A lot of us wish we could invest like Warren Buffett — and for good reason. Buffett and his partners acquired control of Berkshire Hathaway (BRK.A, news, msgs) in 1965. Since then, by taking positions in publicly traded companies such as McDonalds (MCD, news, msgs) and buying other companies outright, Buffett transformed Berkshire into, in effect, a closed-end mutual fund.

To say that shareholders in at the beginning have benefited mightily is a masterpiece of understatement. According to Forbes, Berkshire (Class A) shares were worth $15 apiece when Buffett took over the floundering textile manufacturer. The last time I looked, they were changing hands at $87,000 a share.

You can get in on the action by buying Berkshire Hathaway stock. Although, Class A shares will set you back the aforementioned $87,000,Class B shares (BRK.B, news, msgs) can be had for only $2,900 and change. Whats the difference? Not much. Besides representing less ownership, the only disadvantage of Class B shares is that you have limited voting rights compared to Class A shares.

Beyond Berkshire

But buying Berkshire shares may not be the best way to profit from Buffetts stock-picking wisdom. Heres why.

Buffett is your classic buy-and-hold investor and rarely sells. Consequently, Berkshires portfolio is stuffed with stocks bought years ago. For instance, Buffett added Coca-Cola (KO, news, msgs) in 1988, and its still Berkshires biggest holding. American Express (AXP, news, msgs), the portfolios second-largest holding, was added in the 1960s.

Its possible that Berkshires portfolio is laden with tired stocks whose best days are behind them. A close look at the performance numbers lends credence to that argument.

As of July 2004, Berkshire Hathaway shareholders had enjoyed a 16.1% average annual return over the previous 10 years, easily beating the S&P 500s ($INX) 9% or so annual return over the same period. But that 16% figure was no match for the blistering 31.7% average annual return that Berkshire racked up in the prior 10 years (July 1984 to July 1994). So while recent Berkshire Hathaways returns are still impressive, they are not keeping up with the earlier pace.

Also, Berkshires wholly owned company portfolio is heavily weighted with insurance stocks, making its performance susceptible to a downturn in that industry.

All things considered, picking stocks that a young Buffett would buy if he were just starting out today may be a better alternative than buying into Berkshires existing holdings. Here are some ideas about how you might go about doing that.

Get inside Buffetts head
Buffett hasnt yet written a book describing how he picks stocks, but he gives tantalizing hints in his Chairmans Letter that accompanies each Berkshire annual report. You can download the letters going back to 1977 from the Berkshire Hathaway site.

For best results, plan on spending some time getting familiar with Buffetts thinking through his letters or by reading a book on the topic. Countless authors have penned books purporting to describe Buffetts stock-picking strategies. Those by mutual fund manager Robert Hagstrom and by Buffetts ex-daughter-in-law, Mary Buffett, generally get the best reviews. Hagstrom’s most recent title is The Essential Buffett: Timeless Principles for the New Economy. From Mary Buffett, look for “The New Buffettology.”

Although Buffett trained under legendary value guru Benjamin Graham, he pays as much attention to a companys products, profitability, growth prospects and management quality as he does to valuation.

In a nutshell, Buffett strives to identify highly profitable companies capable of generating strong future earnings growth. To that end, he looks for companies with a sustainable competitive advantage, which, for him, usually translates to a strong brand name. Stocks such as McDonalds, Gillette (G, news, msgs) and H&R Block (HRB, news, msgs), all major Berkshire holdings, are examples.

Buffett doesnt look at analysts forecasts to predict future growth. Instead, he relies on the companys historical results. This requires an in-depth understanding of its business plan. He seeks out companies with strong management and demonstrated expertise in their industry. Conversely, he avoids companies that expand outside their area of expertise.

Ill explain in more detail as I describe a screen for finding stocks that a young Warren Buffett might find interesting.

The Young Buffett screen
Although he doesnt rule out companies currently experiencing rough times, Buffett insists on a strong profitability history. He relies on return on equity (ROE) to gauge profitability, but he also uses return on invested capital (ROC) to rule out high-debt stocks.

Return on equity is a companys net income divided by shareholders equity (book value). If you do the math, youll find that a company cant internally fund earnings growth faster than its ROE. For instance, a company with a 10% ROE cant grow earnings faster than 10% annually without raising additional cash by selling more shares or borrowing. Those are both no-nos for Buffett, who prefers low-debt companies that, if anything, are buying back shares.

