2007 All-America Research Team
Outstanding investment research such as that of ISI’s Ed Hyman is rarely more valuable than during tumultuous times like these.
LONG BEFORE THE SUBPRIME MORTGAGE CRISIS became front-page news, wreaking havoc with hedge fund returns and investment bank earnings and threatening to send the global economy into a downturn, economist Ed Hyman of International Strategy & Investment Group alerted investors to the coming turmoil. In September 2006 he flagged for clients a number of alarming signs: Home prices were likely to post an annual decline for the first time (they subsequently did); the inventory of unsold houses had reached a record high; subprime mortgage issuance had more than doubled from 2004 to 2005, accounting for 24.6 percent of all mortgages, and the figure was rising. In short, Hyman warned, the housing sector was on the verge of collapsing, and it was going to bring much of the broader economy down with it.
A bleak view, to be sure, but one that has since been proved to be accurate. Outstanding investment research such as Hyman’s is rarely more valuable than during tumultuous times like these. Fortunately for the world’s institutional investors, the veteran economist is not the only tough-minded analyst helping clients navigate today’s rough-and-tumble markets. Institutional Investor‘s annual ranking of the best sell-side equity researchers on Wall Street, the All-America Research Team, features an array of researchers whose prescient calls and timely insights win them praise from 2,600 portfolio managers and other investment professionals who participated in our survey.
For a fifth year in a row, Lehman Brothers employs more top-ranked analysts than any other firm. But its lead has narrowed, and the rivals nipping at its heels have shuffled positions considerably amid extraordinarily high turnover among the analysts on the team. Lehman boasts 44 total team positions this year, down from 50 one year ago. Bear, Stearns & Co. leaps from fourth place to second, with 38 total team positions. Citi slips from second to third, with 37 positions. The biggest gainer is JPMorgan Securities, whose 33 team positions -- up from last year’s 24 -- vault it from seventh place to fourth (see leaders table, below). Falling from third to fifth is Merrill Lynch, with 30 total team positions.
This year’s individual analyst rankings reflect the biggest change in years: Twenty-one of the 67 first-place analysts did not occupy the top spot last year. The high turnover reflects the increased volatility in the industry itself, as more top researchers defect to rival firms or seek greener pastures in hedge funds or other markets.
The most highly valued analysts have strong opinions and are not afraid to voice them. This year, for the first time, II asked a select group of our winners to do just that in the pages that accompany our rankings. Among them are Hyman and Ivy Zelman, a specialist in the Homebuilders & Building Products sector who in December famously responded to Toll Brothers CEO Robert Toll’s unrealistically optimistic projections for his homebuilding company by saying, “I’m wondering which Kool-Aid you are drinking, because I want some.” Shortly thereafter, Zelman, then an analyst at Credit Suisse, downgraded all of the stocks in her coverage universe to sell. Today she believes that the housing crisis is getting worse and will make a serious dent in consumer spending (see “The R-Word?,” page 72). Another pointed argument comes from Edward Wolfe of Bear Stearns, the top dog in Airfreight & Surface Transportation for the past five years, who says that the weakness he sees now in transportation, typically a leading economic indicator, suggests a recession is likely (see “Which Beans to Count?,” page 56).
The Street’s top researchers are not just about doom and gloom, however. Bruce Harting, who covers Consumer Finance companies for Lehman, also projects worse times ahead for mortgage lenders but has an alternate play for investors in the sector: credit card issuers, which, he argues, should benefit from distressed subprime borrowers’ seeking alternative funding sources (see “Bubble Trouble,” page 54). Morgan Stanley’s Douglas Terreson, who wins the Integrated Oil sector, says investors can expect another year of sky-high profits from oil companies, based on his belief that the global economy is able to withstand higher oil prices than it has in years past (see “The Gusher Keeps Going,” page 88). And John Hodulik of UBS, the top-ranked Telecom Services researcher, believes that the convergence of wireless and Internet technologies is about to revolutionize the way Americans use their cell phones -- and bring hefty profits to wireless carriers (see “The Need for Speed,” page 82). Even Hyman, ranked No. 1 in Economics for a remarkable 28 consecutive years, stops short of predicting a recession, although he believes the economy is in for a very hard landing (see “Buckle Up,” page 74).
To determine the winners of our ranking, II surveyed individuals at more than 810 firms managing an estimated $13.4 trillion in U.S. equities. The survey covers 67 sectors in ten broad categories, from Basic Materials to Telecommunications; profiles of each of the winning analysts can be found in our Research & Rankings section, beginning on page 101.
All of these elite analysts, along with their employers and clients, face a time of unprecedented change -- not just in the markets but also in the business of investment research. The financial services world has not been the same since the dot-com boom gave way to the bear market of 2001'03 and triggered a battery of reforms designed to address the excesses of the go-go 1990s. The effects of these measures -- including rules that attempt to wall off research departments from the investment banking units of big firms, and limit what CEOs can tell analysts -- are still rippling throughout Wall Street, taking much of the fun, money and prestige out of the job of analyzing stocks.
Big firms have pared back their research budgets, especially as institutional clients change the way they pay for research. A handful of firms such as Fidelity Investments have unbundled research payments from trading commissions, paying flat cash fees for research and using hyperefficient electronic trading systems to limit transaction costs. A bigger group is doing the same thing through so-called commission-sharing arrangements, in which a brokerage firm executing an institution’s trade directs a portion of the commission to a research provider -- often a small, independent firm that does not have brokerage or investment banking operations.
