“Come on, let’s twist again, like we did last summer,

Yeah, let’s twist again, like we did last year.
Do you remember when things were really humming’? 

Yeah, let’s twist again, twisting time is here.
A round and round and up and down we go again.”
-Chubby Checker ‘Let’s Twist Again’ 1961

Ben Bernanke must be nostalgic for his childhood.  On June 19^th in the summer of 1961, when Chairman Bernanke was only 8 years old, Chubby Checker released his smash hit, Let’s Twist Again.  Almost 51 years later to the day, on June 20^th, Chairman Bernanke took what must be his favorite record off his shelf of policy tools, and pressed play.  What the world heard was “Let’s Twist Again.”  Chairman Bernanke, citing decreased inflationary concerns and heightened employment weakness, announced that “Operation Twist,” which had been set to expire at the end of June, would be extended until the end of the year.

As a refresher, “Operation Twist” is the fancy name the Fed has been using for flattening the yield curve.  They are using the Fed’s balance sheet to purchase long-term government debt from the market, while selling shorter maturity bonds.  The purpose of this song and dance routine is to ease without printing more money, and without expanding the Fed’s balance sheet, thus avoiding the inflationary pressure associated with quantitative easing.  By reducing yields on long-term bonds, Bernanke is effectively accomplishing two things: First and foremost, the Fed is enabling those in need of long-term capital to raise it at cheap rates, thus inducing economic activity; a secondary result is that the lower yields on Treasuries push investors even further out on the yield curve, inducing those with capital to take on more risk to achieve desired returns.

We do not envy Chairman Bernanke’s position.  He must walk a fine balance between managing economic growth and fighting off the specter of inflation.  Bernanke stands watch with his hands on the metaphorical panic button, controlling interest rate policy and the dollar printing presses.  Inflation and deflation always hang in the balance.  If inflation were to increase too rapidly, or deflation were to set in, our tenuous economic recovery would quickly see its end.  In this regard, the U.S. stands at the edge of a precipice, and for the past few years, the Fed has stood at the ready as a last defense against letting the economy deflate.  Mr. Bernanke has had to innovate and expand the central bankers’ toolkit, and has arguably done a commendable job fending off deflation despite a backdrop of consumer deleveraging.  

However, Bernanke’s excellent deflation defense (low interest rates, Quantitative Easing, Operation Twist, etc.) comes at a cost.  While increasing expectations of future inflation have not yet showed up in the data, my sense is that all the various easing policy tools must inevitably lead to future inflationary pressures at some point.  The best analogy I can offer is that of pulling on a rubber band.  One can pull on the band and stretch it only to a point.  Little warning comes before it snaps.  Bernanke can only twist the economy so much, before we collectively suffer a sprain. 

In May of 2010, Professor John Cochrane of the University of Chicago Booth School of Business (shameless plug of my alma mater) gave a lecture entitled “Inflation, Deflation and Debt.”  I highly suggest readers go and watch the lecture via iTunes U for free.  Cochrane makes a compelling case for long-term government debt serving as an effective buffer or dampener of inflation.  The reason: if inflation expectations increase, the market value of long-term bonds will decrease before inflationary pressures cause the value of real goods and commodities to rise.  If there is a loss of capital on the bonds, spending power evaporates, helping to ameliorate the inflationary pressure of too many dollars chasing too few goods.  If the government is only rolling over short term debt, their prices can’t decline, and all the pressure goes into current inflation.   By this mechanism, Operation Twist, that is the Fed’s action of taking long maturity debt out of the marketplace, will increase the severity of an inflationary shock in the future. It’s like saving money by not buying fire insurance.

It is currently my belief that of the two potential grisly fates out there for the U.S. economy, inflation is the greater risk than that of deflation.  It is the shared belief here at Corby that the most likely development over the next decade is increased inflation, though in the short-run we may see a period of deflationary pressure, such as what we are currently experiencing.  The rationale is simple: the Fed has a dual mandate to maximize employment and stabilize prices.  Bernanke does not want deflation – primarily because wages are much more sticky or inelastic than the prices of goods.  When prices for goods go down, the likely outcome is layoffs, as it is much easier for say, Ford, to lower the price of a car, rather than get an employee to take a salary cut.  And the solution for deflation is simple – all the Fed needs to do is print more money or lower interest rates. 