Most money managers Ive talked to look for a minimum 15% ROE. Since Buffett is pickier than most, I upped that requirement to 17%. Try reducing it if you dont get enough candidates.

Screening Parameter: ROE: 5-year Avg. >= 17%

Watch return on capital
Because debt reduces shareholders’ equity, all else equal, a high-debt company would have a higher ROE than one with low or no debt. Return on invested capital (ROC) takes debt out of the equation by adding it back to shareholder equity before doing the calculation. If a company carries no long-term debt, its return on capital would be the same as its return on equity. However, for a high-debt company, ROC would be much lower than ROE.

I required a minimum 17% ROC to rule out high-debt companies. If you reduce your ROE requirement, youll also have to cut ROC by the same amount.

Screening Parameter: Return on Invested Capital: 5-year Avg. >= 17%

Profit margins
Buffett looks for companies with above-average profit margins. If youre rusty on your stock-market math, profit margins are not the same as ROE, which is a profitability ratio. Net profit margin is total net income (bottom line income after all deductions) divided by total sales for the same period. For instance, a company would have a 10% net profit margin if it earned $10 million on sales of $100 million ($10 million divided by $100 million).

In theory, the company with the highest net profit margin is the most profitable. However, for a variety of reasons, different companies in the same industry may be paying different income-tax rates, distorting the profitability comparison.

Using pretax margins in place of net profit margins eliminates that problem by using net income before deducting income taxes.

I emulated Buffetts penchant for picking the most profitable companies in an industry by requiring that a passing stocks five-year average pre-tax profit margin must be at least 20% higher than industry average.

Screening Parameter: Pre-tax profit Margin: 5-year Avg. >= 1.2* Industry Avg. Pretax Margin: 5-year Avg.

Valuation
Buffett values stocks using a gauge he dubbed owner earnings, which is reported earnings with noncash expenses such as depreciation and amortization added back in and capital expenses subtracted. Buffetts owner earnings is similar to the more familiar term free cash flow.

Buffett doesnt want to overpay, and the price-to-cash flow ratio approximates his approach to valuing stocks. I emulated how I think he thinks by specifying a maximum ratio no more than 80% of the industry average.

Screening Parameter: Price/cash flow ratio <= 0.8* Industry Average price/cash flow ratio

I also required a positive ratio to rule out negative-cash-flow stocks.

Screening Parameter: Price/cash flow ratio >=0.1

Debt
Buffett frowns on high-debt companies, but his definition of high and low varies with each industry. I use the debt-to-equity ratio (long-term debt divided by shareholders equity) to measure debt, and I require a passing stocks D/E to be no higher than 80% of the industry average.

Screening Parameter: Debt to Equity Ratio <= 0.8*Industry Average Debt to Equity Ratio

Management quality
Buffett emphasizes the importance of picking companies with great management, which can be a subjective exercise. But income per employee, which is a companys net income divided by its employee count, is an objective gauge of managements effectiveness. Generally, the higher the income per employee, the better the management. Im guessing that Buffett would likely consider a company that exceeds its industry average in that department by at least 10% to be well managed.

Screening Parameter: Income per employee >= 1.1* Industry Average Income per employee

I hope that these people are right and that we are coming out of the recession. There are fears of a “W” (not Bush) or a “double-dip” recession and these should not be discounted. But, we don’t really want the recession to carry on in any form; we really don’t want the risks associated with the down-side.

Even though we may be at or near the bottom of the recession there are still plenty of concerns to deal with. My continued concern is that the collapse in the economy was primarily due to a supply side shift and was not initiated by a fall in aggregate demand. This I have tried to capture in posts like my June 22 effort: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply. If the recession was, in fact, initiated by supply shifts then there are structural dislocations in the economy that need taking care of that cannot be satisfied by just increasing aggregate demand to put people back in the jobs in which they were formerly occupied. We cannot just return to factories that are only being partially used or have been cvacated. Trying to push things back to where they were just postpones the restructuring of the economy that needs to take place.

In the past twenty years or so, we, in the United States, have experienced two credit bubbles or credit inflations. These bubbles have created excess growth first in information technology in the 1990s and then in the housing sector of the economy in the 2000s. But, these credit bubbles were not just restricted to the United States.

