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World Economic Tug of War

While it may be a bit presumptuous to say that the US economy is still the “epicenter” of the world economy, given that some of the developing countries, especially China continue to grow, albeit slowing, more than the US, the US is still the #1 powerhouse and force in the world economy. Therefore, it is still valid to consider this “epicenter” and it’s current health. However, as world economies become increasingly interdependent, we must more than ever consider the complex interactions between world economies in order to more completely understand the big picture.
The checks and balances, both within the US economy and between the US and other economies, remains quite interesting. The US economy has been expanding for over 5 years, which has caused the US dollar to appreciate significantly vs. other currencies during this time. Naturally, when this happens for a long enough period of time, US-made goods become more expensive for foreign buyers, which ultimately puts a cap on US growth, allowing other economies to grow in relative terms.
While the time has not yet come for another US recession, especially considering that gas prices at the pump may remain low for an extended period of time as some predict, the relative health of the US economy should remain intact at least for the next few months. Consider that lower gas prices during the 4th quarter of 2014 alone translated into a whooping $130 BILLION in savings for consumers, much of which will drive consumption growth for goods other than gas. Add this reality to the fact that non-US consumers will continue to invest in the US, it will only further prop the US economy and stock market, if only because the US remains the best, brightest, and safest market for investors.

The Relationship between U.S. Inflation and Overseas Markets

Overall inflation in the US is currently running at about 1.5%, still less than the 2.0% target that the Federal Reserve shoots for. Fairly or not, many equate a decrease in inflation enough to cause deflation, with a recessionary environment or economy. While low inflation is not in and of itself bad, when it gets too low it provides less room to avoid a spiraling effect towards deflation in the event some sort of macroeconomic shock occurs. The problem becomes more complicated as the US economy becomes more dependent on the world economy. True, while slow and plodding, it is generally agreed that the US economy is on the mend. However, the specialized calculus as determined by different economists can sometimes result in confusing results when different estimates of the relevant factors are used in the equation. This is why the stock market has been behaving in a more volatile way recently, with large swings in valuation even within a 1 day period.

More directly, what situation would we be in if inflation dropped a mere 0.5%, due to multiple threats overseas such as a possible slide back into recession by Europe, coupled with a decreasingly inflationary environment in China, the so called “manufacturer to the world”.

It is also unclear, given the different strategies employed by the Fed by multiple attempts to stabilize the economy over the last 6 years, what the Fed can effectively do if called-upon to act once again. Our lives in some ways have never been more complicated, to the extent that the macroeconomic forces impact each of our microeconomic lives.

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Corporate tax inversion revisited

Whether US companies are admitting it or not, as long as they place their priorities on satisfying their shareholders, they will continue to look in all corners either make more money or save more money.  This is the reality.  As a result, more and more companies have at least attempted to do this by trying to acquire foreign companies, followed by moving their headquarters to the foreign country, often a company in the UK, which happens to have a lower corporate tax rate.  This process is called corporate tax “inversion”.  Since our blog posting in late April of this year, the attempted inversion by Pfizer to buy AstraZeneca as been rejected, but other large US companies are attempting to do the same thing, such as AbbVie’s attempt to buy the Irish company Spire, and Walgreen’s attempt to buy the Swiss company Alliance Boots.

If too many companies are successful with inversion, it will likely exacerbate the public debt problem in the US, while spreading the tax burden to fewer players.  The only realistic solution is to lower the corporate tax rate ASAP, as the UK did a few years ago, before the problem gets worse.

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US IRS continues to lose battle to effectively tax corporations

Many corporations (and all corporations set up under Subchapter S of Chapter 1 of the IRS code) are not taxed.  And for those that are taxed, many pay much lower than the maximum 40% tax rate.  In fact in 2011, the 10 most profitable companies paid an average tax of just 9%

US law disallows taxation of US company profits overseas.  In the 1990’s several US companies moved to tax havens such as Bermuda and the Cayman Islands, a maneuver called “self-inversion”, to reduce their tax burden.  Since 2004, tighter US regulations have done away with this practice.

Since 2004, US companies have looked for other ways to reduce the taxes that they pay, typically with the approval of shareholders.  One of the most popular ways is through a process of “inversion by merger”, whereby for example, a US corporation merges with a corporation which resides in a foreign country that has lower taxes than the US, followed by moving the newly created holding company to the foreign country.  This has been done several times over the past several years, which effectively moves dollars previously taxed and collected by the US to remain in the pockets of the foreign company and it’s shareholders.  The most recent example of an attempted “merger by inversion” in the news is the attempt by US-based drug company Pfizer to buy/merge with UK-based AstraZeneca.

Inversion activity is a symptom of problems in the international tax system that needs to be addressed.  At the very least, vague or nonspecific language in the current regulations such as requiring the company to perform “substantial business activities” in the foreign country, should be clarified in order to create a level playing field and to improve fairness to all countries in international tax reform.  However, the news is not all bad for the US IRS.  For example, there are still instances where it is advantageous for a US-based company to repatriate funds from overseas to the US, such as for reinvestment in the US.  A recent example is the US e-commerce company EBay, which recently said it will bring as much as $9 billion back into the US, which will create an additional $3 billion tax charge.

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Featured stock Q1 2014

Featured stock:

An example of a high quality equity which we have recently included in our portfolio is as follows:

Microsoft (MSFT)

The Geneva Group Model recently confirmed inclusion of Microsoft (MSFT) for another year in the model.  MSFT gained 40% including dividends for the year from mid March, 2013 to mid March, 2014, doubling the 20% gain for the market index S&P 500 (SPX).  Over the last 2 weeks, MSFT has gained an additional 8% vs. no gain for SPX.  These outsized gains were obtainable due to the Model’s ability to identify stocks which are poised to outperform the market a priori, in addition to using a classic, time-honored “buy low” strategy.

