Tuesday, September 25, 2007


Yesterday, I received a fair question. What happened to the airlines? One fellow was kind enough to note that his Google and Garmin are at record highs but he is in the hole on more than half of his airline shares. I took a look and his QLD has done quite well also but then I have to admit that I have been aggressive on CAL, aggressive for good long term reasons.

The casual observer thinks that airline shares were down hard because of a modest tweaking of guidance at AMR. AMR reports that non fuel costs will be slightly higher this quarter and that revenue growth will be slightly slower. Sure enough, some analysts cut AMR's estimates from as much as $1.04 per share to $.66 per share. This was a bit much, especially considering that the company corrected the figures a bit later in the day to say that cost per mile would come in at $11.98 versus the $12.06 that the analysts were using. Even so, the cost figures were up and the spread between AMR's cost and the costs at CAL, NWA and DAL has grown.


It has become clear that Congress is going to practice a game of "rope-a-dope", also called Chinese Water Torture. As we all know, it is difficult for congress to complete a budget on time. The US fiscal year begins on October 1 and none of the 12 budget bills have been passed. There is little budget discipline to be seen anywhere in the process. For example, the Senate is just about through hammering out the defense appropriations bill and it is loaded with about 300 amendments that do not relate to defense in any real way.

The old "Christmas Tree" game is being played. In this game, one member agrees to support the goodies wanted by another member and another and another until they can cobble together a voting block and attach what has traditionally been called "pork" or "pork barrel spending" to bills that "must" pass. Today Congress calls pork barrel spending "ear marks". Politicians from both sides of the aisle work very hard at "winning these goodies" for their home states or districts. Get a large enough group together and a real government boondoggle will be passed.

A good example of a boondoggle is the corn ethanol subsidies. By agreeing to build 200 small refineries in 200 different counties across the country, enough votes were added to the farm belt votes and to the "environment-at-all-costs crowd" to pass the very wasteful ethanol fuel program.

The way the "rope-a-dope" strategy is going to work is that Congress will drag out the budget process until the November 16 adjournment date and perhaps even into a "recall" session in December. Congress will send Bush bills for him to veto. Then they will send him a continuation bill. Even the continuation bill will not be "clean". If the government gets closed down for a day or night, they will act again but try to blame Bush for the closure. All the while, horse trading will continue; a vote for this will be traded for a vote against that. Of course, subsidized "health care for the children" and attempts to cut off funding for the troops will be trotted out again and again.

In case you are too young to remember, "rope-a-dope" was the strategy used in a famous boxing match 30 or so years ago. The one fighter covered up and allowed the other to hit at his arms and gloves. The blows were largely reflected by arms and gloves and eventually the hitter wore himself out. Congress is going to try to wear Bush out. Bush will have to veto spending deals that include "goodies" for all the districts before the budget is finally passed. The Democrats hope that they can gradually offer the right combination of "goodies" so that they can peel away enough votes to over turn a Bush veto.

The "heath care for poor children bill" has lots of supporters even though it extends Medicaid to families making $85,000 per year and even though it adds to the mess of Medicare and Medicaid. The strategy of the Democrats is like a sacrifice pawn move in chess - by loading the health care system up with inefficiencies it is believed that the whole system can be scrapped in exchange for a comprehensive government plan.

Hillary's latest plan is far better than the one she attempted to pass more than 10 years ago but it is still a "take-from-some-to-give-to-others government confiscation". In her plan, those who are young and those who take care of themselves are forced to over pay in order to subsidize those who are slothful.

The analogy is constantly drawn to the area of auto insurance. It is said that just like all drivers are required to carry auto insurance, we must all be forced to buy a certain kind of health insurance. I agree that a lot of folks drive up the cost of medical care by not carrying insurance and then going to the "free" emergency rooms to get very expensive care for non-emergencies.

However, the analogy to auto insurance only works to a point. Individuals can choose to carry only liability auto insurance and even then only a base level is required by law. More importantly, those who drive carefully pay much less than those who are repeatedly caught speeding or violating other traffic laws. In the Hillary plan, the young guy who eats properly and exercises pays far more than his fair price while obesity is subsidized.


