"The regulatory monkey on our back"

We strongly believe that entrepreneurial activity is the critical engine that drives healthy economies and that has distinguished the economic prosperity that America has enjoyed during all of its most vital economic periods.

Kudos, therefore, to independent journalist Sarah Lacy for her interview from last Friday in which she uncovers an important aspect of the current entrepreneurial landscape.

The important part of this video is at the very end (beginning at minute 4:13 in the clip), when venture capitalist Pascal Levensohn begins discussing the flip side of the issue that is discussed for the first four minutes of the interview.

At first, the discussion is about the discipline the current economic landscape is imposing and has been imposing on entrepreneurs and those who provide capital to them.

But then Mr. Levensohn introduces a very important point: the discipline side is good, but the increased regulatory burden imposed by the government has serious negative repercussions.

"The fact is," he says, "it costs three times more to take a company public now than it did" (5:42).

The actual dollar costs of the increased regulation (which mandate additional work from attorney firms and accountants, for instance) mean that the payoff formula for funding a start-up company is dramatically different -- so different that some companies will not get funded based on projected revenues.

Companies that it may have made sense to fund before the regulation enacted in the past seven years may never get funding today. The "regulatory monkey on our backs now" (to use the phrase Levensohn employs) thus means that an entrepreneur does not build a company into a successful business that adds value to customers and to the economy. It means that employees do not get hired who would have gotten hired. And it ultimately means, as Levensohn correctly points out, that capital goes other places (such as overseas) in order to find opportunities for funding business formation in a less onerous regulatory environment.

Very revealing.
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Beautiful Growth Companies

We have written before about the fact that the investment management philosophy we have followed for over fifteen years is directly descended from that practiced by the late Mr. Thomas Rowe Price, Jr. (pictured) and the late Mr. Richard C. Taylor.

A hallmark of this approach is the emphasis, in the words of Mr. Price, on directing the attention of the investor towards "the simplicity and soundness of the growth stock theory and away from the belief of most people that you have to play the stock market in order to be successful."

This week, as Wall Street attention and speculation focuses on the upcoming Fed meeting and various ways to "play" the dollar's continuing decline, or the eventual tightening that the Fed's current easing will necessitate, we would point to the simplicity and soundness of reacting to the current "crisis of the day" the same way that Mr. Price and Mr. Taylor weathered the crises of previous decades: by trusting in the ownership of growing businesses.

In his 1973 essay entitled "A Successful Investment Philosophy based on the Growth Stock Theory of Investing," to which we have also referred in the past, Mr. Price outlined the fundamental characteristics of a growth company which he had settled upon after over fifty years' experience in the fields of money management, investment counsel, investment banking, and brokerage.

"While no mathematical formula alone can be relied upon to aid in identifying growth companies," he cautioned, "certain fundamental statistical guidelines" that an investor must consider include:

1. A return on invested capital of 10% or better, and continued increase in capital from retained earnings.

2. Above average profit margin for the industry in question, and a favorable trend of improving the profit margins.


3. Compound annual earnings growth of better than 7%.

Although the names and the businesses have changed, there are still growth companies that meet these and the other criteria that Mr. Taylor and Mr. Price looked for in a previous era.

For instance, medical waste treatment company Stericycle* (SRCL), which last week reported its ninth consecutive quarter of double-digit organic earnings growth, measures nicely against the three statistical guidelines Rowe Price set forth above. ROIC is over 11% in the most recent quarter and for all the previous quarters in 2007. Margins are well above industry average, and management indicated that their ability to increase margins by 20 to 40 basis points sequentially "on the steady state" remains intact.

By these measurements, as well as other considerations about the business it runs that are less statistical but by no means less important, this company is a beautiful growth company!

There are plenty of uncertainties on the horizon today, as during any period of investing, not the least of which is the return of ugly inflationary signals (which we've also discussed before). But we firmly believe that the best way to weather these situations is to tie a portion of your investments to the kind of good businesses represented by the company described above, and others that resemble the businesses that classic growth pioneers Rowe Price and Dick Taylor sought for their own portfolios.