There was a credit inflation throughout the whole world. Evidence of this has just been released in a report by Close Brothers Corporate Finance in the UK. (See “UK is Europe’s capital of distress” in the Financial Times: http://www.ft.com/cms/s/0/aba06ea2-758e-11de-9ed5-00144feabdc0.html.) The report claims that “The UK has western Europe’s highest percentage of financially distressed companies after being the leveraged buy-out capital over the past decade.” But, the report goes on to show that the credit bubble resulted in the serious collapse of the European manufacturing sector, as well as in the retail and leisure sectors. And, of course, there is the case of Japan in the 1990s and 2000s.

The problem created by credit bubbles or credit inflations (in addition to the excessive amounts of debt created) is that too much capacity is created in areas of the economy that cease to be needed any more once the bubble has burst. The normal response of the economy is to restructure so as to eliminate the excess capacity that exists and re-deploy resources into areas that are experiencing growth and development. A Keynesian effort to “pump up” aggregate demand is just an effort to re-employ resources in the same areas that formerly prospered but that now need to be “down-sized.” This does nothing to get rid of the excess capacity and postpones the restructuring of the economy. Furthermore it retains the misallocation of financial capital that evolved during the period of the credit inflation or credit inflations.

The drop in capacity utilization in the United States since the start of the recession has been extremely dramatic. Firms have gone from using about 81% of their capacity to using only 68%, a drop of 16%. This is the steepest drop for the longest period of time in the data series. But, even more important in my mind is that capacity utilization has been dropping steadily since 1967. Obviously, capacity utilization drops in periods of economic recession. Yet, in the United States, capacity utilization, after a recession, has never returned to the peak level it reached in the previous period of economic expansion.

Capacity utilization in the United States has been falling since the 1960s. This can be seen in the accompanying chart.

Although the United States has grown around 3% compounded annually over the last forty years and employment, through most of the period, has been at relatively high rates, there are still two pieces of information that are rather unsettling. The first is the continuing decline in capacity utilization just mentioned. The second is the decline in the civilian participation rate. For the United States, this rate peaked in the 1990s a little above 67.0% and has declined through the late 2000s remaining below 66.2% since 2004. This may not seem like much of a fall but it indicates that a lot of people have left the labor force!

The latter problem can be confirmed by figures from the Bureau of Labor Statistics. There are major sectors of employment in the United States that have experienced significant reductions in jobs and employment. These are in industries that one could seriously argue were in substantial need of restructuring. (I will return to this topic soon in another post.) The question is, should people to be pushed right back into these jobs again by a government stimulus program of increasing aggregate demand? Instead, it seems as if there needs to be a significant education of a large portion of the civilian population that would like to participate in the labor force again.

If there are structural problems in the United States and in the world that result from the existence of excess capacity in industries that are declining or less technologically relevant, shouldn’t we let these industries decline or try to become technologically relevant rather than stagnant? Should we try and keep people producing buggy whips when there are means of transportation evolving other than buggies?

So, to reclaim full economic health there is a need to reduce the excess capacity that has been built up in industries that are not so relevant any more and a need to deleverage financial structures. Unfortunately, a large portion of the needed financial deleverging is connected with firms that have excess capacity. Furthermore, there is a need to restructure U. S. manufacturing and business, and train more of the workforce to fit into twenty-first century jobs so as to get the labor participation rate up.

In my study of the Great Depression, this is one of the reasons why it took so long for the United States economy, and the world economy, to recover through the 1930s. The structural change in the United States taking the country from an agricultural society to an industrial society did not really take place until the beginning of the Second World War My concern is that the needed current economic restructuring will be delayed if Washington continues to focus on companies with redundant capacity by stimulating the re-employment of the same workers that used to work in them. The economic statistics (the leading economic indicators) may continue to improve in such cases, but the economic recovery will continue to languish.

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What Kind of Economic Recovery?

The company provides services to a broad range of commercial, industrial, utility and institutional customers. They report operations in six market segments: (a) electrical construction and facility services within the U.S.; (b) mechanical construction and facilities services with the U.S.; (c) U.S. facilities services; (d) Canada construction services; (e) United Kingdom construction and facilities services; and, (f) Other international services. The electrical construction and facilities segment involves systems for electrical power transmission; premises electrical and lighting systems; low-voltage systems, such as alarm, security and process control; voice and data communication; roadway and transit lighting; and fiber optic lines. Mechanical construction and facilities services include systems for heating, ventilation, air conditioning, refrigeration and clean-room process ventilation, fire protection; plumbing, process and high purity piping; water and waste-water treatment and central plan heating and cooling.