Both the house and the senate passed bills to fund an important upgrade to the air traffic control system. Of course, as usual, the Democrat majority passed a bill that would increase taxes and one that would continue to force the major airlines to pay for an extra large share of the system. Like the subsidized heath care for the obese, they would give the corporate jet fleets a major break; small jets now pay only 3% of the cost of running air traffic control systems but they consume 16% of the services provided. In one way this is no big deal but when day after day thousands of passengers are delayed, routinely by 30 minutes or more and sometimes by several hours or even days, as a result of waiting on small jets to clear, the problem is real. As always, when the government sets the price, great harm is done to some while others are given great gifts. The Soviet Union fell apart for the very reason that central planning is wasteful; markets are the most efficient means to set price.

Charging set rates for FAA services is similar to what has happened in NC to the highway system. In the old days, all the gasoline tax dollars were used to build roads. In order to have great roads, NC citizens went along with one of the highest gasoline tax rates in the country. Many years ago, Governor Hunt, who had preschool education as a priority, started finding ways to take money from the highway trust fund. The annual "withdrawal" is now around $175 million per year. Not a huge amount in terms of state government but enough to service the debt to build about $3.5 billion worth of roads.

Over the years, NC roads have suffered and the current governor is pushing to build toll roads. Of course one idea behind toll roads is that of a user fee. Another idea is that politicians tend to want to raise revenues (taxes) and they can because the government knows how to spend money better than the market place.


The old saw that a camel is a horse designed by a committee contains truth about collective wisdom; folly follies when "group think" wins. On the other hand, the wisdom of the crowd has been proven time and time again in markets all around the world. Markets are not perfect but they are far more perfect than are "group think" asset allocations.

The following is an example to show the wisdom of the crowd. If a large number of people are asked a question about which they know little they will tend to offer an average answer that is better than the one derived at by a committee. Specifically, if 10 to 1000 city folk at the fair are asked to guess the weight of an large animal, it does not matter if it is an elephant or a jersey cow, the average guess will be very close to the right answer. The more people that guess, on average, the closer the average guess to the actual weight. However, ask a group of 10, 20, 30, or more to get together to choose one best guess and the wisdom of the crowd goes away. The dominate members of the group pull the group toward their guess rather than toward an average estimate.


Congress has passed continuation funding for the current air traffic control system. Three months worth! The huge sums of money spent lobbying Congress for the past several months is simply not enough! Give the passengers sitting on the tarmac three more months to soften them up! In the mean time, AMR and its unions will have their own little slug fest. AMR is the only major line to have made it through 9/11 without filing bankruptcy. The AMR pilots took big cuts in pay to "save the airline". After bankruptcy, DAL, NWA and even UAUA have lower cost structures in place. The pilots are in the unenviable position of asking for their wages back even though they are already earning more than most other pilots. They are asking for wage increases of more than 30%. I doubt they will get more than 10 or 12% but the fight is on. The lowering of guidance by AMR yesterday was probably related to the negotiations ahead. This is one of those times when the airlines are accounting for every expense they can find.

CAL just put an extra $50,000,000 into its pension plan. As I recall, the accounting on pension deposits is a complicated mess but all in all I suspect that CAL was able to lower its current earnings by some portion of this addition and the prior ones made.


The cash hordes being built by the major carriers tells my story. Until sentiment turns and the "feel good factor" boosts these stock prices, the "accounting game" can hide a lot of stuff but the billions in unrestricted cash says a lot. One might guess that these cash hordes will be used to fend off a hostile takeover but we all know that financing the purchase of a company is much easier if the company to be acquired holds lots of cash. One might argue that the cash will be used to buy new planes but in reality planes are usually leased or acquired with long term financing.

A couple of weeks back, Alaska Air announced a share buy back. It seems that the wisdom of the stock buy back might finally be spreading to the airline business. The pay negotiated at AMR will effect all the other carriers but once a deal is done, a share buy back announcement by any major carrier could be the catalysts to sentiment change. CAL is currently selling at around 7 times trailing earnings and 5.7 times forward earnings; boost these numbers to the market average and you get a jump in share price from $30 to $80 lickity split.