The Fed may be ever weary of inflation, but it does not seem worried about it currently.  Common logic is that there can be no real uptick in inflation if the economy is not at full employment, there is no wage growth, and there is a housing overhang.  Check, check, and check.  Whether or not the underlying presumption is true, it appears that the Fed agrees that deflation is the bigger risk at the moment, and has acted accordingly, as demonstrated below.

U.S. M2 Money Supply

The chart above shows that over the last year, the M2 money supply has gone up by 9.36%.  This measure is generally what is used by economists to quantify circulating money.  This increase of the money supply is often erroneously pointed to as “wealth erosion,” achieved by the Treasury through the printing of new dollars.  So the obvious question I hope you are all asking yourselves is, “If there are 9.4% more dollars in circulation, why do I keep hearing that inflation is below 2%?” 

The short answer is that inflation isn’t being felt because the velocity of money has SLOWED.  The U.S. consumer is currently engaged in debt deleveraging.  Individuals and corporations, learning the lessons from the past decade, are saving more money to self-insure.  The concern is, will the Fed be able to properly recognize when consumer attitudes change, and adjust monetary policy accordingly? 

 

 

M2 Money Supply, Velocity of Money, and S&P 500 Index, 1982-Present

 

As you can see in the chart above, the velocity of money (green line) is currently at multi-decade lows.  In fact, you’d have to go all the way back to 1972 to get a reading as low as what it is currently.  The significance is that the same dollar is now moving more slowly through the economy than it did at the turn of the millennium.  To me it is a clear indication that we do not have a truly healthy economy on our hands.

You Can Run, But You Can’t Hide From Inflation

Inflation, the economic apparition that gives you chills at the gas pump, but can’t be seen in the official data, is the Grim Reaper of investment returns.  Just like all ghosts, it seemingly lays-in-wait behind every turn, ready to chomp into purchasing power and investment returns.  However, it is rarely seen, and those that proclaim its arrival soon find themselves discredited by the level-headed establishment. 

Earlier, I mentioned 1972.  While there are many similarities between 1972 and 2012, which I will likely elaborate further on in future newsletters, suffice it to say that in 1972, we also had a sitting president up for reelection.  He had inherited an unpopular war, and was first elected amidst a U.S. recession.  He expanded public welfare programs in an unprecedented way, and even started a class warfare of sorts against a high profit industry (at the time, believe it or not, it was the steel industry).  Determined to prevent another recession and to increase his chances of getting reelected, he pressured the Fed to lower interest rates, and in the year leading up to the 1972 election the M2 money supply grew a startling 13%.  That year, President Nixon carried all but one state in his reelection bid.  The problem is what happened thereafter.  By 1973, annual CPI inflation had ticked up from roughly 3% in 1972, to 9% in 1973, and 12% in 1974.  If you had buried your savings in the backyard at the end of 1969 and dug it up at the end of 1979, you would have likely found that you could only buy half as much stuff with it.

I don’t know when and if inflation, and the higher interest rates that come with it, will turn up.  I also can’t say with certainty which sectors of the economy will most feel the impact.  In the 1970s, the heaviest impact reverberated in the energy sector, compounded by the concurrent oil embargo.  My best guess is that this time around, inflation is much more likely to show first in agricultural goods.

However, while history doesn’t necessarily repeat, it does rhyme.  Considering that deflation is the lesser long-term risk, if only for the reason the Fed seems apt to prevent it, I thought it would be a worthwhile endeavor to take a look at what asset classes fared the best throughout the last spurt of inflation in the U.S. 

