Columnist Lee Schafer provides short takes on economic incentives and choices, business strategy and performance, market moves, what business leaders are saying and doing and other topics that pique his interest.

It may be time to take deflation seriously

Posted by: Lee Schafer Updated: December 19, 2014 - 3:42 PM

At least Narayana Kocherlakota didn’t waffle about what he thinks.

The statement Friday by the Federal Reserve Bank of Minneapolis president more or less pounds his colleagues at the Fed for not being worried nearly enough about the specter of deflation. It’s not just what the Fed is doing that’s wrong, through the policy levers it can throw, but it’s what the Fed is saying about the economy and its policy.

Talking now about raising interest rates eventually, he wrote, is a really bad idea. If it were up to him, he would keep alive the idea that the Fed would continue its extraordinary purchases of bonds, called quantitative easing, so long as the inflation rate stays below the Fed’s target.

It’s clear that for at least this Fed president, the threat of deflation looks very real.

It’s still a bit jarring for those of us who are baby boomers to hear talk of deflation, as most of us came of age when the big problem in the economy was too much inflation, or an overall increase in the general level of prices.

But inflation hasn’t been much of a problem for a while, and at least since the end of the Great Recession there’s been talk about the risk of deflation. And if you think inflation is bad, wait till you live through deflation.

Falling prices for many of the things we buy is not inherently a bad thing. Productivity gains and technological change can drive down the cost of products or services, the notable example being computing power. The iPhone on my desk is far cheaper and far more powerful than the computer I bought a decade ago.

The problem is when the price of everything seems to fall, and worse is if consumers and business people assume prices are going to keep falling. When Kocherlakota talks about expectations, that’s what he’s referring to.

Falling prices can mean lower sales and profitability for businesses, leading to cutbacks and wage reductions for workers, who in turn cut their spending. And then with falling prices they put off buying the things they do need, assuming they are soon going to be available at cheaper prices.

The normal functioning of the debt markets also more or less stops, too. People with bonds get paid back in dollars that are worth more than the dollars they lent, enhancing returns even though the interest rate may be near zero. The reverse is true, of course, for borrowers. Each scheduled payment becomes progressively more expensive as the purchasing power of the dollar increases.

Very few Americans still alive can remember what it was like to live in a deflationary period, during the Great Depression of the 1930s, but there have been far more recent examples of a big market economy that experienced a long period of deflation, such as in Japan.

But deflation can occur even without being precipitated by a deep recession. And deflation has played a significant role in US history, including a period called “the Great Deflation” that lasted basically from just after the end of the Civil War in 1865 until the end of the century.  

There was more than one reason for it, from the return to a strict gold standard after the sloppy financial practices of the Civil War era to improvements in productivity as the nation industrialized. For whatever the reason, prices just kept dropping, and that was before the Panic of 1893, a sharp and brutal depression.

Some of the major political battles of the late 19th century, such as the debates over so-called “free silver,” were all about mitigating some of the effects of deflation.

Farmers of that era had an expression for when they faced economic challenges, saying “times were hard.” And you must admit, a decade or two of hard times doesn’t sound like very much fun.

The California Bear on Best Buy is Still Bearish

Posted by: Lee Schafer Updated: November 21, 2014 - 4:14 PM

One good quarter of comparable-store sales growth didn’t shake the conviction of Michael Pachter, a senior analyst with Wedbush Securities of Los Angeles and a holdout among securities analysts who post a recommendation on Best Buy Co.’s stock.

According to Thomson Reuters, of the 27 investment recommendations published about Best Buy’s stock on Friday, 17 were a buy or strong buy rating. There was precisely one sell recommendation.

That’s got to be from Pachter, who actually has an “underperform” rating with a 12-month target price of $18 per share. If he’s right, that would be quite a painful ride down for shareholders, given the current share price of more than $38.

Pachter, in an update report published Thursday after Richfield-based Best Buy released its quarterly results, once again makes a very good case for skepticism. If his were the only research report a shareholder ever read, that investor just might sell.

It is important to note that he is not critical of the people running the company. To the contrary, he’s somewhere between fair and generous in his comments.

In his latest update he apologizes even, for not only having been wrong in his comments in a TV appearance about the iPhone 6’s impact on revenue growth, but also saying Best Buy was disingenuous. 

After seeing this CNBC segment, I would maybe suggest he think also about following up with a handwritten apology note. And maybe flowers. 

The point he makes in his far more measured research report is that the challenges are beyond the talents of anybody trying to run Best Buy.