Star analysts may no longer be pulling down the eight-figure compensation packages seen at the height of the dot-com madness, but researchers’ pay is anything but paltry today, especially for those regarded as the best in the field. Our exclusive, inaugural survey of what sell-side analysts earn shows that the average cash take for a senior analyst in 2006 was more than a half million dollars; All-Americaranked researchers commanded more than $1.4 million on average (see “What They Make,” page 86).
A follow-up effect of postbubble reforms has been that many veteran analysts have chosen to leave sell-side research. Many have followed traditional career paths, chasing hedge fund riches or starting their own research firms. Two analysts who have done that of late are Jason Trennert, who left ISI Group to form Strategas Research Partners in March, and Zelman, who left Credit Suisse in June to start Cleveland-based Zelman & Associates.
Other analysts are starting down a less-traveled road, becoming executives at the companies they once covered. Such former analysts as Susan Decker, now president of Internet media titan Yahoo!, and Charles Phillips Jr., No. 2 executive at enterprise software giant Oracle Corp., are enjoying unprecedented power in corporate America. Many of the analysts who have joined Decker and Phillips on the other side of the earnings call say that they are working harder than ever, in jobs that make Wall Street hours look like half days (see “Crossing Over,” page 76).
Additionally, in the wake of recent years’ turmoil in equity research, some buy-side clients have begun to demand a different style of analysis from Wall Street. Frustrated with what they say is the sell side’s quarterly-earnings-focused tunnel vision, a group of these institutions, including the California State Teachers’ Retirement System and the New York City Employees’ Retirement System, have banded together to offer special economic incentives to research firms for producing reports focusing on long-term issues that affect stock prices, such as climate change and government regulation (see “Taking the Long View,” page 58).
Still, as illustrated by the summer’s subprime-related volatility, no matter how much change comes to the research business, one constant remains: Good ideas have value. Some big firms appear to be embracing that idea again and building their U.S. research departments after several lean years that saw them invest only in faster-growing, foreign markets.
Even talking about expansion is a far cry from the more-with-less mentality that has dominated the business in recent years. Lehman analysts, for instance, cover two dozen more U.S. stocks than they did last year, for a total of 1,175, but the firm’s analyst head count remains unchanged at 85, according to U.S. research chief Stuart Linde.
Similarly, JPMorgan has the same number of research analysts it had last year, 75, but they now track some 1,400 companies -- 10 percent more than one year ago. “We’ve been able to cover more stocks than ever, partly due to increased investments in training and technology,” says Thomas Schmidt, JPMorgan’s head of U.S. equity research.
But Wall Street firms are taking small steps toward expanding their U.S. research once again. Jonathan Rosenzweig, Citi’s U.S. equity research director, says the firm recently hired a derivatives strategist, and plans to hire further to address “new kinds of products and services.” Lehman will soon follow suit.
“We plan on expanding our head count in select areas, such as quantitative analysis, small-cap research, convertibles, derivatives, risk arbitrage and other equity-linked products,” says Linde. “Clients now rely on multiple investment strategies -- fundamental, quantitative and technical -- to generate alpha, and they incorporate these views through multiple products and asset classes. We believe these areas are ripe for additional investment.”
Things should get worse before they get better for mortgage lenders, but credit card issuers could beneÞt from subprime turmoil.
For the first time since the Great Depression some 75 years ago, the U.S. economy is facing a nationwide decline in home prices, which should fall between 2 and 5 percent in 2007 and again in 2008. Time will tell whether the Federal Reserve Board’s 50-basis-point reduction in the federal funds rate last month -- the first Fed easing in more than four years -- will prevent housing market troubles from sending the economy into recession. But a look at numerous negative statistics in the residential real estate market clearly shows that further increases in mortgage-loan and credit card delinquencies are inevitable.
The current inventory of unsold homes is at its highest level in more than 15 years, while home sales have dropped to decadelong lows. Problems with subprime mortgages have rocked Wall Street and the global capital markets and driven some home lenders that specialize in this sector out of business or into the arms of bigger competitors. But the worst of the actual losses and foreclosures has yet to occur. About two thirds of the $800 billion of outstanding subprime adjustable-rate mortgages have some chance of being refinanced into lower-cost loans with fixed or hybrid rate structures. Unfortunately, the remaining one third faces a serious threat of going into foreclosure or serial delinquency. Despite the efforts of government and some lenders to help as many subprime borrowers as possible, losses in the sector are likely to continue rising for at least another year.
Prime mortgages, which account for about 75 percent to 80 percent of all loans, continue to perform well. But even these higher-quality loans could see a rise in delinquencies because home price declines may prevent people who lose their jobs or suffer other financial setbacks from selling their homes to pay off their mortgages. As of mid-September most economists expected unemployment to rise slightly into 2008, a trend that will contribute to higher delinquencies and losses. If the economy hits a recession and unemployment spikes more dramatically, losses will climb materially in this overextended housing and mortgage market. A recession led by consumer weakness could trigger a quantum leap in loan problems.
For higher-quality banks, savings and loans and mortgage companies, the next year will be a test of whether higher net interest margins, fueled by the Fed easing, will offset potentially rising mortgage losses. Given the rapidly mounting problems in the mortgage arena, it’s likely that loan losses will outpace any positive offsets for the next several quarters, reaching well into 2008. If the Fed eases further, there may be a positive offset from higher net-interest-margin revenue later in 2008. Stocks will swing based on this trade-off
-- dropping on fears of falling home prices and resulting losses but rebounding from time to time on the potential for revenue growth and predictions that the housing problems are bottoming out.