Consensus estimates for sales ending 12/09 are projected to be $7,246.88 million. Consensus EPS estimates for the same period range from $2.28 to $2.65.

Sales growth is 24.8% YOY and EPS growth is 45.1% YOY. The historical five year growth rate for sales is 8.4% and for EPS it is 13.2%. The company reported positive earnings surprises for the quarters ending 10/08 and 07/08.

At its recent price of $20.72, EME is selling at 7.9X next year’s estimated earnings. Operating margins have steadily expanded from 0.9% in 2004 to 4.2% currently. Similarly, net margins have grown to 2.5% from 0.7% in 2004. The company does not pay a dividend.

Our estimate of fair value is $29.97 to $48.96 with a mean value of $41.97. Using consensus EPS of $2.58, EME is valued at 11.6X to 18.9X earnings; the average fair value multiple is 16.27X earnings. The low end of our estimate provides a PRG ratio of 0.88, based on historical growth rate.

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EMCOR GROUP, INC. The Rebuilding Of America

To be sure, Fisher never advocated the use of price/sales as a stand alone indicator of value. It is just one tool to use when in conjunction with other tools to estimate a company’s value. The PSR is particularly useful when looking at a company without earnings as the more commonly used P/E ratio is meaningless.

According to Fisher, the underlying strength of the PSR, when compared with the P/E ratio, is its consistency or predictability. Earnings can fluctuate widely as we know today. Sales, on the other hand, are more stable. Sales also have the advantage of being less likely to be manipulated. Earnings are, after all, estimates based on accounting assumptions. They fluctuate with one-time expenses, write-offs and short-term changes in margins.

Fisher has been a long time contributor to where he has advocated the use of the Price/Sales ratio. In a 1984 article in Forbes, Fisher provided an important and frequently overlooked modification to the PSR. In this article he introduced what he called the “Debt Adjustment Factor.” As the name implies, Fisher found it necessary to adjust the PSR to reflect both short term and long debt. His DAF can profoundly effect our understanding of the basic PSR. For illustration purposes, we can look at some companies in the aerospace industry and compare PSR’s with debt adjusted PSR’s:

Company PSR Debt Adjusted PSR
Alliant Techsystems (ATK) 0.62 1.93
Boeing (BA) 0.46 3.29
Ceradyne (CRDN) 0.84 0.30
Honywell Int’l (HON) 0.63 1.98
Locheed Martin (LMT) 0.75 15.00

Fisher developed a range of PSR values to measure a company’s popularity in the market. The ranges vary by size of company and between high margin businesses and companies operating industries with inherent thin margins such as supermarkets. Accordingly, small growth companies are unpopular if their PSR is under 0.75 and very popular when the PSR is over 3.00. Similarly, companies with multibillions in sales, such as LMT mentioned above, are unpopular when their PSR is below 0.20 and popular when they are over 0.80. Thin margin businesses are unpopular at the 0.03 level and popular at 0.12.

While the PSR is a key factor in Fisher’s approach, it is clearly not the only factor to consider. Terrible companies can have a low PSR simply because the market sometimes recognizes a badly run company. The other things we need to consider are profit margins, earnings growth and free cash flow.

There is any number of ways to determine if a company’s common shares are priced for positive future returns. Fisher offers us an insight to one such method.

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The Price Sales Ratio Revisited

Standard and Poor’s rates TEVA as a strong buy with a target price of $56. This is based, in part, on S&P’s forecast of a 29% rise in sales for 2009 from the acquisition of Barr Pharmaceuticals, the introduction of new products and sales in new markets.

TEVA is selling at a lofty 65x trailing twelve month earnings of $0.78; 3.4x sales and 2.3x book value.

Quarter over Quarter, sales increased about 10% for the quarter ending 12/08. Sales for the TTM increased about 17.8% vs. TTM 1 year ago. These sales growth rates are substantially below the 5-year average of 27.6%

Earning per share for the most recent quarter crated by 227% vs. the 1-year ago quarter. Similarly, EPS declined 70% for the TTM compared with the prior year period. The 5-year EPS growth rate is -7.7%.

Gross margins for the TTM at 53.84% exceed the 5-year average gross margin of 50.89%. However, operating margins for the TTM period are at 10.33% as compared to the 5-year average of 16%. Net margins are down to 5.79% for the TTM period from the 5-year average of 11.7%.