*The Principals of Taylor Frigon Capital Management own shares of Stericycle (SRCL).

for later blog posts dealing with this same subject, see also:

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The current investment climate

We recently published "The Investment Climate, April 2008" in the commentary section of the main Taylor Frigon Capital Management website.

Not long ago, we wrote a blog post which described the over-allocation of capital to real estate and mortgage-based areas, much of which was a reaction to the severe market correction of 2000 to 2002. Fueled by the Fed's excessively long period of low interest rates (which were also a reaction to the severe market correction of 2000 to 2002), investors from large to small acted as though the very real progress in technology for the sharing of data over the internet (including over mobile networks) had been a giant dead-end, and therefore the progress in that direction was put on "pause" for a few years while real-estate and related asset-backed securities got all the capital.

There are many indications that the "pause" button has been released, and that numerous new applications of the expanding ability to share all kinds of data (including video data) are taking off for businesses and consumers.

for later blog posts dealing with this same subject, see also:

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Brian Wesbury's Excellent Congressional Testimony

Brian Wesbury is a respected economist whose analysis we have learned to value highly over the years.

On April 9th, he delivered testimony before the House Committee on Financial Services that gives one of the clearest perspectives on the current economic situation you will find anywhere. Click here to read the entire transcript of Brian's testimony.

In it, he explains how things got to where they are (hint: misguided government policy was a primary culprit, as we touched on in this previous post and this previous post), outlines the reasons for the Fed's reaction and likely outcomes (which we have also touched on in previous posts, such as this one), and demonstrates why comparisons to Herbert Hoover and the Great Depression should emphasize (although they rarely do) that Hoover's turning to protectionism and higher taxes made what could have been a mild recession into a major calamity. This last point is very important, because there are growing rumblings today from many lawmakers for both higher taxes and greater protectionism, as we have noted with some concern in previous posts such as this one and this one.

If you want greater situational awareness of the economic scene, you would do well to consider Brian Wesbury's excellent Congressional testimony. Let's hope those in Washington who have a hand in steering the ship are paying attention.
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Complaining about hedge fund managers and their paychecks

Yesterday, the New York Times ran a much-remarked-upon story entitled "Wall Street Winners Get Billion-Dollar Paydays" in which they suggested, by their tone and choice of quotations, that income inequality poses a hidden danger to the economy.

To come up with their story, the Times used an article in a magazine called Institutional Investor's Alpha which estimated hedge-fund managers' paychecks for 2007 by looking at the reported performance of those funds and their stated fee structure and calculating what the Alpha article called "earnings" and the Times story called "the manager's pay."

Whether or not that translates directly to the managers' actual pay for the year, the real question is -- what is the problem?

Plenty, according to the Times and the sources they quote in the story. The story's author notes that, while the top 25 hedge fund managers all made $360 million or more in 2007, "the median American family, by contrast, earned $60,500 last year."

This inequality of income must be a harbinger of disaster, according to the Times. "Since 1913, the United States witnessed only one other year of such unequal wealth distribution — 1928, the year before the stock market crashed," the article says, citing research by a senior fellow at the Economic Policy Institute in Washington (a lobbying group of academics that bills itself as "a nonprofit, non-partisan" think tank but whose articles generally advocate against free-market policies). "Such income inequality is likely to impede economic recovery," the Times quotes the same source as saying.

The Times also quotes famous bond manager Bill Gross, who says that the widening income divide (widening because of the high pay of hedge fund managers) is a cause for worry:

"Like at the end of the Gilded Age and the Roaring Twenties, we are going the other way," Mr. Gross said. "We are clearly in a period of excess, and we have to swing back to the middle or the center cannot hold."

