Monday, January 15, 2007

The Budget Debacle

With apologies to accountants, that’s one career I never yearned for. I admire their ability to work with numbers, but that is not my forte. In fact, it is my belief that most individual are bored with numbers — that’s why we have accountants, because they are good at it. That’s also the reason I hesitated to write this article — it’s about numbers — dollars really. But they’re your dollars so perhaps you will be interested after all.

There is a fascinating web site (actually more than one if you Google the subject) that provides a debt clock that tracks the federal deficit, changing every second:

National Debt

At the time of this writing, on December 19 th, at around 9:48 PM, the gross deficit for the federal government was $8,617,077,333,949 (that’s trillion). That is an astounding, mind-boggling number that is increasing by an equally shocking $134 billon per day, and unlike other official government statistics, does include money borrowed from Social Security and other government trust funds that are not usually counted as debt but should be. Here is what should interest you as a taxpayer: you and every member of your family owe $28,864 as part of the nation’s debt. (The above website also explains the president’s claim that he is on track to cut the deficit in half by 2009 — not so.

If you think those numbers are alarming, how about this projection?: “…the U.S. national debt, now reaching $9 trillion, will grow to about $46 trillion in the next few decades if the country doesn’t reinstate fiscal sanity to its budget–making process.” The article I quote from goes on to report, “None of this should shock anyone. This coming crunch has been predicted for years. Yet our leaders in Washington haven’t addressed the looming disaster, largely because the U.S. public has let them get away with fiscal recklessness.” Now, what left-wing liberal think-tank wrote that libel?

Actually, the above quotes are from the editorial page in The Wall Street Journal about three months ago, a publication not exactly known for its liberal politics. The editorial cited the fact that the Comptroller General of the U.S., David Walker, who also heads the Government Accountability Office, has been traveling the country in an effort to publicize the problem. I rarely agree with any of the Wall Street Journal’s editorials, but I applaud them for this one as well as for the following ending statement: “This must stop with the 100 th Congress that takes office in January. But it’s only going to end if enough people listen to Walker and others sounding similar alarms. It’s time for belt tightening [and the total elimination of earmarks] before we end up like some Third World IMF ward.” Amen!!! There — that wasn’t too bad to decipher, was it?

Click here to view the next article titled "Index Funds — Boring! Boring!"

Index Funds — Boring! Boring!

In a recent interview on the TV program “Frontline,” John Bogle, the founder of the Vanguard Group, was asked, “What percentage of my net growth is going to fees in a 401(k) plan?” Bogle’s answer was both revealing, and probably surprisingly disappointing to participants in that type of program. “Well it’s awesome. Let me give you an example. An individual who’s 20 years old today, starting to accumulate for retirement — that person has about 45 years to go before retirement — 20 to 65 — and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that’s 65 years of investing.”

Bogle continues, “If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow to around $140,000. Now the financial system — the mutual fund system in this case — will take about 2.5 percentage points out of that return, so you’ll have a net return of 5.5 percent, and your $1,000 will grow to $30,000 to you the investor. Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return. And you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That’s a financial system that’s failing investors because of those costs for financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed.”

Using the word “fixed” in another context, the system actually is fixed — much in favor of the investment companies and even more so against the investor. Here is what the Motley Fool website says about actively managed mutual funds: “There are dozens of magazines cluttering the shelves of your local book megastore with covers proclaiming ‘The Best Mutual Funds You'll Ever Find for This Year!’, ‘Mutual Funds That Really Work in Crazy Markets Like This One!’ and other equally over-capitalized headlines. Don't pay any attention to them. Almost everything that you'll ever need to know about mutual funds is contained in these four simple words: ‘Buy an index fund.’ If that seems too simple and not sufficiently attention grabbing, try it this way: ‘BUY AN INDEX FUND!’”

It is, in a sense, difficult for me to believe that my personal attitude towards actively managed mutual funds has changed so drastically, from being a strong advocate to an equally strong antagonist. About 16 years or so ago, I started publishing a bi-monthly financial newsletter concentrating on what I called “outstanding mutual funds.” My readers were almost exclusively, what I would term as “amateur investors,” the very folks alluded to in the Motley Fool comment above — those with only a superficial knowledge of investing who did rely, at best, on recommendations from magazines and the like — and at worst, relied on mutual fund company advertising to make investment choices. That newsletter survived for some ten years, by which time I had gradually come to the realization that while there indeed were several “outstanding mutual funds” at any one given time — one month, six months, perhaps one year — funds would cycle in and out of this classification. The problem was, there was no long-term performance persistency related to any one fund, and if there were, it was impossible to predict beforehand which fund within the group would turn out to be the winner. (Incidentally, the newsletter was essentially free of charge except for mailing fees.)