The skies may actually be brightening, however, for credit card companies. Over the past year U.S. credit-card-receivables growth has increased to the 6 percent to 7 percent range, largely because fewer Americans are taking equity out of their homes. This growth rate should persist through 2008 as homeowners continue to seek alternative funding sources. Additionally, the ongoing shift away from cash and checks to plastic payments should support relatively consistent annual growth of about 10 percent in aggregate debit card and credit card spending for some time. That said, the U.S. credit card market is maturing; longer-term, growth rates shouldn’t considerably exceed that of nominal gross domestic product. In particular, companies that differentiate themselves with international exposure and product diversification into debit- and rewards-based credit cards may enjoy faster-than-average growth rates. It is worth noting that spending-volume growth is somewhat tied to economic cycles and thus would most likely be hurt by a consumer slowdown. For example, U.S. spend-volume growth dropped to 6 percent and 5 percent, respectively, during the downturns of 1991 and 2002. But volume on a global basis has not grown by less than 10 percent annually since 1980, showing the benefit of geographic diversity.
An economic slowdown would also have an effect on credit quality, which has held up quite well over the past couple of years. Charge-offs have been at historically low levels over the past two years thanks to economic strength and a 2005 bankruptcy law that made it harder for many consumers to file for protection from creditors. Although unemployment, typically the primary driver of credit quality in the card sector, may be on the rise, forecasts are still for unemployment to remain relatively low based on historical standards. As a result, charge-offs should rise steadily but slowly over at least a year, to more normal levels.
When credit quality deteriorates, card issuers typically raise rates to offset higher risks. Card companies have already started to reprice at higher levels in anticipation of credit normalization and in response to higher LIBOR-based funding costs. However, the recent reduction in the fed funds rate may lead to wider net interest margins over the next year -- especially if the Fed keeps cutting.
NAME: Bruce Harting
FIRM: Lehman Brothers
SECTOR: Consumer Finance
WHAT WE KNOW: An 11-year Lehman veteran, Harting in 2005 and 2006 finished first in Mortgage Finance, which has been merged into Consumer Finance.
Which Beans to Count?
All indicators point to a strong economy -- except for volumes in the bellwether transport industry.
It is quite difficult to square all the data pointing to continued growth in the U.S. economy with the cold, painful facts of one of its most critical industries: transportation. Domestic rail, truck and airfreight volumes have been in a recession since about November 2006. In past recessions the freight industry typically has led the way for the larger economy. Is history about to repeat itself?
Many analysts, economists and strategists have suggested that industrial companies are a smaller part of the U.S. economy today than in past cycles and that the current economic slowdown is disproportionately skewed toward housing and automobiles -- industries that rely on trucks, rails and planes to move their products -- as opposed to the bigger, service-oriented portion of the economy.
But our research shows that only 5 percent of rail freight traffic is directly housing-related and that the downturn in this sector is quite severe. Rail volumes are down about 3 percent year-over-year for the past nine months, twice as much as they fell during the 2001 recession and their worst showing since 1991. The weakness also has been broad-based, with seven of eight reported customer segments down year-to-date, led by lumber and paper shipments, which together are off some 15 percent from an already anemic 2006.
The current weakening in the freight sector mirrors past slowdowns and recessions, in which transportation companies have weakened before the broader economy, as customers reduce inventory and then cut back on production. As with the 2001 recession, which was preceded by weakening truck volumes as early as the first quarter of 2000, the current slowdown has seen truckload volumes soften since the first quarter of 2006. The softening has since migrated to air express parcels, less-than-truckload shipments, rail shipments, ground parcel shipments and, during the past few months, year-over-year import volumes into U.S. ports. And although exports have surged recently as the value of the dollar has declined, they are still far smaller -- about one third the size -- than imports.
One reason the economy looks better on paper than it might actually be doing is that the government might be counting the wrong beans. Consider, for instance, the data on inventories. Retailers are reporting less inventory in stores, a condition that suggests the economy is hanging in there, but our research shows increased inventory at the warehouses of retailers, as well as their suppliers and logistics companies. As supply chains have stretched around the globe, labor and material costs have come down but transportation and logistics costs have increased, and inventory is being stashed in different places along the line, not just on store shelves. Additionally, shippers are retaining an increased amount of safety stock at import and distribution centers in the U.S. since 9/11.
A turnaround does not appear imminent in freight. Rail, truck and air volumes do not seem to be weakening further. But they also do not show any near-term signs of getting better. As a result, a short and relatively weak peak freight season appears increasingly likely this fall.
With weakened volumes expected to continue at least into the first half of 2008, it is important to examine the supply of transportation capacity as an indicator of which freight sectors can better maintain margins. North American railroads are best positioned to retain their pricing power through the current downturn. This is because competition among them is light, they have locked customers into multiple-year contracts, and they do not compete directly with trucks for the vast majority of their freight.
Also well-positioned are non-asset-based logistics companies, which buy space on trucks, railcars and planes instead of owning them, because they can offset weaker volumes with lower costs in periods of excess capacity.
Trucking companies continue to suffer from overcapacity, in part because they rushed to buy grandfathered vehicles in 2005 and 2006, before new government emissions standards went into effect in January 2007. Truckload capacity will probably tighten gradually, beginning in mid-2008 and progressing into 2009 as smaller carriers exit the industry and purchases of new trucks -- the ones with the more expensive, less productive, post-2007 engines -- remain muted.