Why "the center cannot hold" is a mystery (it is also, of course, a literary reference to a line from W. H. Auden's poem "The Second Coming," published in 1920 and therefore written during the period that Auden was "a left-wing political poet and prophet"). Why does the ability of any American to make a paycheck of whatever size threaten the prosperity of anyone else?

The anger certain elements feel about the paychecks of others stems from either envy or (if we want to put a more charitable interpretation on it) the persistence of the erroneous zero-sum mentality, which we have discussed in earlier posts such as this one.

A perfect illustration yesterday of zero-sum thinking was radio talk show host Michael Savage, railing about the hedge fund managers' pay and citing the Times article, who said that it was obvious that three billion dollars didn't materialize out of thin air, and that for hedge funds to make that money, someone else had to lose it!

Those hedge fund managers did not coerce anybody to invest in their funds, and they publicized their fees to investors before they invested, so participation was absolutely voluntary. Investors voluntarily weighed the potential value that those hedge fund managers could bring versus the cost of participating in those funds, and those who felt that the value was justified invested and those who did not used their money elsewhere.

The manager with the pay cited prominently in the Times article and by commentators on the article, whose calculated revenues were $3.7 billion, achieved that number by making investment returns in 2007 of 590% and 353% on funds that he managed.

Clearly, such investment returns are considered valuable to some investors, who willingly pay those who can achieve such returns for them. Also obvious is the fact that, if you can return 590% on a sum in the millions or the billions of dollars, you can add more value than if you earn 590% on a smaller amount, such as on one dollar. Generally, when people earn a lot of money in a free society, it is because they add a lot of value in a way that others are willing to pay for (in other words, in a way that others will trade some of the value that they added by their work somewhere else). Of course, this argument concerns earnings that were not achieved through coercion or through fraudulent deception (for example, if the hedge funds held a gun to investors' heads and ordered them to invest with them, or if they said that their fees were going to be one thing and then they deceptively charged something else, but nobody is arguing that this is what happened).

The ability to make money by adding value wherever you most see fit to do so is the mark of a free economy. Not only is it not a threat, but it is vitally necessary. People like Bill Gross who say that rising pay on the upper end means that "the center will not hold" are mistaken: it is when governments come in and remove the ability of citizens to make more by adding more value that things fall apart.

If governments regulate against income inequality, it actually leads in extreme cases to forced labor. If pay were mandated to be equal for all work, and someone who ran a hedge fund or did brain surgery or jumped out of airplanes in the middle of the night into combat situations was mandated to have the same pay as someone who splits peas for a living, then there would be no incentive for searching out ways of adding more value. It would be necessary for the government to force people to do more dangerous, difficult, or unpleasant work, because there would be no reason to sign up for the added risk or difficulty. In fact, this is just what happened in communist countries such as China during the twentieth century.

The zero-sum mentality that is behind all the agitation against the paychecks of hedge fund managers, CEOs, or partners at investment banks is fallacious and ultimately dangerous to freedom.
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Titanic and the concept of Situational Awareness

April 15th each year not only marks the deadline for income tax returns but also the anniversary of the sinking of the Titanic and the tragic loss of the lives of over 1,500 passengers and crew (sinking at 2:20am on the 15th, after striking an iceberg less than twenty minutes before midnight on the night of the 14th).

It is worth reflecting on the events of that fateful night, and the catastrophe which continues to hold a powerful place in the popular consciousness. Such reflecting should not slip into the tendency to pass judgment on those caught up in the disaster itself, or to revise history in light of some social or political ideology, although even now nine decades later many seem compelled to do so. And yet, even so many years after the event, there is much that applies to situations individuals continue to face, and the valuable concept of situational awareness.

The various branches of the US military have used the term "situational awareness" for over a decade to describe the difficult task of obtaining a true picture of what is actually taking place in a given situation. The military employs this term because they recognize that it is quite possible to carry a picture in one's mind which is not aligned with the actual situation. Often, particularly in situations in which real danger is involved, the picture of what is going on at the time resembles the pictures produced by the old Polaroid "instant cameras," which would spit out a black square that slowly developed, revealing in greater and greater clarity the image you just photographed.