Of course, 16 years ago, even ten, there was much less in the way of solid data on the long-term advantages of index funds than there is today. Even amongst professional investors and investment companies, the use of index funds as an investment vehicle was limited. Today, however, with the advent of Exchange Traded Index Funds, institutional investors, including hedge funds, vastly outnumber individual investors as users. What do they know that the average individual investor does not?

A good portion of the answer can be found in an article in The New York Times by Paul J. Lin titled “If You’re Playing ‘Beat the Benchmark’, Don’t Expect to Win.” The article opens with, “Good old-fashioned indexing — the plain-vanilla strategy of buying and holding all the stocks in a broad market benchmark like the Standard & Poor’s 500 — became popular in the late 1990s, when the major stock indexes were returning more than 20 percent a year. But investors who’ve recently turned their back on this strategy are probably regretting their decisions.” The article continues, “This year through September, only 28.5 percent of actively managed large-capitalization funds — which try to beat the market through stock selection — were able to outpace the S.& P. 500 index of large-cap stocks, according to a new study by S.& P. In the third quarter alone, it was even worse, with only one in five actively managed large-capitalization funds beating the index.”

Well, you might point out, that’s only short-term information, what about longer periods. A study by Standard & Poor found, “Over the five years through the end of the third quarter — a span that included both bull and bear markets — only 29.1 percent of large-cap funds managed to beat the S & P 500. What’s more, only 16.4 percent of mid-cap funds beat the S & P 400 index of mid-cap stocks, and 19.5 percent of small-cap funds outpaced the S & P 600 index of small-company shares.”

In fact, of the 8,000 or so mutual funds available, just 48 have beaten the S&P 500 in each of the past seven years and continue to beat it this year. That's 0.6 percent of the funds in existence. And of those 48, many are inappropriate comparisons for the S&P 500, which is a fund that invests in mostly large U.S. companies. Some of those 48 invest in overseas companies and small companies, which have done extremely well in recent years and should be compared to different benchmarks than the S&P.

Jeremy Siegal, Professor of Finance at the Wharton School, University of Pennsylvania, provides an even longer-range study of the subject. He says, “Most of us are unwilling or unable to spend all the time and effort it takes to pick individual stocks, which is why the money management business is so large. There are many individuals and organizations that, for a fee, will be happy to manage your money. Money managers are constantly hawking their portfolios, telling you that they are able to outperform the market.”

He continues, “However, data I analyzed indicates that the vast number of these mangers can't beat the market after fees are subtracted from their portfolio returns. Over the period from 1971 to 2004, the average annual return on all actively managed equity mutual funds trailed the S&P 500 Index by 87 basis points per year, and the broader-based Wilshire 5000 Index by 105 basis points a year. Over long periods, this difference in return amounted to substantial differences in wealth. This lagging performance of active managers shouldn't be a surprise; it's a matter of simple arithmetic. For every investor who succeeds in beating the market, someone else has to fall short of matching the market. When the costs (time and money) of actively picking stocks are subtracted from the outcome, those who actively engage in picking stocks must, on average, lag behind the market.”

While the S&P 500 Index is widely considered representative of the market in total, it actually reflects only the performance of the 500 stocks with the largest dollar capitalizations in the stock market. More representative would be a “total stock market” fund such as the Vanguard or Fidelity funds that covers the equivalent of the Wilshire 5000 Total Stock Market Index that includes the smaller size companies as well. In the last five years, this index, and most funds associated with it, has surpassed the performance of the S&P 500 Index funds by a significant margin. That means that it has also outperformed an even greater percentage of actively managed funds.

There may be some readers of this article who are more dedicated students of the investment market (and more specifically the mutual fund market) than the average individual investor. This (presumably) small group of readers might spend considerable time and research effort, and thus manage to outperform the indexes. However, I would bet they are few and far between. While investing in a diversified assortment of index funds (or exchange traded index funds) may be boring, and may not provide conversation for cocktail parties, you will nevertheless discover you will ultimately admire you portfolio’s performance in quiet contemplation.

Monday, January 01, 2007

Ethanol or Hybrids? — The Real Story, Part III

Who Killed the Electric Car?

There must have been a considerable amount of consternation expressed within the headquarters of General Motors several weeks ago with the release of the movie, Who Killed the Electric Car? The movie theorized a conspiracy that was led by General Motors to eradicate a concept that could have revolutionized not only the automobile industry but the oil industry as well. The movie implies that GM preferred the status quo, and in the process forfeited a $1 billion investment effort to introduce an electric powered car that had the potential of eliminating, or at least minimizing the American addiction to oil.

In 1996, GM launched the first environmentally friendly gasoline-free, cost saving electric car — the EV1. Well, that’s not exactly correct, since many of the original automobiles produced in the early 1900’s were powered by batteries. Nevertheless, unlike those ancient batteries, the one powering the EV1 was rechargeable by plugging it into any electric outlet. GM built some 1100 EV1’s and then chose not to sell them, but to lease about 800 of them for a three-year period. Drivers loved the car, and ultimately there was a long wait list for them.