Looking at the entire picture, it appears that freight volumes have probably bottomed. But it is also likely that the current weakness in the transportation sector -- as it has done in downturns past -- will bleed into the broader economy, which is headed for harder times.
NAME: Edward Wolfe
FIRM: Bear, Stearns & Co.
SECTOR: Airfreight & Surface Transportation
WHAT WE KNOW: This is the fifth straight year that clients have voted Wolfe the top analyst in his sector.
Get Big or Die Tryin’
Cheaply assembling computers and phones for tech companies is becoming a mature, scale-intensive business -- and the poster child for globalization.
The electronics manufacturing services industry is at the center of the technology food chain, assembling the majority of the world’s computers, televisions, cell phones, gaming consoles, set-top boxes and other devices. Insights gleaned from this sector provide a good assessment of the health of the global economy and carry investment implications for other sectors, such as semiconductors and computer hardware makers.
Several seismic shifts are in store for the EMS business. Manufacturers are still battling overcapacity, despite a wave of multiyear restructurings. Global competition is heating up, with low-cost Asian players pressing Western rivals. In short, the industry is maturing. Consequently, the market valuations of manufacturing services companies, historically in the rarefied territory of technology companies, will migrate toward the lower multiples typically associated with industrials. Scale is becoming critically important to profitability, which should lead to the biggest, most global companies performing far better than smaller rivals.
These forces will manifest themselves in a number of ways throughout the sector over the next year or so. First, expect more consolidation. The acquisition of Solectron Corp. by Flextronics International should prompt boards of directors and executive management teams to discuss potential M&A opportunities. Rivals will be watching closely to assess the synergies of this deal, compared with any business lost as a result of the combination, as well as the magnitude and the timing of any restructuring actions.
Asian competitors should continue to increase their market shares, expanding beyond personal computers into wireless phone handsets and other consumer electronics products. Taiwan-based Hon Hai Precision Industry Co. and other Asian companies are aggressively entering non-PC sectors and will compete more directly against their U.S. peers. Some view the Asian competition as focused on low-margin consumer devices. But non-U.S. companies are becoming more meaningful players in higher-margin services like product development, manufacturing and design -- much like the router manufacturing that Hon Hai now does for Cisco Systems. Often non-U.S. companies have very low cost structures or are vertically integrated and can thus more aggressively bid on production than their U.S. competitors can. As the industry is becoming more globally competitive, keeping costs low is critical.
Manufacturing services companies are finally starting to work through big inventory gluts, which are the product of both mismanagement and the overeager pursuit of new business in recent years, and have had ripple effects on the global economy. As inventories continue to get tighter over the next several months, semiconductor companies should see currently stagnant order flow from the EMS sector begin pick up during the remainder of 2007 and in 2008.
The performance of EMS stocks has lagged of late, while the semiconductor sector, which historically traded in line with the manufacturing services names, has rallied. Some see this as a temporary divergence, and therefore as a buying opportunity. We believe it is a permanent realignment, as the industry matures and valuations shrink. Picking the right EMS stocks will therefore be essential, and scale will be the biggest factor that determines performance, which should vary widely between winners and losers. Investors will focus on the high-revenue, profitable companies with less interest in restructuring stories, which seem to be perpetual in nature and very distracting. The industry should grow by 7 percent in 2007 and 8 percent in 2008; bigger companies that can exploit economies of scale and have strong operations around the globe should expand at more than twice that rate, while many others will grow more slowly.
Perhaps the most interesting trend in the EMS industry is that major customers are shifting their business from longtime suppliers to those with excess capacity, global operations and lower costs, to get the best pricing, quality and delivery terms. Already in 2007, Cisco, Juniper Networks, Eastman Kodak Co., Sun Microsystems and plastic toymaker Lego Group have reallocated some programs. Currently the industry is operating at just 68 to 70 percent of capacity, far below the optimal level of 80 to 85 percent. This situation will continue to favor the biggest, most global and vertically integrated producers and make things more challenging for second- and third-tier rivals. That triumph of scale may very well also be the fundamental theme in the story of globalization for the rest of the global economy.
NAME: Jim Suva
SECTOR: Electronics Manufacturing Services
WHAT WE KNOW: Suva, who joined Citi from business school in 2003, was first ranked last year as a runner-up in the EMS sector.
Dollars and Stents
In the health care sector, medical-technology companies should perform best -- but won’t be immune to concerns over the rising costs of care.
The business of health care has long been a haven for investors fleeing cyclical economic downturns, and with markets nervous about the impact of the housing bust on the economy, health care is once again getting a longer look. Among the best-positioned companies in health care are those that sell medical technology and devices. These players should continue to prosper and grow over the balance of this decade and into the next, even as an aging population and demand for best-in-class care put pressure on global health care budgets. In the U.S. health care expenditures have increased more than eightfold since 1980 and now make up 16 percent of gross domestic product. This compares with 9 percent in 1980.
The key to medical-technology companies’ success is innovation. Doctors, after all, want nothing more than to improve the lives of their patients and are therefore eager to adopt new devices and technologies that improve patient care or make it less traumatic. The biggest challenge: innovating in a way that both improves care and reduces costs. More often than not, there is a trade-off between these two objectives.