While in hindsight and with the benefit of time (and safety) the picture seems clear and the details easy to put in their proper perspective, being able to perceive the true situation and have an accurate perspective at the time is very valuable -- and the same is clearly true in the world of finance and investing as well.

In the Titanic disaster, the ship had received six messages on April 14th via Marconi wireless (a relatively new technology, yet related to many of the technological advances at the leading edge of today's wireless developments), but only two of these actually made it to the bridge, for a variety of reasons. Because of this, although the captain had an inkling of the danger posed by the ice in the area and had in fact altered his course southward in response, he did not have an accurate picture of the true situation or the fact that the ship was steaming directly into an ice field detailed in a message that was still sitting under a paperweight in the wireless room that night.

We have written already about the under-appreciation of risk that took place over the past five years with investment banks involved in mortgage-related and CDO securitization. That chapter has now been clearly revealed to be a case of having a more optimistic picture than the situation justified. But it is also entirely possible to erroneously have a worse picture of the situation in one's mind than actually exists -- and to take a wrong turn because of it. In fact, as we argued in that previous post, the over-allocation of capital to real estate and related securities was in part a reaction to fallout from the dot.com collapse and the erroneous perception that the technological advances that drove it in the first place were just a big trap and that telecom and technology were suffering from overcapacity and were all but dead.

Similarly, today there is a widespread perception that the worldwide economy is on the brink of a cliff, that the shocks the system has encountered are just the beginning, and that it is time for investors to "batten down the hatches" if they haven't done so already.

In fact, however, it is our assessment of the situation today that there are important growth drivers in the economy (beyond the carnage in the financial sector) which will continue to develop in 2008 and over the next several years. Among these are the situational awareness-enhancing technologies that have begun to enable data, maps, video and the connecting power of the internet to become more mobile. The power of these developments to help not just consumers but also businesses of all sorts to navigate through dangerous waters with greater awareness of both obstacles and opportunities should not be underestimated, although in the aftermath of the financial sector's recent shocks few investors are looking to the future right now.

The concept of situational awareness is one that deserves important consideration. On this noteworthy anniversary, it is worth pausing to consider the events of April 14th and 15th, 1912.

For later posts dealing with this same topic, see also:

"It's a panic, not a Great Depression" 01/21/2009.

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Don't be misled by the media's Great Depression quotations

The general media continues to bombard investors with sensational headlines about the slowdown in the economy, such as the quotation from a speech delivered today at the Brookings Institution in Washington DC by Britain's Chancellor of the Exchequer, Alistair Darling.

In the beginning of his speech, Darling said: "Today I want to make the case for urgent action by the world's major economies to deal with what is the biggest economic shock since the Great Depression."

The line was perfect for the news media, who have been repeating it on the radio and television news, combining it with the release of a negative consumer confidence reading and leaving the impression that we are facing the most severe downturn since the 1930s.

However, Darling was specifically referring to the financial system, which did indeed receive a great shock, although that is not the same as a depression or a recession, nor did Darling say it was. In fact, throughout the rest of his talk, Darling said a number of very sensible things which will not be picked up and repeated by the media, such as:

"It is more important than ever to promote openness to trade and investment [. . .] We just need the political will to do so -- all of us, wherever we sit, rejecting protectionism, breaking down barriers to trade" (page 7 of the speech transcript).

Meanwhile, protectionist sentiment grows in the US, as evidenced most recently by the shelving of discussion on trade with Colombia yesterday (see this article in the NY Times and this editorial in the Wall Street Journal).

Darling's speech also contained calls for restraint in regulation in the face of the recent shocks to the financial system. He said that while regulation and supervision are important, he advises against "more regulation," saying: "Not requiring more regulation -- though reform is needed -- but effective regulation" (3).