Measures of management effectiveness also show deceleration. Trailing twelve month ROA, ROI and ROE are all below 5-year averages.

We agree with the analyst at S&P who considers TEVA a company with good prospects ahead. Generic drugs are definitely a growth market worldwide and TEVA has a strong product pipeline.

However, we disagree with his conclusions. In our assessment, TEVA is currently fairly priced in the $46-$47 range. We base our estimate on our evaluation of TEVA’s profitability, ability to generate free cash flow, and balance sheet adjustments for intangible assets and long term debt.

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Teva Pharmaceutical: A Fair Price

For over a year I have been arguing that more attention needs to be given to the supply side of the equation. Yes, the growth rate of real GDP has been going down and the rate of employment has been going up. But, the rate of inflation, as measured by the rate of increase of the GDP price deflator has not declined since the fourth quarter of 2007. If it were just a demand side problem, this would not be the case.

I focus on the rate of increase in the GDP implicit deflator because of some of the measurement problems associated with the Consumer Price Index, such as the treatment of housing expenses and energy. Certainly, the CPI should be watched, but in dealing with economic aggregates, I prefer the former.

My point has been that if the problems in the economy were all tied to a substantial fall in aggregate demand, then there should have been a more substantial lessening in the rate of price increases. Consequently, my argument has been that something has happened on the supply side of the economy for the numbers to have been reported as they have been.

I would like to point to two areas of the United States economy that indicates that the problems of recovery may be more difficult to overcome than if the dislocation in the economy were just one of inadequate aggregate demand. The first area is that of industrial output; the second area is the labor market.

In terms of the industrial base of the economy I would like to focus upon industrial production and the industrial utilization of capacity. Industrial production has been declining steadily since the start of the recession in December 2007. At that time, industrial production was growing at about a 2.0% year-over-year rate of growth. By April 2008 the year-over-year rate of growth had become negative. The figures for 2009 are
January -10.8
February -11.3
March -12.6
April -12.7
May -13.4

This certainly shows a continuing weakening in the economy. However, taken by itself I don’t think that it carries more meaning than does the decline in the rate of growth of real GDP which has been declining as well.

Combine this performance with the figures on capacity utilization and one gets a different picture. As expected, total industry capacity utilization has dropped substantially in this recession. In December 2007, the figure stood at a little over 80.0%. In May 2009, capacity utilization had fallen to about 68.0%. This is the largest 18 month decline in the post-World War II period.

But, this is not all. The peak in capacity utilization in the past ten years was only slightly more than the December 2007 figure. But, this peak of the last ten years was substantially below the level of capacity utilization for most of the 1990s which was below the peak utilization in the 1970s which was below the peak utilization in the 1960s. That is, it appears as if we have been using less and less of our capacity on a regular basis since the 1960s.

The structure of our industrial base is changing. We can see that in autos, in steel, and in many other parts of our manufacturing base. It appears as if the weakness in our economy is composed of two things: first the cyclical swing in business; but this weakness is on top of a secular decline in our productive ability. The economy is in the process of restructuring!

This shift is also showing up in labor markets. The civilian participation rate in the labor force for the United States rose from the late 1960s into the 1990s when it peaked a little above 67.0%. The civilian participation rate has declined since late 2000 and has remained below 66.2% since 2004. In terms of the number of people who are not participating in the labor market any more, this represents a large number. People have left the labor force in the last five or six years and this trend has, of course, been exacerbated by the recession. Over the past forty years the rise in the participation rate has slowed down or stopped during recessions, but at no time did it decline as it did in the in the past six years.

Of further interest, the Labor Department reported that separations from jobs in April remained relatively constant as they have for the past two years, but the rate of hiring continued to be quite low. In early 2008 the percentage of the labor force that were separated from their jobs was about equal to the percentage that were being hired. Since then separations have exceeded hirings, as might be expected, causing the unemployment rate to rise.

In terms of those that were separated from their jobs, there was a dramatic shift between those that quit their jobs and those that were laid off or discharged from their jobs. The percentage of layoffs and discharges rose dramatically from April 2008 to April 2009 whereas quit levels dropped substantially. That is, although separation rates did not change much at all during this time, the composition of those being separated from their positions experienced a tremendous shift. This is an indication that there is a structural shift in what is happening in the labor markets.