Nevertheless, the plug was literally pulled by GM who claimed there was insufficient demand to justify further production; leases were not renewed; by 2002 all the cars had been collected; and except for a few that went to museums, the cars were crushed and destroyed. The movie maintained that car companies, the oil industry, poor marketing, consumer suspicion and governmental disinterest at both the state and federal level, contributed to the failure. However, a conspiracy theory has evolved that is even more relevant based on very recent events.

Does the Name Stanford R. Ovshinsky Ring a Bell?

Probably not — still, much of today’s technology would not exist without his inventions, enough to have earned him over 300 patents relating to such diverse fields as LCD displays, semi-conductors, solar energy, copying and fax machines, personal computers, and cell phones. Wikipedia, the Internet encyclopedia, describes Ovshinsky as follows: [He] “is a self taught Jewish American-Lithuanian engineer, inventor, and physicist. He has invented amorphous semi-conductor materials, which gave rise to a whole new segment of material engineering, aiding in the construction, of semi-conductors, solar energy, and electric cars.” The article continues, “A true autodidact [a self-taught person], Ovshinsky was forced to drop out of school during the great depression of the 1930’s [he is now 84 years old] in order to help support his family. Despite this, he developed into a successful mechanical and electrical engineer.”

A month ago, The Economist ran an article about Ovshinsky with the headline, “The Edison of Our Age.” (Thomas Edison, a noted anti-Semite, must be spinning in his grave wondering how a Jew could possibly be compared to him). In fact, a recent biography is titled, Stan Ovshinskyand the Hydrogen Economy, in which the author, George S. Howard of Notre Dame calls him “the father of the hydrogen economy.” He cites the fact that “almost five decades ago, Stan, and his wife Iris (who passed away a few weeks ago) proposed a radical idea, the hydrogen loop, to fully utilize the benefits of hydrogen, the universe’s ultimate energy source.”

Few people realize that in any discussion about moving the American predilection away from oil reliance automotive vehicles, Stanford Ovshinsky is a key player. For one, it was he who invented the batteries that made possible both hybrid and all-electric vehicles, and potentially, as well as those that ultimately will be used to power autos and trucks with Hydrogen.

In 1960 Ovshinsky founded his company, Energy Conversion Devices (ECD), where he created his many inventions, one of which was the Nickel Metal Hybride (NiMH) battery that was used in the GM electric car. In 1994, Ovonic Battery Co., a subsidiary of EDC, and GM formed the joint venture, GM Ovonic in order to manufacture and commercialize Ovshinsky’s invention. This led to the creation of GM’s EV1 electric car.

Conspiracy at Work?

Was it mere coincidence that in 2002, Texaco, who had acquired a 20 percent interest in GM Ovonic bought GM’s 60 percent share, thereby gaining majority control of the company and its patents? Texaco subsequently was purchased by Chevron and a company named Cobasys was formed by Chevron to control the patents to the NiMH battery. Interestingly, Toyota had also produced an electric car called the RAV4 EV, employing a similar battery produced by Panasonic. Cobasys sued both companies for patent infringement and Toyota ended up paying $30 million, agreeing not to build “large format” versions of the battery that could be used in plug-in vehicles. This derailed the RAV4 EV and Toyota also pulled all the leased cars off the market. (Remarkably, most of those that had been sold instead of leased are still running as well as ever). At that point, Chevron’s Cobasys, basically pulled the NiMH battery off the market, and refused to sell it for normal automobile production.

It is not difficult to imagine why Chevron would be reluctant to encourage an oil-free automobile, but why would car companies also comply? Think about it — where do most automotive profits originate? Dealers make most of their money from repairs or logistical support. The electric vehicle is therefore a threat, not only to the oil companies, but to dealer service and parts (the eclectic car motor has only one moving part), as well as to the automotive support structure including gas stations, brake shops, muffler shops, radiator shops and tune –up shops.

Moronic and Ironic

In an interview, Rick Wagoner, who was CEO of GM at the time, has admitted that the worse decision of his career was “axing the EV1 electric car program, and not putting the right resources into hybrids.” While Mr. Wagoner’s original decree was moronic, ironic was the most recent GM decision announced in November that (possibly in an effort to shed its image as an electric car killer) it now plans to sell a plug-in hybrid version of the Saturn Vue, probably sometimes in 2007. Even more ironic is the fact that none other than Cobasys, the ECD/Chevron subsidiary that has withheld the NiMH battery from the auto market for the past four years will now supply a new version of that battery to GM, thus coming full circle. However, the most ironic coincidence of all is the fact that the Chairman and CEO of ECD, Stan Ovshinsky’s company, is none other than Robert Stempel, a staunch advocate of the electric car concept who actually promoted the launch of the electric EV I car as chairman and CEO of General Motors until he was forced out of office in 1992. He joined ECD in 1994 in his current position.