Still, the need for medical-technology innovation is as strong as ever in the U.S., driven by such factors as a soaring obesity rate -- nearly one in three Americans is clinically obese -- and the spread of debilitating diseases like diabetes, which claims 1.5 million new patients annually. That is why companies spent more than $15 billion on research and development for medical devices in 2006, and venture capital firms kicked in a further $2 billion in investments in the sector. These capital flows ensure a steady procession of new products, enabling industry revenues to compound at a rate of close to 10 percent annually. They also encourage interplay between big-company innovation and small-company invention that helps make the industry so successful. Equally critical is the interaction between industry and leading clinicians. This interchange of ideas -- the insights of the surgeon meeting the talent of the engineer -- is the foundation of much of the industry’s history and ongoing development.
Looking at the coming year, the factors underlying continued industry innovation are all firmly in place: the aging of the population and the growing impact of chronic diseases, the demand in the U.S. for best-in-class care and the willingness of government and society to pay for this care, the interaction between industry and clinicians, the interplay between companies large and small, healthy corporate margins and the free flow of capital. All of this should contribute to the ongoing health and dynamism of the medical-technology business.
More specifically, the weaker dollar should boost revenues and profits for the industry’s large multinationals in 2008, while lower interest rates and growing profits should boost stock prices, particularly at a time when U.S. economic growth and broader corporate profit growth are expected to slow.
Considering the more distant future, our research projects a series of changes or emerging trends. For starters, five to ten years from now, patient care will be more information-driven. Put simply, the industry will have better information about what works, as well as better information about how a patient is doing away from the hospital or doctor’s office. We will be able to monitor more and more patients with chronic diseases, alerting the doctor’s office to a worsening in the patient’s condition long before that next office visit or the emergency trip to the hospital.
There are several particularly promising areas for innovation. In surgery and complex catheter-based procedures, robotics will play an increasing role. Surgeons will still perform the procedures, but the increased use of robotics and image guidance will allow for a precision previously unknown. In prostate surgery this is happening today. Over the past five years, there has been an explosion in the number of gastric bypass and banding procedures for obesity. In the next five there should be substantial improvements on these procedures as well as newer, less-invasive approaches promising less risk to the patient. In diabetes we will see new forms of insulin delivery and monitoring, including, within five years, one device that can do both in a real-time, a closed-loop system. The industry will develop diagnostic tests that reduce the all-too-common risk of hospitalization-associated infections. And major advances in cartilage and tissue repair will come to orthopedics.
In the decade ahead a U.S.-dominated industry will increasingly take its technology overseas. Rising living standards in China, India and other developing regions should lead to better health care and increased per capita spending in those countries. Meanwhile, in the U.S. the pressures around reimbursement will rise, particularly for high-end medical devices, forcing companies to show not only the clinical benefit of their new technologies but also the economic value.
NAME: Michael Weinstein
FIRM: JPMorgan Securities
SECTOR: Medical Suppliers & Devices
WHAT WE KNOW: Weinstein has been ranked for ten consecutive years and finished first in his sector for four of the past five.
Severe housing downturns usually coincide with recessions. And today’s housing slump sure looks like a doozy.
Over the past two years, housing has continued to evolve as the most important factor in determining the future health of our economy. Although many have debated the impact that troubles in the housing sector will have on the U.S. consumer, our firm strongly believes that the current housing recession will substantially reduce consumer spending in 2008 and 2009. This downturn is much more severe in many markets than the 1990'91 housing recession and is much wider in scope.
Following March’s blowup in the markets for subprime mortgages and related securities, extensive credit tightening has significantly magnified the decline in demand for homes. Additionally, the consumer has completely lost confidence in housing, as the market’s woes have been the focal point of nearly every media outlet’s coverage of late.
Recent results speak to just how severe the reduction in demand has become. Sales have nearly disappeared entirely in many metropolitan areas, with rising cancellations of deals by prospective homeowners resulting in negative sales in many subdivisions. And this paralysis comes as markets were already struggling with the elimination of investors and the largest glut of existing and new inventory in history. Furthermore, the loose mortgage-underwriting standards of the past several years have come back to haunt us, with skyrocketing defaults and foreclosures. Pending resets of adjustable-rate loans that were taken out on highly borrower-friendly initial terms are likely to exacerbate the problem -- no matter what members of Congress and other politicians do to bail out overextended homeowners in an attempt to soften the potential blow to the economy.
To be sure, several developments -- a few of which have already happened or appear likely in the near future -- could help settle the negative sentiment and calm the secondary mortgage market. These include the Federal Reserve Board’s recent reduction of the federal funds rate, any government bailout of foreclosed homeowners, modifications of existing loans and a higher ceiling for government-sponsored lenders Freddie Mac and Fannie Mae to purchase conforming loans.
But even if all of this should come to pass, home values and sales will remain under pressure due to a lack of affordability. Our research concludes that consumer expenditures are strongly tied to housing starts. The historic correlation rate is 75 percent. Each of the last four declines in housing starts of 20 percent or more was accompanied by a fall-off in consumer expenditures. That is bad news for the economy today, considering that housing starts for the 12 months ended June 30 were down 24 percent over the same period one year earlier.
During the residential real estate boom, when home prices surged at a double-digit pace to unsustainable levels, consumers responded to their rising equity by using their homes as ATM machines. Cash-out mortgage refinancings became a primary funding source for home improvement, vacations and even bill paying. Now we will be seeing that phenomenon play out in reverse. As home prices continue to fall and adjustable-rate mortgages reset to become more costly, the erosion of home equity and higher monthly payments will result in many formerly confident consumers feeling poorer and spending less.