It’s hard to summarize his lengthy analysis, but perhaps the simplest way to sum up his views is that Best Buy is doing a good job of improving the experience of customers who come into a store, but it just can’t seem to get any new customers.

Further, having to match prices will mean more very painful margin contraction. Finally, the company’s online efforts are just too late.

He wrote that one of the biggest mistakes of his career was thinking that Blockbuster was going to be able to build a competitive online business to go head-to-head with Netflix. After $1 billion of cost and Blockbuster’s bankruptcy, he concluded that any traditional retailer trying to catch up with an online competitor faces very long odds.

Pachter may one day be proven spectacularly wrong about Best Buy, yet his position is actually an easy one to respect.

If one quarter of stronger-than-expected revenue growth was enough to collapse his convictions that Best Buy remains vulnerable, then he wouldn’t be an analyst worth following.

Why Cash is Piling Up on Balance Sheets

Posted by: Lee Schafer Updated: October 24, 2014 - 2:35 PM

In looking for data this week on how American businesses use their cash, to confirm the observations of a longtime Minneapolis portfolio manager interviewed for an upcoming column, I reviewed the most recent look at cash flow produced by The Georgia Tech – Scheller College of Business.

The authors have a broad enough view to produce a regular report on cash flow that’s far more interesting than might be suggested by the title “Cash Flow Trends and Their Fundamental Drivers.”

The authors are looking at the cash flow data of 3,000 or so companies that have a market capitalization in excess of $50 million. The focus of their study is “free cash flow,” which is the cash profits left over after all obligations have been paid.

It’s truly “free,” meaning the company can use it to make acquisitions, invest in capital items like new stores or increase the dividends to shareholders.

The most recent report has data back to 2000. While the numbers from quarter to quarter bump around a little, and it’s easy to see impact of the Great Recession in several charts, there are long-term trends that are very striking.

One is that cash and short-term investments, usually shorthanded as simply “cash” when investors and columnists write about corporate finance, just continues to steadily mount. The median amount is about $88 million, up from just over $30 million 14 years ago.

What explains that?

Well, one other long-term trend is the shortening of the cash cycle, measured in days. This basically is keeping track of the money tied up in inventory and receivables, after subtracting the bills the company has paid yet. And it’s down from over 60 days in 2000 to less than 50 days in 2014.

Another is the decline of capital expenditures, the investments companies make in capital items like buildings or new computer technology. It was around 5 percent of revenue early the last decade, and most recently declined to less than 3.5 percent of revenue.

Capital spending, of course, rolled off the table in the Great Recession and did not recover all the way to prerecession levels, but it had been declining before the start of the last big downturn.

The way to summarize this is that American companies have increasingly figured out how to own fewer assets other than just cash. They might now outsource manufacturing, and thus don’t need a big assembly plant. They may drive more sales through e-commerce channels rather than open more physical stores. And they are a lot savvier about limiting inventories.

One way to look at this is that it’s great that American companies became more efficient with capital, and they should be able to return more capital to shareholders in the form of share buybacks and dividends.

Then there is a contrary view, that American business managers remain excessively cautious and focused on short-term profitability. They would much rather let cash balances build than invest in new technologies or new physical assets. And this can’t be a healthy thing for the economy over the longer term.

Support MNsure? How about MNgrocer?

Posted by: Lee Schafer Updated: September 19, 2014 - 1:44 PM

In talking about MNsure in the last week, one of my go-to guys in the health insurance market tried to once again explain the continuing hostility toward MNsure on the part of a large slice of the public as well as many health benefits brokers and others in the market.

It’s fundamentally opposition to its very existence and really not criticism of its effectiveness or doubts about the intentions of the people now in charge.

MNsure was created as an online marketplace in Minnesota for those seeking to purchase health insurance who might be eligible for subsidies under the Affordable Care Act. States had the option to proceed with such an exchange or have everyone go to a federal exchange.

For MNsure critics, the issue is that MNsure is an artificial market, created by the state, and people who are eligible for subsidies for their health insurance costs have no choice but to use it.

They say there had to have been a better way, leaning on the private sector, to achieve the policy goal of enabling a subsidy to reduce the number of uninsured people.

As my expert pointed out, folks eligible for the Supplemental Nutrition Assistance Program, or SNAP, usually get an electronic benefit card. They can take that into Target, Cub or Coborn's to shop for groceries.

Imagine, he said, if the MNsure model came to food, and the state made everybody eligible for SNAP go to MNgrocer.

There would be an uproar, and not just because it’s a grocery store located in an industrial area of St. Paul that’s not easy to reach from public transit, or it may not have fresh milk that day.