It is all too apparent that the stranglehold on the NiMH battery patents held by ECD is the result of Chevron’s attempt to limit the expansion of hybrids in general and more specifically, its greatest nightmare, a car requiring no gasoline at all. It is all the more puzzling that both Ovshinsky and Stempel cannot exert more influence on Chevron to act more in the interest of the country by licensing the patents. Although ECD has been building a plant to produce NiMH batteries, its production capability will be only about 60,000 units, a pitifully small number.

A Business Oriented Report

Why is the above historical account describing the reluctance of both the auto and oil industry to fully embrace the concept of a gasoline free, or at least a gasoline-conserving car, so important? Eventually there are only two avenues to pursue if America is to cure its addiction to oil. One is to build cars with the traditional internal combustion engine, perhaps tweaked with some type of electric booster to conserve gasoline, like the Toyota Prius. The second is to create a new transportation model that requires no gasoline at all.

The transition to both modes is outlined in a 49 page Report published in June by the investment company Alliance Bernstein. (It was given to me by Boca Pointer Bill Duff). The report is headed, “Ending Oil’s Stranglehold on Transportation and the Economy.” A deep analysis of this nature, produced by investment analysts is probably more accurate than what is found in traditional magazines, newspapers, and even academic studies since it approaches the subject from a calculated and objective business standpoint.

The Report offers some interesting, and at times, contrarian opinions. For example, it maintains that a growing popularity of hybrid vehicles “will occur due to the superiority of these vehicles rather than an explicit effort to reduce oil consumption.” It also cites the probability of the “Peak Oil” theory ultimately playing out, but delayed in time as a result of reduced oil demand from the transportation sector. That in turn will be a product of the transition to hybrid-powered vehicles that use electric motors to boost oil efficiency. Another major contradiction relates to an International Energy Agency projection that oil demand for cars will increase from close to 20 million barrels of oil a day currently, to 32 million barrels a day by the year 2030. The Report suggests that as a result of hybrid activity, the latter number will be 50% lower at 16 million barrels. Obviously, the Report foresees the future of the automobile industry as being tied to hybrids.

A Hybrid in Your Future?

However, a peculiar dichotomy exists in the production and marketing of hybrids. Demand has outstripped supply, thereby inducing price premiums above the list price that have ranged from $4,000 for the Honda Civic to $6,000 for the Toyota Prius. These have eased somewhat since gasoline prices have moderated. Yet, as production is ramped up and economics of scale set in, the differential between a gas-only car and a hybrid should fall to only about $2,000. A recent study by P.L. Polk indicates that 71 percent of U.S. consumers would consider buying a hybrid.

Another demand driver for hybrids is the fact that “in the U.S., the high travel segment, comprising business and government fleets, as well as high mileage travel individuals represent 30 percent of new light duty vehicle sales.” These constitute vehicles that typically put on 15,000 to 54,000 miles per year. These are potential customers who are early adapters of new technologies especially when reduced fuel bills can be anticipated.

Another significant driver of demand will be the sharp proliferation of available hybrid models. Within the next two years, every major auto manufacturer has announced its intention to market at least one new hybrid, led by Toyota with eight, Honda, Ford and GM with six each, for a grand total of 44. Nissan is a laggard with only one. This type of commitment indicates quite clearly that the industry is in a transformational mode, and as technology advances, the future potential for reducing our reliance for oil is looking much brighter.

A speedy transformation to an auto industry based on hybrid technologies will have not only enormous ramifications on our geopolitical policies, but a significant impact on auto pollution control and global warming as well. Next month’s article will describe and examine the different hybrid technologies.

Ethanol Redux

If after reading the past two articles on the subject, I have not yet convinced you of the futility of believing in the ability of ethanol to solve our addiction to oil, the following might be the clincher. American Scientific magazine is a highly respected publication that is known for its circumspect consideration of the scientific facts relating to articles it publishes. In its most recent (January 2007) issue, under the title, Is Ethanol for the Long Haul?, the article concluded (as did the two Viewpointe articles on the subject), that ethanol could not even come close to solving America’s love fest with oil. Using the same arguments you read about in Viewpointe, the magazine came to the following (identical) conclusion: “In the meantime, relying on ethanol from corn is an unsustainable strategy: Agriculture will never be able to supply nearly enough crop, converting it does not combat global warming, and socially, it can be seen as taking food off people’s plates. Backers defend corn ethanol as a bridge technology to cellulose ethanol, but for the moment it is a bridge to nowhere.” Right on!!!