Given the supply overhang in the market and the fact that home prices have to decline by at least a further 10 percent to become affordable again, we expect single-family housing starts to drop considerably in 2008 and 2009 before troughing in 2010. These notable declines will not only impact consumer confidence but also should continue to result in more job losses as companies right-size businesses and reduce liquidity to many housing-related players. It is even possible that the economic impact could trigger some corporate bankruptcies.
There have been nine periods since 1950 when residential investment has fallen 10 percent or more, this being the ninth. If history is any indication, this dramatic drop in housing turnover will ultimately flow through to the overall economy. Six of the previous eight downturns of this nature have overlapped with recessions. To stave off a housing-triggered recession, other sectors of the economy or the strength of the global markets will need to take a substantial step forward.
NAME: Ivy Zelman
FIRM: Zelman & Associates
SECTOR: Homebuilders & Building Products
WHAT WE KNOW: An eight-time All-America first-teamer, Zelman left Credit Suisse over the summer to start her own research firm.
Global economy, this is your captain speaking: Prepare for a hard landing but no recession.
The recent subprime debt crisis notwithstanding, the world is still flooded with liquidity. One big reason is the unprecedented success of developing-nation economies -- which account for a huge 30 percent of global gross domestic product, are growing by roughly 6 percent each year and possess more than 85 percent of the world’s labor force. Countries in the developing world have average annual national saving rates of 30 percent, compared with 12 percent in the U.S., contributing to a global savings glut that shows up in the purchases of U.S. Treasury securities by foreign central banks.
The global money supply is growing by more than 10 percent annually and accelerating, driven in large part by rates of increase of more than 20 percent in such places as Brazil, the Philippines and Singapore. And four pools of investment capital are increasing daily, adding to the savings backlog: petrodollars, corporate cash, foreign central bank reserves and the net assets of the ultrarich.
Because there is also a global labor glut, all this money is creating excess supply -- factory capacity, planes in the air, stores on the ground -- instead of excess demand, keeping inflation remarkably tame. Also curbing inflation are the world’s central banks, whose aggressive inflation fighting since the 1970s and ‘80s has been quite successful. Today U.S. inflation is roughly 2 percent, with unemployment slightly above 4.5 percent, a virtuous combination that would have been viewed as unattainable 30 years ago.
In keeping with this inflation-fighting policy, the Fed tightened preemptively during recoveries in the 1980s and the 1990s, creating midcycle economic slowdowns that prevented wage-price spirals. With the series of hikes that preceded last month’s easing, the Fed created a third midcycle slowdown.
Interestingly, every single Fed tightening cycle has ended with a financial crisis. In this light, the current subprime debacle is familiar territory. Some crises have led to recession, like the tech collapse did in 2001 and the savings-and-loan crisis did in 1990. Others, such as the Continental Illinois and Mexican debt crises, instead led to the midcycle slowdowns of 1985 and 1995, respectively. Today’s environment looks more like another midcycle slowdown. Historically, these have been good for the stock market.
The arguments against recession are many: Inflation is easing, bond yields are falling, expansions typically last about a decade, interest rates are low, the dollar is a stimulus, developing economies are booming, wages and prices are under control, profits have been strong, inventories are lean, money is abundant, and the Fed is easing aggressively. Additionally, the models we use to forecast GDP do not project a recession. It is the combination of these arguments, not any single one, that makes a recession unlikely.
Still, there are many weak sectors in the economy, and our models indicate the weakness will spread, slowing GDP growth to 1 to to 1.5 percent in the second half of this year -- a rough landing but no recession. Our weekly homebuilders survey is depressed and still headed down. Same for our weekly house price survey. Retail sales growth slowed in August to just 3.7 percent year-over-year, down from a 2005 peak of 9 percent. Employment has slowed, and it now appears that growth in nonresidential construction spending, which has been very strong, is being buffeted by both the credit crunch and the slowdown in GDP. Both business confidence and consumer confidence surveys are generally pointing down.
And there have been glimmers of other major economies slowing. Leading indicators are declining in Germany. Japan’s business and consumer confidence surveys are generally pointing down, and GDP there is slowing. U.K. house prices fell in August for the first time since 2005, suggesting a global housing slump.
Given all this, developing economies will likely slow at least some. If nothing else, the disparities are too great. For example, U.S. imports excluding oil in July were down 3.4 percent over the previous year. In contrast, a basket of developing economies’ exports we track was up 24.5 percent, on average. Group of Seven industrial production in July was up just 1.5 percent year-over-year and slowing. In contrast, developing economies’ industrial production was up 10.8 percent and accelerating. The Organization for Economic Cooperation and Development’s leading indicator, which includes both developing and developed economies, is trending down.
Although a global slowdown is probably in the making, the subprime financial crisis is spreading out in an astounding manner -- from the big losses for Goldman Sachs Group’s Global Alpha fund in August, to the Australian interest rates surging, to U.K. bank Northern Rock blowing up and a report that U.S. shopping centers have been caught in the credit squeeze.
The combination of a growth slowdown and a financial crisis is significant and dangerous, which justifies the Fed’s aggressive and creative easing moves. We expect the federal funds rate to be cut to 4.0 percent. But there are probably many more weak data points to come before Fed easings start to improve the economy in 2008. And even then, the improvement is likely to be muted by continued weakness in house prices. History tells us that Fed easings take up to one to two years to affect GDP.
Looking further ahead, the purpose of the midcycle slowdown is to cool inflation so the expansion can be extended. After this midcycle slowdown inflation seems likely to be tame for at least a few years. At least, that is the plan. The next recession is probably in 2012.