MSFT in recent years has shown a notable ability to reinvent itself in order to maintain the success of the past as technology changes.  This ability will insure that MSFT will continue to maintain it’s status as one of the most consistent revenue growers in the market.  In fact, MSFT has been able to increase revenues in each and every year of it’s existence, with the only exception being the “Great Recession” year 2009, when revenue decreased a mere 0.6% from year 2008.  MSFT successfully reinvents itself by evolutionary rather than revolutionary change, more recently by the introduction of it’s successful X-box consoles for gaming aficionados.  MSFT has recently changed leadership at the top by the appointment of Satya Nadella, who is promptly leading efforts to strengthen the presence of MSFT in the cloud.  The term “cloud” is in reference to cloud computing, which is a way to provide easy, scalable access to computing resources and IT services.  MSFT will benefit from a combination of “Platform-as-a-service” (Paas) and “Software-as-a-service” (Saas) portions of the cloud, whereby the end user will be able to store and potentially use it’s ubiquitous Office products from anywhere.

Today MSFT disclosed a new version of it’s Office software for use on an iPad.  Compared to it’s Windows  and other products, Office has generally produced most of the profits for MSFT.  It has been estimated that MSFT will be able to grow annual revenue by more than $1 billion for Office on the iPad (fiscal yr 2013 revenue was $77.8 billion).  Much of this is expected to come from new sign ups of Office 365, which is an online version of Office that consumers and businesses rent and install on their computers, rather than buy.  As MSFT continues to reinvent itself in an evolutionary way, investors and consumers alike will continue to benefit.


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Did Facebook overpay for WhatsApp?

Last week, Facebook announced that they were buying the instant messaging company WhatsApp for $19 billion.  Where does this valuation come from, and does it make sense for Facebook to buy WhatsApp?

One way to evaluate WhatsApp is based on the price for each and every user, which with 450 million users works out to $42 per WhatsApp user.  Therefore by this measure Facebook bought WhatsApp at a premium to what Facebook bought Instagram for last year (close to $30 per Instagram user), suggesting that Facebook believes it can ultimately make even more money with WhatsApp than it can with Instagram.

But is Facebook properly evaluating any of the companies it buys based on price per user?  Will WhatsApp ever earn $42, or even $30 for each and every user??  Maybe or maybe not, considering that just last week, the Japanese firm Rakuten bought a similar messaging app named Viber for only $9 per user, a greatly different valuation for this messaging firm which is centralized in Japan.  To be fair, there are unknowns such as whether the average Viber user is worth more or less than the average WhatsApp user, how well the respective companies can gain and retain users, the savviness, creativity, and ingenuity of company management to monetize it’s users, etc..

It appears that Facebook, while having the luxury or a large cash stash and getting brownie points forbeing  bold, is giving WhatsApp a lot of credit for future success.

Obamacare and the effect of it’s implementation on health care stocks

It is estimated that in 2014, as many as 30 million new people will be able to purchase private insurance on the federal or state regulated exchanges.  With a current population of about 317 million people living in the US, this represents a nearly 10% increase relative to the current population.  While cost savings will surely be wrung out of the system, we expect that a significant portion of this additional 10% will show up as additional earnings and profits by many of the companies represented by the health care industry, including hospitals, large pharmaceutical, and biotech companies.  And while the sickest segment of the population will continue to be heavily burdened with high medical costs, it is advisable especially for this segment to overweight their portfolios with health care stocks over the next 2 years so that the costs incurred can be at least partially offset by gains made by the health care companies.

Natural gas boom continues


Interest remains keen in natural gas production from shale reserves in the US.  In fact, as the map above shows (red areas), North America has more assessed basins of shale oil than any other region of the world, leading some to believe that future shale oil and gas production and exports will lead the US to economic prosperity.

As we reported in 2012,” lower natural gas prices are creating a structural economic advantage for the US, and is becoming a new competitive strength for U.S. manufacturers. Companies who purchase energy in Asia pay up to six times as much for natural gas as their counterparts in Texas and Louisiana.  Significantly, low U.S. natural gas prices should encourage an expansion in U.S. natural gas exports, especially once LNG terminals go online starting in 2014 and 2015.”

With the cost of natural gas remaining at a historically very low level, the process of exporting compressed natural gas  is becoming a reality.  For example, in May, 2013 the Obama administration approved a $10 billion facility in Freeport, Texas,  previously a second facility was approved at Sabine Pass in Louisiana, and  a third facility recently obtained conditional approval (Dominion Resources) at Cove Point, Maryland.  Exports are expected to begin in 2017 and 2015 respectively for the approved facilities.  In all, another 18 applications to export gas are being reviewed, indicating that this new business promises to be a very significant growth driver of the US economy.  Indicative of the magnitude of this industry, the approved facilities are each expected to export at least about a billion cubic feet of liquefied natural gas per day.


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Featured stock Q4 2013

Featured stock:

An example of a high quality equity which we have recently added to our portfolio is as follows:

CBRE Group (CBG)

CBG is a play on the recovering US and Global real estate market.  On Dec. 23, 2013, CBG announced that it has finished it’s $480 million acquisition of Norland, a best-in-class provider of technical engineering services for commercial buildings in the United Kingdom and Ireland.  CBG is a well-managed company that has seen double digit revenue growth in the latest quarter, much better than competitors in the slowly improving global leasing market.  This indicates that CBG is doing a good job choosing and managing growing properties, while  leaving underperforming properties alone.  We think CBG will continue to outperform the market over the next 12 months, CBG has thus far doubled the performance of the market since it entered the model portfolio on Dec. 18, 2013.

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