Investment Returns 1969-1979, assuming you invested $1,000 in each strategy at the end of 1969

	Small Caps	Large Caps	LT Bonds	ST Bonds		% Change in CPI
1969	$1,000	$1,000	$1,000	$1,000
1970	$835	$1,041	$1,127	$1,065		5.6%
1971	$989	$1,189	$1,324	$1,111		3.3%
1972	$982	$1,416	$1,397	$1,154		3.4%
1973	$584	$1,207	$1,417	$1,233		8.9%
1974	$410	$888	$1,495	$1,331		12.1%
1975	$696	$1,219	$1,622	$1,408		7.1%
1976	$1,077	$1,512	$1,802	$1,480		5.0%
1977	$1,314	$1,402	$1,818	$1,555		6.7%
1978	$1,607	$1,493	$1,742	$1,666		9.0%
1979	$2,314	$1,774	$1,900	$1,840		13.3%
10Yr Return:	131%	77%	90%	84%		104%

Source: Rare Investing http://rareinvest.blogspot.com/2007/12/investing-in-1970s.html.  Author Larry Bleich and Bloomberg.

There are two important takeaways to glean from this table. Those who kept savings in cash would have lost half their purchasing power by the end of the decade.  (Although not shown above, the story was better if you were a wage earner, with wages rising commensurately over the decade to offset a loss in purchasing power.)  Nevertheless, the only domestic asset class other than commodities that outperformed inflation was small cap stocks.

This is exactly what the SGI strategy heavily favors at this time.  There may or may not be a major blip over the next decade, but the lesson that should be learned is that if you have the ability to stay invested, over enough time, the portfolio likely can and will recover.  The Strategic Growth and Income strategy is overweight small cap firms at a time when it seems like every publication is pushing you into blue chips.  Lastly, don’t expect bonds to be a reliable safe haven.  Even if you do not see a loss of principal, inflation will have eaten into your profits when the principal you invested is finally returned with less purchasing power.

No matter what you do, inflation will bite into your investment returns.  At the same time, it seems like the Executive Branch of the Federal Government has an inclination to increase taxes on high earners and raise taxes on all forms of financial income, especially dividends.  This scary proposition of low interest rates, potentially higher inflation in the future, and the likelihood of higher taxes on wealth is why you are probably hearing much ado about “Financial Repression” or a “War on Wealth.”  The only choice left is to try to outrun the IRS.  I don’t mean running for the borders, like Facebook co-founder Eduardo Saverin, but instead, outrunning inflation and taxes.  If you want to preserve purchasing power, you will need to find quality investments that will grow faster than inflation, no matter the business cycle or economic environment. 

At the same time, if cash flows are reinvested internally by a firm, it affords an investor the opportunity to potentially wait for a more favorable tax regime in the future before realizing capital gains.  This affords investments in equities an inherent advantage over bonds.  Additionally, corporate revenues can inflate along with the CPI.  Coupon payments on bonds will not.  A case can be made that smaller companies, with less bureaucracy than larger entities, might better adapt to the ever shifting winds of economic fortune with greater ease than larger competitors. With this in mind, I have highlighted a company below with strong growth potential in any economic environment.

Der Twist Beginnt

Unbeknownst to most, Chubby also recorded “Twist” in German.  While Angela Merkel is locked in a seeming dance to the death with the more profligate spenders of her zone, there is still little clarity on how the Eurozone will evolve, or for that matter, devolve.  I don’t know if the dance on display between Merkel and ECB Chairman Mario Draghi is best described as a soft-toed ballet, or rather the Chicken Dance. However, if this were a game of musical chairs, it sure seems that there would be no end in sight.  The Eurozone sovereign debt overhang will continue to be a cause of volatility to equity market returns, both domestically, and abroad.  At the same time, the headwinds coming from the “Fiscal Cliff” will also be a source of consternation for equity valuations here at home.  While stress-inducing, we view both of these economic episodes as occurrences that will ultimately be resolved over time, but may get worse before getting better. In the meantime, the short-term volatility and pressure on valuations may offer attractive entry points in solid, growing companies, especially in Europe.

 

Highlighted Holding of the Month: Align Technologies

A sustainable growth investor faces three major considerations when choosing investments: growth, confidence in the ability to achieve the growth, and the price that must be paid for the growth.  In this, the first SGI newsletter, I highlight Align Technologies, ticker ALGN. One of the more expensive holdings in the SGI, many of you will be more familiar with Align’s primary product, Invisalign, which are clear orthodontic trays used in place of metal braces.  The company has seen incredible growth over the last four years, with revenues growing 14% per year over that time span – compared to negligible growth for the rest of the dental industry. It enjoys modestly better margins than other companies in the dental supply space, and has used the profits towards extensive R&D, marketing, and smart acquisitions. 

