a secret. It would take an unbelievable amount of skill to fudge the numbers and actually get away with it, with hundreds of economists, market strategists and reporters checking every detail of your work. Then it would take an inhuman amount of humility not to have one person involved “tweet” it out to the world or update his Facebook status to read, “Just fooled America into believing unemployment is getting better.”

With all respect for Mr. Welch’s business career, the conspiracy theory just does not hold water. However, I understand the reaction; something strange happened in last week’s data and it was not just the unemployment report. For those like us who follow economic data daily, there seemed to be a pattern developing: starting around May the formerly mixed economic data started to be all negative. Manufacturing especially fell off the cliff. The Empire State manufacturing report was horrible. Shippers from Fed Ex to Norfolk Southern have warned on earnings, twice in the case of Fed Ex. The August jobs report was horrible. The only “good” data was coming from housing and frankly all that means is that we finally seem to have hit a bottom.

Then out of the blue came the Institute for Supply Management’s (ISM) manufacturing survey which showed a modest expansion in manufacturing activity, especially in new orders. This was taken as a big positive since the expectations were for continued slowing. After that we received another ISM report on the services sector that once again was better than expected. Then, finally came Friday’s big news about the unemployment rate. What has happened?

It seems to us that only one of two things could be occurring. One possibility is that we, and most other market watchers, have been wrong about the economy and we simply had a summer break in activity and now we are back to work. The recent data could support this outcome and the return to 2 percent growth – still slow, but better than the 1.3 percent of the second quarter and the seemingly even slower activity in most of the third quarter.

The other possibility is that these reports are statistical blips caused likely by the looming fiscal cliff. When one digs into the employment numbers, there were 114,000 jobs created in September. The population grew by 206,000, so jobs created obviously did not by itself lower the unemployment rate. What lowered the rate is that revisions added approximately 800,000 jobs of which approximately 600,000 appear to be part time. This is why the “underemployed” rate remained the same at 14.7 percent.

So we have a sudden increase in manufacturing orders,orders and a large increase in the number of part-time employees – many of whom are typically temporary. If I were a procurement officer in the Armed Forces and saw the cuts coming to my budget next year should the fiscal cliff not be averted, I would be stock-piling. If I were a civil servant with projects to be done I would be doing everything possible to get them done by year-end, including hiring part-time and temporary workers. In other words this could be a natural reaction to the impending fiscal cliff.

How will we know? We believe the answer will be found in third-quarter earnings reports and company forecasts. If things are as bad for companies as we previously believed, then it is likely that these improvements are illusionary blips. If, on the other hand, companies surprise on the up-side, or more importantly report signs of improving activity, then this may be a real improvement. We hope for the latter but the prudent course is to be prepared for the former. With the International Monetary Fund announcing yesterday that the risk for another global recession is “alarmingly” high, that unfortunately seems like the safer bet.

Chuck Osborne, CFA
Managing Director

~Figures Lie and Liars Figure