This is in line with what we wrote some weeks ago, in the post "What NOT to do right now about the economy." And yet in that post we noted links to the inevitable chorus of cries for greater regulation. While the media will repeat Mr. Darling's quotation about the Great Depression, you can be sure it will never repeat his call for "not requiring more regulation." During his talk, Darling noted that the innovation in financial markets (meaning securitization to diversify the scope of risk, which many criticize as inherently bad) in and of itself has considerable benefits, such as enabling more efficient flows of capital.

In short, Mr. Darling's speech was more about the need for economies to remain flexible and avoid retreating into a protectionist or regulatory shell than about a return of the Great Depression. "The evidence shows that economies which are both stable and flexible are more resilient in the face of shocks," he said (2).

As we wrote in our previous post, we believe that the re-assessment of risk will be a positive for well-run companies that are positioned in front of growth trends. We also believe that there are some very evident growth trends that are even now just beginning to take off (and that were delayed by factors we discussed in that same previous post), some of which we will touch on in upcoming articles.

For later posts dealing with this same issue, see also:

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Stocks and the massive misperception of risk

The past five years saw a massive mis-perception of risk that rapidly came to an end over the last several months.

What were seen as good risks by the largest investment banks on Wall Street (companies with control of huge amounts of capital) turned out to be very poor risks indeed.

That is as much of the story as most people understand, but if you probe a little further you will discover some important insights. The fact that a massive amount of capital was directed into instruments such as CDOs means that capital was not deployed to other opportunities.

Beginning in 2003, there was a perception that real estate investment was the ultimate "safe" investment, a mis-perception that was at the heart of the problem. Conversely, in the lingering psychic aftermath of the 2000-2002 bear market, stocks were perceived as very risky.

The graph above, showing global CDO issuance, reveals a massive deployment of capital into mortgage-related securities over the same years that stocks in general have performed sluggishly.

As risk has been re-assessed on a massive scale, capital may well flow back towards companies with a demonstrated ability to provide value to their customers and a history of being able to grow their business.

We have written before that ownership of good companies should form the backbone of any system for long-term growth of capital (see also this post).

As those controlling the largest capital pools reevaluate the risk landscape, they may return to the conclusion that we have believed all along. If so, it will be good news for well-run businesses positioned in front of fertile fields of growth.

For later posts dealing with this same subject, see also:

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The important section 7520 rate

This month, the section 7520 rate that the IRS uses to value certain charitable interests in trusts is only 3.4%, making this April, May and June a good opportunity for moving assets outside of your taxable estate if it is appropriate for your overall wealth planning situation.

The section 7520 rate is very important because most estate planning strategies are designed to minimize what you "give" to the government (as opposed to beneficiaries you choose, such as causes you care about and members of your family), and the 7520 rate plays a key role in assessing how much of an asset gifted to an irrevocable trust will be exposed to estate taxes and gift taxes.

The IRS sets the section 7520 rate each month using the Federal Midterm Rate, which is determined using an average of the yields of government securities with terms of more than three years and less than nine years. The rate represents a rate of return by which assets in a trust can be reasonably expected to grow in future years, and so the section 7520 rate is basically the rate of return that the IRS projects onto those assets.

In the diagram above, for example, which depicts a charitable lead trust, a wealthy family has created a trust which will donate an annual payment to a charity (such as a college) for a certain number of years and then at some future time give the remainder to non-charitable beneficiaries (such as children or grandchildren). The IRS will use the section 7520 rate for the month in which the trust was established to determine the net present value of the (non-taxable) gifts to the charity, and how much would theoretically be left over for the remainder beneficiaries (a taxable gift). If the assets in the trust grow at a rate of return which is greater than the section 7520 rate, then the amount beyond the calculated "taxable gift" passes to those beneficiaries (the children or grandchildren in this example) free of estate taxes and gift taxes.