This information leads me to believe that there is a substantial restructuring taking place in the United States economy. And, a structural shift is a supply side issue and not a demand side issue. In fact, demand side responses can just make a bad situation worse by trying to force people back into positions that companies and industries are attempting to eliminate because the world has changed.

The figures on industrial production and capacity utilization seem to indicate that industry is changing and the numbers from the labor market reinforce that conclusion. Pumping up aggregate demand is an attempt to stop this restructuring or, at least, slow it down.

The problem that policymakers’ face is that they, or we, do not know what the new industrial structure is going to look like. It is impossible for anyone to know. People can make guesses, but that is all they are—guesses. And, in situations like this, it is more likely that the guesses will be wrong rather than being right. It’s just that the future is unknown. The need for the United States economy to restructure just adds another “unknown, unknown” to our list of “known unknowns” and “unknown, unknowns.” My guess is that this restructuring is going to take some time and could be sidetracked by huge government deficits and a supportive monetary policy.

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A Walk on the Supply Side

In the world of finance we can innovate and change and find ways to get around regulation. This has been the modus operandi of the financial system during my entire professional career. Consequently, the financial system of today in substantially different than the financial world that existed in the 1960s. I have called the last fifty years or so the age of financial innovation. Regulation and oversight of the financial system does have to change. But, we need to be careful about the change in regulation and oversight that results and not just give in to populist calls to “put a stop to the greed on Wall Street”.

The characteristic about finance that fails to be taken into consideration when people believe that they can “control” finance is that finance is about nothing more than information. Finance is numbers, nothing more, and numbers can be packaged in any way that a person wants to package them. On our currency we read that “This note is legal tender for all debts, public and private.” That is, people and governments can pay you for things in this script and you must take it. And, what more is a check, or a bank deposit, or a bond, or a stock certificate? In most cases today, these are nothing but 0s and 1s in a computer system. Finance is nothing more than information and how information is handled and transformed.

The unique thing about information is that it spreads and, as we have found out historically, information cannot be contained. Of course, its spread can be postponed or stymied for a while, but eventually its spread takes place. All human history is a record of this fact.

We see this trend also works in non-financial areas. Information relating to modernity and science and democracy is spreading throughout the world. In some areas this spread is being resisted by some who are attempting to keep the world mired in the ideas of the 7th or 8th century (C. E.) This attempt to prevent the spread of the idea of the modern world has resulted in violence and tremendous pain to many. But, the spread continues. It has all through recorded history. In the end, the resisters cannot stop it and their efforts to slow it down do nothing but cause unhappiness and dislocation.

The financial system over the past 50 years or so has been an engine of new creations. In the 1960s, we saw the movement of banks from being asset managers to becoming liability managers through the creation of instruments like the negotiable certificate of deposit and Eurodollar accounts. This broke down the geographical limitations on banks and helped them continue to evade government rules and regulations. In the academic world increases in computing power combined with the vast amount of data available on the stock market allowed for the development of ideas relating to portfolio management and risk control, which culminated in the creation of CAPM and the efficient markets hypothesis. A third innovation related to the growth and development of venture capital that put money into the hands of more and more innovators starting up small businesses. All of these developments had to do with information and how that information was bundled and traded.

In the 1970s we saw the development of the mortgage backed security, the junk bond, and the leveraged buyout. The creation of the mortgage backed security by the federal government was the test case for “slicing and dicing” up cash flows into tranches that could be packaged in ways that met the specific needs of different investors. And, as they say, the rest is history.

The development of the junk bond? The legend is that Michael Milken, sequestered in the bowels of the Lippincott Library of the University of Pennsylvania discovered information about the performance of “fallen angels”. These were high quality bonds issued sometime in the late 1920s or early in the 1930s whose companies had had financial difficulties. The bonds fell out of favor and hence yielded very high returns. Milken discovered that because of the lack of interest in these securities their actual performance substantially exceeded the performance exhibited in their market pricing. This information, which was confirmed by more current information, led Milken to develop the junk bond, the first such issue coming to market in 1976.

In addition, fund managers arose, like KKR, which discovered information concerning the value of assets that were on the books of many corporations. Often, these assets were undervalued because they were recorded at historical values and were substantially below current market values. Previously, these companies were “out-of-reach” of corporate raiders, but with the creation of the junk bond, all companies in the United States came within the reach of well-funded organizations. So, finance could now reach the largest, as well as the smallest, businesses.