NAME: Ed Hyman
FIRM: International Strategy & Investment Group
WHAT WE KNOW: The ISI co-founder makes his record 28th straight first-team appearance.
The Need for Speed
Imagine surÞng the Web at cable-modem speeds on your cell phone. Wirelesscarriers are closer than you think to making that happen -- and to raking in big profits as a result.
he telecommunications industry has been driven by two major trends in recent years: increasing adoption of wireless communications and rising Internet use. Now these trends are converging. As a result, the spread of wireless data services -- enabling consumers to access their e-mail and surf the Internet on handsets at speeds that are now mostly restricted to desktop computers -- will be the most significant catalyst in the sector over the next few years. Growing interest in and purchase of wireless data services should boost the financial performance of both the carriers providing these services and the makers of mobile devices.
Americans clearly love their cell phones, but they do not come close to exploiting the full range of communication capabilities that are now built into these handsets. More than 80 percent of us carry them, and on average, subscribers spend almost 14 hours per month using their phones. But most of that time is devoted to phone calls; only 15 percent of monthly revenue now comes from data services, and most of that fraction is from text messaging.
But service providers such as wireless carriers AT&T, Sprint Nextel Corp. and Verizon Communications recently have invested billions of dollars to make wireless data communications more appealing for consumers and are committed to further investments that will improve service. Sprint and Verizon completed the rollout of third-generation, or 3-G, networks earlier this year. AT&T will have comparable service in place in the top 100 U.S. markets by year-end. These 3-G networks can carry voice and data traffic roughly twice as fast as did previous technologies. Next year Sprint will push the competition even further by beginning to activate its 4-G network, using superfast technology called WiMax, in about 20 of the country’s biggest metropolitan areas, comprising a population of some 70 million. Sprint is partnering with Clearwire Corp., a WiMax company founded by wireless pioneer Craig McCaw, to extend its 4-G coverage into less-populated areas. WiMax-based service will deliver data speeds approaching what consumers now experience on their home computers with digital subscriber line or cable modems. Last, despite a number of recent setbacks, new and incumbent carriers continue to roll out Wi-Fi hot spots, often with the help of local municipalities.
As 3-G and 4-G wireless networks are activated, a new generation of handsets optimized for data is hitting store shelves. Apple’s iPhone and the new iPod Touch are probably the first of these devices to gain wide acceptance, but Apple and other hardware makers have more in the works. These products allow users to access weather reports, stock quotes and maps, among other information, with just one touch. The iPhone is doing for these applications what Research In Motion’s BlackBerry did for mobile e-mail, making them both intuitive and indispensable. As more of these devices are unveiled and marketed to consumers, interest in and adoption of wireless data services should rise.
The combination of broadly available high-speed wireless networks and new, data-centric handsets prepares the stage for the development of a richer array of consumer and business content and applications. On the consumer side these may include location-based services that enable retailers to use the Global Positioning System to deliver relevant offers, based on where a user is walking or driving; and servers that supply full-motion video clips or full-length TV shows to handsets, perhaps accessed from the digital video recorders sitting in customers’ own living rooms. For businesses, the convergence of wireless and broadband will likely further improve the ability to connect securely with a desktop computer sitting at home or in the office, to transfer files and boost productivity.
In the not-too-distant future, then, wireless data services will be as essential to people’s lives as the basic, voice-centric cell phone is today. The existing carriers, with their large subscriber bases, valuable spectrum and next-generation high-speed networks, are best positioned to benefit from these developments.
NAME: John Hodulik
SECTOR: Telecom Services
WHAT WE KNOW: After being ranked second or lower five times, Hodulik makes his first-team debut in the newly consolidated Telecom Services sector.
Hollywood studios and big TV networks are taking vastly different approaches to online distribution.
ew technology, specifically the Internet, is creating exciting possibilities for the way films and television shows are distributed. Many investors focus on the technological changes, such as Apple’s iPod or the increased adoption of broadband service by consumers, that make new distribution methods possible. But technology alone does not boost consumer demand. Content owners must also grant permission for the legitimate use of their products online. And the two major providers of video -- Hollywood studios and the major TV networks -- are taking far different approaches to the online world.
The film industry, at this point, is not willing to embrace all the possibilities of the Internet. Why? Because in Hollywood’s mind its current business model, based on so-called film windows, is working very well. The film industry has been able to create a system of multiple partners, spanning differing payment systems and finite time periods. These windows allow one film to be sold repeatedly to theater owners, big-box retailers, video rental outfits, cable movie channels and broadcast networks -- with the studios gaining a big share of the consumer spend in each instance.
Studios also are not embracing Web delivery of films yet because they are very cognizant of the impact that digital sales had on the music industry. Although there is little doubt that Apple has benefited nicely from the development of the iPod, consumer spending on music continues to shrink as online distribution cannibalizes physical record sales and causes great price deflation. Film studios are very aware of this and are worried about allowing a cheaper, less-secure distribution source into this market, especially with a company like Apple that is more focused on selling hardware than driving content profitability.
In stark contrast, the television industry is much more aggressively embracing the Internet as a distribution form. That is primarily because the traditional TV business model is not serving content owners as well as the film-window system enriches Hollywood and needs to be modernized to serve today’s newly empowered consumer. The old model is best characterized by the business cycle of Seinfeld, which debuted in May 1990 and was deficit-financed by its producers for five years until enough episodes were available for reruns. The show ended its run in May 1998 and further repeats were sold in 2001 and 2002. Seinfeld DVDs went on sale finally in 2004, 14 years after the show premiered on NBC. Clearly, the returns on capital in this model were not very attractive.