Therefore, the lower the section 7520 rate is in the month in which you establish the trust, the better it is for your non-charitable beneficiaries, because there is a greater chance that the trust assets will outperform the rate that the government foresees, growing outside of the tax system and not subject to estate and gift taxes.

Even better, you actually get to choose the most favorable (i.e. the lowest) of the section 7520 rates for the month you establish the trust or the two prior months. The lowest the section 7520 rate has ever been since it was established in 1988 was in July of 2003. The second-lowest was the following month, August of 2003, in which the rate was 3.2%. This month, April of 2008, is the next-lowest after that, at 3.4% (the two months previous to this one were 3.6% and 4.2%).

To see just how powerful the section 7520 rate is, consider the charitable lead trust described above and add some numbers. If a wealthy individual (the grantor of the trust, indicated by the figure on the left of the diagram) establishes an irrevocable trust into which he grants $1,000,000 (indicated by the first green arrow going into the trust), and the terms of the trust dictate that it will gift $75,000 per year to a certain charity (represented by the green arrow with vertical arrows on top of it) for a period of twelve years, then the IRS would use the section 7520 rate to determine the net present value of the original million dollars minus those twelve years of gifts, which would be the amount of the trust that is subject to estate and gift tax when it passes to the remainder beneficiaries.

At 3.4%, the amount subject to gift and estate taxes is $270,965.93. This is over a hundred thousand dollars less than if the trust had been established under a section 7520 rate of 6.2%, which is what it was as recently as August of last year.

By increasing the gift size or duration of the gift stream to the charity, the amount subject to gift and estate taxes can be brought to zero. Any remainder would then pass to the remainder beneficiaries completely free of estate and gift taxes. There would only be a remainder if the growth rate exceeded the section 7520 rate, of course. However, the lower the 7520 rate, the better chance to do so. And obviously, the lower the 7520 rate, the less you need to increase the gifts to the charity in order to leave the taxable gift at zero (at 3.4% in our example above, you could zero out the taxable gift by increasing the annual charitable gift to $100,000 and extending it to thirteen years).

Other types of irrevocable trusts, such as Charitable Remainder Trusts and Grantor Retained Annuity Trusts, also use section 7520 and benefit similarly from a lower 7520 rate.

Because the trust uses the lowest section 7520 rate of the current and prior two months, it seems logical that this June would be an even better month to establish this type of trust (because the rate may continue to go down, but if it doesn't you can still use the April rate of 3.4%). However, the stock market is also down right now, meaning that if you grant assets to the trust that are stocks and they are valued at a lower price right now, that will also work to lower the amount that ends up being potentially subject to estate taxes. There is no telling whether stock assets will still be low in June.

The combination of low asset prices and a historically low section 7520 rate makes this a potentially valuable confluence of events for drafting these types of trusts, if it is appropriate to your situation.

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Have you been adding to your equity strategy?

A few months ago, on January 21st, we published a post entitled "A few lessons from 2002."

In it, we noted that during significant corrections in the past, including the bear market of 2000 to 2002 as well as 1981 to 1982, diving three or even more times while testing for a bottom is very common, making it hard to call the actual bottom until afterwards.

We also noted that being aware of this pattern can present an opportunity, if your cash-flow situation permits you to deploy fresh capital into equities during significant corrections.

Here is the chart from that previous blog post:

Notice any similarities to the chart in today's post, which shows the Dow from April 20, 2007 through today?

In our earlier blog post, we wrote: "Remembering the three arrows in the chart above, you should be willing to add and then add again later during corrections (if your cash-flow situation makes that possible)."

The question for today is, "Have you been doing that?"

If not, why not?

Many investors, even wealthy investors, fail to take advantage of the opportunity to add to their equity strategy during periods of lower prices. While we don't believe that anyone, ourselves included, can predict market bottoms with any degree of consistency, history has shown that adding to your equity portfolio regularly, and stepping up those additions during market downturns, has been a successful long-term strategy.
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