Wall Street expects Align to grow its earnings at a 20% clip in the coming years.  These are some lofty expectations.  For this growth, investors must pay up.  Align, with a P/E of 30, and an EV/EBITDA multiple of close to 18x, is not cheap.  However, Align is a case where we are willing to pay up for a quality asset, and we expect the company to be able to deliver on its lofty expectations, with trends continuing to improve over time.  With this in mind, we don’t find Align particularly expensive based on future earnings expectations.

Through consumer marketing, an avenue rarely targeted by orthodontic suppliers, Align has built demand for its product based on an aesthetic advantage.  Historically, people in need of braces relied on what their orthodontist thought would be the most appropriate solution, usually the dreaded metal braces. Invisalign, with its clear trays, changed this proposition.

Orthodontists have quickly found that if they don’t offer Invisalign, they lose business to other providers that do.  Invisalign was originally marketed only to orthodontists, but due to federal trade rules, the company was forced to make the product available to all dentists.  The company has worked to build dental professional brand loyalty by striving to offer the most effective aligner solution, while also rewarding its providers by offering price breaks on volume. Invisalign is not a suitable solution for all orthodontic issues that would otherwise be treated with traditional braces, and not all case types are suitable for general dentists.  However, the company is increasingly working towards advancing the technology to treat incremental case types.  The company has also developed extensive CAD tools, enabling a digital database of thousands of orthodontic cases, and has developed specialized internal human capital in its technician workforce - both of which make it less likely that a competitor will surpass Align's technological advantage. This is one reason we have confidence that Align will be able to protect its niche; it has built a moat through consumer marketing and enjoys a scale advantage in the sense that its technical staff has had the broadest exposure to aligner orthodontic cases.  Additionally, Align has vigorously defended its intellectual property portfolio against multiple potential entrants into the aligner market - most recently against ClearConnect.  Future growth will come from multiple avenues.  Invisalign still has a long runway for domestic growth, as it continues to gain share in the braces market vs. traditional braces.  At this point, only 25% of Align’s revenue are generated overseas and Invisalign only began to roll out late last year in China. 

Additionally, last March, Align paid $190 million for Cadent, a maker of 3D scanning systems for orthodontists. Cadent’s main product, iTero, negates the need for the paste that has historically been used to take dental impressions, one of the least enjoyable (among many) experiences at the dental office.  Instead, iTero uses a small probe to scan the mouth, making digital images.  CAD software is then used to model treatment and design the tray solutions to align teeth.  While there are competitors in the 3D scanning space – including giant 3M, we believe that Align’s tight integration between the scanner and the Invisalign product will make iTero the solution of choice for the orthodontic market. 

Align is one of the most richly valued companies in the strategy. This is not a cheap investment, and the stock has high expectations built into the price.  For all the reasons mentioned above, we are comfortable with paying up for a solid company like Align, on occasion, when there is a strong history of execution and a clear path for future growth.  

 

Daniel Kurland,

Portfolio Manager

June 22, 2012

 

­­

Important Disclosures:  This article may provide information, commentary, and discussion of issues relating to the state of the economy and the capital markets.  All opinions, projections and estimates constitute the judgment of the author as of the date of the article and are subject to change without notice. Corby Asset Management, LLC is under no obligation to update this article and readers should therefore assume that Corby Asset Management, LLC will not update any fact, circumstance or opinion contained herein.  The content of this article is provided for discussion purposes.  This article is based on information obtained from public sources which are believed to be reliable, but not guaranteed.  Specific citations are available upon request.  All forward-looking statements or forecasts included in the content are based on assumptions derived from historical results and trends.  Actual results may vary from any such statements or forecasts, and no reliance should be placed on any such statements or forecasts when making any investment decision.  No investment decisions should be made based solely on the content of this article.  This article is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and particular needs of any specific person.    No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Corby Asset Management. 

 

(c) Corby Asset Management

www.corbyasset.com