Of course, the change in sentiment is not the whole story. A buy back of shares will increase the earnings per share. The normal roll over that will take place in the oil market over the next few years will also result in higher earnings per share.


CAL has quickly added a lot of flights to its new hub. Many of these flights are on "feeder sized" planes. The big jets will still be used to leave the hub for profitable long haul flights.

If you do not appreciate just how much growth there is in international business, take a look at the recent action by Google. Google will partner to put a new communications cable beneath the Pacific Ocean. Google will gain access at cost rather than the current extra high Pacific rates. These rates have been pushed up because demand is great relative to available space. A fellow on one of the business shows said it well last night. He notes that just because the world has been blessed to be able to bring a few hundred million Chinese out of poverty over the past 20 years it does not mean that we should forget about the 2 billion others. He says the globalization story is still in the early stages. There is no doubt that air traffic is growing most rapidly within the borders of China and India but US International Carriers will get a fair share of the traffic that spills out to the rest of the world.


Being of virtue is tough. Patience was never my strong suit. However, in regard to market moves, I have had to learn to wait, wait, wait, wait, wait and wait some more. The current situation takes my memory all the way back to the summers of 1982 and 1974. In each case, waiting for the market to make its big move was like waiting for paint to dry. The 1974 time was more exciting than the summer of 1982 but not in a good way. In 1982, most of the shares I purchased just sat there. They did not keep going down much but it seemed that the start of the "big bull" would never come.

This time we have had a number of fits and starts. For example, it was late July of 2006 when value lost its momentum to growth and when small lost its momentum to large. Even so, value stocks and small stocks keep making surges. Our QLD has made us happy but the last dip was large and the recent very strong run has just now put us back close to a new high. An upside break out from here would probably run-up another 15% pretty quick but who can time the market? We are left with the charge to be patient. Congress will eventually get its work done and the odds are good that no major new taxes will be passed. The drain to the markets will not be great enough to kill this bull.


One thing that will help you be patient is to recognize that right now, bad economic news is actually good news! With T-Bills trading at 3.75%, it seems that the FOMC will need to cut the Fed Funds Rate by another 50 basis points pretty soon. Big Ben and company many feel the need for cover. Bad economic news would do the trick. If personal spending slows or if there is an increase in unemployment claims, the FOMC may have all the ammunition it needs to give the patient another high powered electrical jolt.


One of the funny things is how short sighted prognosticators can jump to the long term view at just the wrong time. We all understand that those who want to be negative can always find a reason to do so. In the case of lower interest rates, the negative always jump on the risk of higher future inflation. While it is true that if interest rates are too low for too long, the economy is likely to overheat and there is likely to be inflation, but that process does not happen in days, weeks or even months. The immediate effect of lower interest rates IS LOWER INFLATION!

The decline in the cost of money from 5.25% to 3.75% is a tremendous price reduction. For many a business, it is like a 28% cut in the cost of raw materials. TV pundits seem to love to talk about the decline in home prices and inflation in the same breath. Again, those who are looking for "bad numbers" can find them or they can make them up. When the price of gasoline was rising, inflation was terrible. Now, with the price of gasoline back down to $2.62, it is the price of oil that is the problem.

The facts of life today include that each and every day a large number of people stop paying for certain magazines and newspapers. These folks have found that the Internet provides all the news they need. The marginal cost of this Internet news source is ZERO! The price of the newspaper falls from 50 cents to ZERO! The law of substitution lives and breathes. The bottom line is that publishing a newspaper online is far more economic that physically printing a newspaper. My old boss, the President of Legg Mason Wood Walker was fond of saying, "In the long run, economics wins!"


Put all of Grandma's CD's into just a few big stocks such as GE, MSFT and WB and she will do well. She will no longer be on a fixed income as her profits will grow over time.

Be sure that the grandkids own Google in what I call an ABC portfolio. My only grand child owns APPL, BIOGEN, CAL, Dell, Etrade, Google and Sprint. We plan for her to own the rest of the alphabet before too long. We pay no mutual fund fees and no commissions except for the initial purchase. The educational value for her to own small quantities of so many companies is worth more than the millions she will eventually earn. We live in freedom! We are blessed beyond measure! Praise the Lord!