The irritating part would be that participants on their way to MNgrocer would pass a Target or Cub that is perfectly able to meet their needs – with fresh milk that’s competitively priced.

Another Casualty of the Medtronic Deal: Estate Plans

Posted by: Lee Schafer Updated: September 5, 2014 - 11:54 AM

There has been plenty of media coverage of the capital gains tax facing Medtronic shareholders when the company’s proposed acquisition of Covidien closes.

The structure of the transaction is an inversion, which triggers a capital gains tax for holders of Medtronic when they exchange their shares for shares of the newly merged Irish company, Medtronic PLC.

One aspect of this tax that has not been deeply explored is how it blows up the estate plans of lots of Medtronic shareholders, many of them retirees from the company. It has the effect of creating a tax, consuming a bunch of their family’s wealth, when they had a perfectly legal plan to never let their Medtronic stock gains get taxed.

The basic principle at work here is what’s called a stepped-up basis. Under the federal tax laws, there is an exclusion from estate taxes of a certain amount of assets when a person dies. Under current federal law, it is more than $5 million, and twice that if it’s a married couple that manages its affairs well.

When an estate files its tax return, the assets of the estate are valued at fair market value. In the case of a publicly traded stock like Medtronic, that’s just a matter of looking it up on Bloomberg and filling in the form, and today it’s around $64 per share.

When the heir takes possession of the stock, that $64 is her historical cost, her “basis,” even though Dad may have had an average cost of $10 per share. That’s what’s meant by a stepped-up basis.

So, by dying with the shares in his estate, Dad effectively transferred $54 per share of gain to his daughter in a way that’s never going to be taxed. His daughter can sell it today at $64, with no taxable gain.

How many individual Medtronic shareholders had exactly that in mind for their Medtronic shares? Impossible to say, but the guess here is that it was a lot of them.

That’s no longer possible, not unless Dad and Mom manage to die between now and when the transaction closes. 

So when you meet the Medtronic shareholder in their golden years who sounds very crabby about the pending transaction with Covidien, please understand that a simple plan to leave some wealth for the kids just took up to a 30 percent hit.

Labor v. Machine, and Labor is Hanging in There

Posted by: Lee Schafer Updated: August 29, 2014 - 3:34 PM

A great paper for the Labor Day weekend, if you have the time and stomach for it, is MIT economist David Autor’s latest work on machines’ ability to take our jobs.

Called “Polanyi’s Paradox and the Shape of Employment Growth,” the paper starts with the quote from the philosopher Michael Polanyi who famously observed that “we can know more than we can tell.”

It’s this idea, that we can do complex jobs that we really don’t fully understand, that lies at the heart of the argument that computers and robots will never successfully replace human labor.

What’s interesting is that the quote also refers to the irreplaceable art of driving a car -- we are good at it even though we may not understand the physics or engineering of our vehicle. A machine-driven car in 1966 seemed beyond the wildest forecast of machine capability, of course, but thanks to Google we know it’s coming, likely in most of our lifetimes.

Autor, however, is mostly an optimist about the ability of humans to hang in there in the labor market.  The computers haven’t been able to do the jobs that require non-routine work, at both ends of the income spectrum. As he put it, “the challenges to substituting machines for workers in tasks requiring adaptability, common sense and creativity remain immense.”

In one great example, he writes it is relatively easy to come up with the machine that can recognize shapes and patterns, but a machine isn’t going to as easily understand what an object is for. Meanwhile, a person looking for a chair will quickly reject the toilet and a traffic cone that, to a computer, might both look suitable for sitting.

His implied advice is that people looking for skills and good employment prospects need to think of jobs that are complemented by computers, and he's not just writing about jobs in management or the top professions.

While many middle-skill jobs do have tasks that can be easily automated, to do them well a person needs a broad range of skills. It’s not that easy to unbundle a job and assign to a computer just the specific, repetitive tasks that lend themselves to automation.

An example he uses is calling software tech support. A computer might search the databases for known issues that seem to be the customer’s problem while the technician politely chats up the customer on the phone. When a solution is located, the technician can read back what the computer found.

Yet that is not a very productive form of labor organization, he wrote, making it possible for jobs to persist with routine and nonroutine aspects are complementary. Back to the example of tech support, the technical expertise has the most value when it comes from a person who has the judgment to help the customer figure out what’s wrong and can talk her through the best solution.

All of which is to suggest, he concluded, that the pessimists about the future of human work are overstating their case. It also means, thankfully, that we can look forward to many more Labor Day weekends.


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