This evolution, of course, continued into the 2000s. The point is that as information becomes available it can be used in many different ways to serve many different purposes. “Slicing and dicing” the information known as cash flows is not new, but is a part of a process that has a long history. And, due to the nature of information this process is not going to go away.

The Obama administration is now making its attempt to re-regulate financial institutions and financial markets. The proposal offered yesterday is much watered-down from what the “more progressive” wing of the political spectrum had wanted: its thrust is not sufficiently “Rooseveltian”. Still others express concern that the administration is going too far in some areas.

My take on the Obama proposals for financial regulation: it will make little difference in the end. Obama needs to take some kind of action and look like he is attacking the problems faced by the society. In the longer run the new regulatory scheme will make very little difference.

Financial innovation is going to continue. If some efforts are constrained in the United States, they will pop up elsewhere in the world. The incentives to innovate are still there. If we force the innovation to go off-shore, then we are, in my mind, the losers. This innovation will help others but provide little benefit to us.

What is needed? To me the most important thing that is needed is openness and transparency. We need to know what is being done and by whom. As derivative securities and hedge funds grew and prospered, we heard over and over again that they could not tell anyone what they were doing because, if they did, the narrow spreads they were working with would go away. Well, guess what! Most everyone knew what deals were being struck and the spreads went away anyway. That is why these organizations needed to use more and more leverage to take on riskier and riskier deals.

Highly competitive markets where there are few if any barriers to entry cannot continually provide exceptional returns. “Trading” is not the source of sustainable competitive advantage and keeping things secret will not salvage trading schemes. Openness and transparency will result in financial institutions focusing on what really creates competitive advantage and what is sustainable. This is necessary for the existence of a strong and healthy financial system.

Secondly, we need methods to close or put-out-of-business in a more timely fashion financial institutions that are troubled or are insolvent. Re-instating and improving mark-to-market accounting is a must. Increased openness and transparency should help the market place carry out this function, but, the regulatory system needs to have more FDIC-type efficiency to move quickly into institutions and shut them down. (The Federal Reserve is not the institution to do this. It needs to keep its focus on the conduct of monetary policy.) Moving quickly to resolve problems has always been the best policy. Managing institutions based on wishful thinking, a major trait of the banking system, is not a good policy.

We need financial regulation and oversight, just as we need periodic checkups and advice from doctors. However, there is only so much that regulators can do. Unlike our physical systems, our financial systems are going to innovate and change. My guess is that in the future with the continued advancement of information technology financial innovation will continue to increase rapidly and will serve as the model for more and more of our non-financial markets. “Information markets” is the model for the future. This innovation will, in one way or another, get around whatever regulation that is imposed. That is why openness and transparency is so important. But, that is also why the system of failure and bankruptcy should be enhanced and enforced. These, to me, are the major requirements we should impose on the financial system.

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Financial Well-Being and Regulation: the Obama Effort

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The company reported FY 08 earnings per share of $14.90 compared to $10.90 for FY 07, representing a 36.73% increase. EPS for the MRQ is reported at $3.55, down from $3.59 in the December 07 quarter. Sales are up 41.92% from $636.308 to $903.017 for the year. The five year growth rate for sales is 17.73.

Gross margins have expanded to $47.84%, well above the five year average of 29.01%. Net margins are hight at 46.77%, also well above the five year average of 27.33%.

Are these high growth rates sustainable? Current, fast-changing prices of agricultural commodities and fertilizers make it risky for farmers to invest in fertilizers. In many countries, it is anticipated that distributors and farmers will experience trouble in accessing credit to purchase agricultural inputs, including fertilizers. Where there are sufficient phosphorus and potassium reserves in soils, farmers are likely to rely temporarily on the reserves. Nitrogen should not be as greatly affected.

Nitrogen supply/demand conditions are tight, driven by strong nitrogen fertilizer demand worldwide. Production outages in exporting countries and delays in the commissioning of new capacity further tightens supply. World grain stocks remain at a record low despite two good consecutive harvests in 2007 and 2008. Projections by the Food and Agricultural Organization of the United Nations and the US Department of Agriculture point to a modest recovery in 2009.

We construct our estimate of TNH’s value by developing risk-adjusted capitalization rates for our estimate of free cash flow. The reciprocal of the capitalization rate is the Price/Free Cash Flow multiple.