The television industry has exploited new technology in recent years to create new sources of revenue. Digital video recorders are now found in 20 percent of all TV-viewing homes; certain programs, like NBC’s The Office, are being “DVR-ed” by 20 percent of all viewers. Additionally, advertising dollars continue to shift to the Web. My colleagues and I estimate that the Internet grabbed about 70 percent of the overall growth in U.S. ad spending in 2006.
These developments have pushed networks to embrace new distribution methods. A program like Desperate Housewives can still be seen on the local ABC affiliate Sunday night at 9:00 p.m. However, if you miss that window, Walt Disney Co., which owns the show and the network, now makes the original episodes available the next morning on ABC.com, where you can watch them for free with commercials that cannot be skipped. You also can purchase the episode online at Apple’s iTunes the next day or watch it for free -- with commercials -- through Comcast Corp.'s video-on-demand cable service. Although the show is barely three years old, you can also watch repeats on Lifetime or buy them on DVD at Wal-Mart Stores. That’s a far cry from the 13 to 14 years it took for the owners of Seinfeld to fully monetize the value of that asset.
So what are the ramifications of this new business model? Interestingly, the content producer is rather indifferent to how the content is consumed. However, the one party here that does not get as big a share of the revenue pie as it used to get is the local station owner. The more ubiquitous distribution becomes, the more likely the local station’s audience flow is disrupted, negatively affecting viewership of highly profitable late-night news and syndicated shows. As a result, the local-affiliate model is most likely to be wounded by the shift in TV content distribution.
The divergent approaches of the film and TV industries to online distribution mean that Hollywood studios are likely to just tinker at the margin with new windows, preserving their current business model, while TV networks appear to be on the verge of a new frontier that will benefit creators of premium content at the expense of their current local-station partners. In both cases the technology itself is only part of the picture.
NAME: Michael Nathanson
FIRM: Sanford C. Bernstein & Co.
WHAT WE KNOW: A former Time Warner executive, Nathanson tops the entertainment sector for a second year running.
The Gusher Keeps Going
Investors are underestimating the
potential for oil and gas companies to keep posting record proÞts.
he good times for global petroleum companies aren’t likely to end anytime soon. Fundamental conditions should remain positive throughout 2008, and valuations of companies in the sector are attractive. That should make them good investments for the foreseeable future.
Results in the sector are driven by the markets for petroleum commodities, such as crude oil and natural gas, and the outlook for those commodities is quite positive. To offset rising manpower and materials costs, as well as increasing tax rates, companies need to be able to sell oil and gas at higher prices today than they have in years past. The petroleum industry currently needs crude oil to be selling for near $65 per barrel for returns on investment to approximate capital costs. That compares with $30 per barrel as recently as 2000. The good news is that the global consumption of oil, gas and refined products is likely to continue rising, even with petroleum prices approaching record levels. That strong demand should keep the oil industry’s profits also near record levels next year.
Why is the global economy able to withstand significantly higher petroleum prices today than it was in the past? There are several explanations. Among the biggest factors: Petroleum now represents a smaller portion of the global economy than it used to, and the wealth transferred from consuming countries to producing countries is being invested differently, resulting in improving budgetary conditions and higher levels of currency reserves. Additionally, spikes in the price of oil are less destabilizing to the global economy today because of advances in monetary, fiscal and other government policies. Floating exchange rates and more-flexible labor regulations, for example, represent important differences from decades past.
These are some of the reasons why the world’s consumption of petroleum has grown, on average, by 1.7 percent per year from 2000 to 2007, exceeding the 1.3 percent average annual growth rate during the previous decade, despite a 125 percent increase in the price of petroleum since 2000. A further boost to demand could come from the weak U.S. dollar. Because petroleum is denominated in dollars, any further weakness in the currency should stimulate future consumption -- especially by fast-growing nations with stronger currencies. The prices of crude oil and natural gas, as well as the profit margins of refiners, should remain high through the end of the decade.
Consequently, the financial condition of the petroleum industry should remain superb, with earnings and cash flow near record levels beyond 2008. Companies in the sector will likely exhibit strong discipline with respect to capital spending, leading to significant free cash flow. The most successful players will take advantage of this golden opportunity to enhance their stock market valuations by repurchasing shares and investing in areas with high returns. Share repurchase programs are already widespread in the industry and should remain an important component of capital management policies. The leading companies in the space buy back between 8 and 10 percent of their shares outstanding every year.
Even though management teams throughout the petroleum industry will be sitting on ever-larger piles of cash, strategic activity is likely to be confined to the second tier of integrated oil companies, as well as to exploration and production concerns. Deals are also possible among the so-called supermajors that have been active in recent years, though antitrust issues preclude combinations involving the biggest, most global companies.
In spite of such rosy fundamentals and an outstanding financial outlook, the market appears to be undervaluing energy stocks. We project returns of 18 percent from companies in the sector over the coming year, whereas market valuations suggest that investors expect just 15 percent. Likewise, energy stocks are trading at levels more consistent with a future price of $55 per barrel for crude oil, compared with our longer-term projection of $65 per barrel. Such a discount is not unusual for cyclical sectors in which normalized results are rising. But in our view, it represents a great buying opportunity for investors.
WHAT WE KNOW:
Terreson has been voted to the All-America team for 13 straight years, including first-team appearances in three of the past four year.