Risk Premiums
Market Value of Equity 11.65%
Book Value of Equity 13.57%
5-Year Average Net Income 11.19%
Market Value of Invested Capital 2.78%
Total Assets 14.02%
5-Year Average EBITDA 12.23%
Sales 12.83%
Number of Employees 15.68%
Average Operating Margin 9.36%
Coefficient of Variation of Operating Margin 14.31%
Coefficient of Variation of Return on Book Equity 12.75%

Mean Risk Premium 12.76%

Projected Free Cash Flow per Share $35.04
Projected Average Valuation $274.61

Disclosure: The author has no financial interest in TNH

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Terra Nitrogen: Food for Thought

This is just one more piece of information that the banking system still has major problems.

This is the case even though banks are posting first quarter profits. The latest, Bank of America posted a $4.25 billion net income figure for the quarter. (See http://online.wsj.com/article/SB124021187032334351.html#mod26articleTabs%3Darticle.) But don’t get overjoyed: Apparently, excluding merger costs, Merrill Lynch contributed $3.7 billion to the posted number which included a $2.2 billion gain related to mark-to-market adjustments on certain Merrill Lynch structured notes. The results also included a $1.9 billion pretax gain on the sale of China Construction Bank shares. What does this mean? I don’t know. Who has any trust in the financial reporting of banks anymore!

What information do we have that indicates that the banks still have massive problems? Let me suggest several bits of information that add up to an exceedingly weak banking system.

First, let it be noted, again, that the Monetary Base, the aggregate money figure that is defined as all bank reserves and anything that can become bank reserves (currency in circulation) has doubled in the past year (97.5% increase year-over-year using non-seasonally adjusted data). This measure was increasing at a 2.0% annual rate in August 2008.

The in-bank component of the Monetary Base, Total Reserves in the banking system, in March, was increasing at a 1,722% annual rate (again, year-over-year using non-seasonally adjusted data). We have never seen figures like this before!
In August 2008, the annual rate of increase was -1.0. Yes that is a negative one percent year-over-year rate of increase.

And, what are the banks doing with these funds?

They are holding onto them!

Excess reserves in the banking system (non-seasonally adjusted) were right at $2.0 billion in August 2008. These are funds in the banking system that are just sitting idle on the balance sheets of banks in the banking system—not earning interest or anything. In the banking week ending April 8, 2009, excess reserves totaled $724.6 billion.

Let me put this in perspective. On September 4, 2008, the assets of the Federal Reserve System totaled about $945 billion. So, in the first week of April 2009, the banking system was keeping, in cash, a little less than the total amount of funds that the Federal Reserve had put into the banking system in the first week of September 2008!

If I look at the Federal Reserve Release H.8, I see that commercial banks in the United States, non-seasonally adjusted, had Cash Assets on their balance sheets in March of $915 billion, again quite close to Federal Reserve assets in early September. One year earlier these banks had Cash Assets of only $300 billion, so Cash Assets rose by 205% in the past year.

Now, the total banking system, in aggregate, is lending some. Total bank credit outstanding rose at an annual rate of 3.2% from March 2008 to March 2009. Within this category, Commercial and Industrial loans rose by 4.3% and real estate loans rose by 4.7%. Consumer credit rose by about 9.0%, of which credit card debt rose by 13.0%. So lending in these categories were increasing, but not by major amounts.

The interesting thing to note, security lending—Federal Funds lending and Repurchase Agreements with brokers—dropped by a third, -33.0% and Interbank loans remained basically flat. Banks reduced their lending to other financial institutions, including other banks, during this time period. Talk about risk averse.

The major story that these data tell is that commercial banks are afraid to lend, especially to their own kind. Delinquencies continue to rise, write-offs continue to rise, and banks continue to increase the provision they set aside for future charge-offs. The banks have gone back to lending only to those that don’t need to borrow, the way banking used to be. They are afraid to lend to anyone else and they are still uncertain about the value of the assets that they already have on their books.

This situation is not going to change overnight. There is not much that the Federal Reserve can do if banks won’t even lend to banks!

We see that “U. S. May Convert Banks’ Bailouts to Equity Share.” (See the New York Times article, http://www.nytimes.com/2009/04/20/business/20bailout.html?_r=1&hp.) Still the question remains, “How deep is the hole in bank balance sheets?” We cannot provide the answer to this. Ultimately, the bankers, themselves, will have to provide that answer, and my guess is that bank lending will not start to pick up again until these bankers have that answer.

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The Banking System and Bank Lending