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GP 17 August 2005: Investment Outlook: Infrastructure

House Built on a Weak Foundation.  We’ve not issued a new investment outlook since the first quarter of 2004, since the thinking put forth there—to search around in deep value sectors of the equity markets and in some unusual asset classes—has not been too risky a course even amidst the bubblegum economy around the world.  But things have now gotten more chancy in mid-2005, and it’s time to be goin’ elsewhere. 

Some of you will remember a long forgotten chant, we think from Harry Belafonte, that ran, “A House Built on A Weak Foundation / Cannot Stand / Oh No, Oh No!”  The housing boom is beginning to bust.  It and all the rest sits on a weak foundation.  It had stemmed from worldwide policies that fostered excessive consumption to include easy money.  Prescient Wall Street seer Ray DeVoe can now say “I told you so,” since he has been warning us about puffy housing markets for a couple of years.  At last the Fed is firmly and consistently ratcheting up interest rates, having previously flooded us with money.  This is Alan Greenspan’s last act as Fed Chairman before his presumptive retirement in January: it looks like he is conscience-stricken and abashed at his spendthrift ways, ready to take on the virtuous mantle before he is carried out of office. 

Even before his reversal on interest rates, the housing bubble, the successor to the Internet bubble, was beginning to quiver in the breeze.  Now signs of distress are pouring in, noticed by all but real-estate promoters, whose venal hope springs eternal.  They’re still building sumptuous, awkward palaces all through exurbia.  If you wander down the street, you may see a new house a-building that looks much like a dormitory.  Squire Firehock of Staunton Virginia advises us that CNN has provided an ample list of housing markets, led by Boston and closely followed by several other East and West coast locations, that are ripe for meltdown entitled “America’s Riskiest Real Estate.”  Seattle, Pittsburgh, and Indianapolis are still safe harbors.  But much of the rest is over the top (http://money.cnn.com/2005/08/03/real_estate/buying_selling/pmi_riskiest-markets/index.htm).  Even bleaker is the data, only some of which has been published, on the mounting inventory of unsold housing.  The Wall Street Journal (August 12, 2005, pp. A1 and10) notes “Rise in Supply of Homes for Sale Suggest Market Could Be Cooling.”  Houses on the shelf are up sharply in San Diego, northern Virginia, Massachusetts, Chicago, Las Vegas, and Orlando.  (Also see www.nytimes.com/2005/08/13/realestate/13froth.html.) 

Swensen’s Doubts.  If rising interest rates and declining housing fortunes are not enough to make you nervous about your investments, then take a read of David F. Swensen’s new book Unconventional Success: A Fundamental Approach to Personal Investment.  He’s the wizard at Yale who has generated 16.1 percent long term returns, a record other institutional money managers can only dream about.  This has been instrumental in giving the university an endowment in excess of $15 billion as well as a $500 million-plus annual contribution to its operating budget.  He’s an interesting fellow who beefed up the portion of Yale’s portfolio in equity and alternative investments.  We have had calls from more than one chief executive asking how to copy the Swensen approach. 

He had set out in his book to show the individual investor how to copy his approach.  But he has since realized that Joe Doaks simply can’t do it.  Poor Joe does not have Yale’s research.  He can’t access great hedge managers.  All the mutual funds skewer him, overcharging for mediocre or worse performance.  So dour Swensen would basically have us invest in a mix of index funds where one can at least avoid excess transaction charges.   

Don’t take Swensen too seriously.  But take him seriously.  Like all experts, he has fallen into the trap of believing in experts and expert methodology.  Be assured, for instance, that we and our associates, without benefit of inside information, superior research expertise, or Street wizardry, have long exceeded the averages.  So you can, maybe, do better than Swensen thinks you can. 

But his book, coming out now, has great symbolic value at this very time.  It’s a warning to us.  We are now in financial quicksand where it will be easy to lose your shirt, for the world financial markets are truly a mess: they’re in  much worse shape than when we published our last report in early 2004.  Things are so bad that you truly can expect horrendous returns, if you are looking for short term results (i.e., less than 7 years).  Don’t buy for tomorrow or the day after tomorrow; even the hedge funds are now having trouble investing for 2-, 3-, or 5-year cycles.  Look out a decade.  Read about his book at www.nytimes.com/2005/08/13/business/13nocera.html and see Swensen at http://mba.yale.edu/faculty/others/swensen.shtml

The Bernstein Index.  Peter L. Bernstein is a marvelously literate investment advisor and one-time OSS operative, Air Force captain, college teacher, and researcher at the New York Fed (www.peterlbernsteininc.com).  For the individual investor, he’s a more important read than Swensen because he has a wider compass.  In 1996, he came out with Against the Gods: The Remarkable Story of Risk just as we were entering a world where risk management skills became more critical in running the nation, the economy, and one’s portfolio.  Risk assessment surely would have kept more of us out of some of those Internet stocks that crashed and burned, and would  contain some of the awesome hubris that still afflicts us in this new century.  In 2000 came his Power of Gold, just as it became more and more profitable to plough a bit of your lucre into all sorts of commodities. 

Now, equally timely, is his Wedding of the Waters: The Erie Canal and the Making of a Great Nation.  By implication, it tells us and the nation where to invest now.  (See www.foreignaffairs.org/20050301fabook84235/peter-l-bernstein/wedding-of-the-waters-the-erie-canal-and-the-making-of-a-great-nation.html, www.washingtonpost.com/wp-dyn/articles/A54777-2005Jan6.htmlm.)  This is the story of the building of the Erie Canal—linking the Midwest and the East to Europe and the world through New York State.  Its 300-plus miles made New York the Empire State, and New York City the capital of the world.  Interestingly, it was New York politics and finance that put the canal together, just as it will be developments initiated at the state, instead of federal level, which will account for America’s future greatness in the world.  New York State is sorely in need of another De Witt Clinton—a man who had enough push and vision to realize New York’s Manifest Destiny at the Canal’s opening in October 1825.

See our “Courtly Congressman, Amory Houghton, Jr.,” where we contend that even today New York State can play a unique role in rebuilding the national infrastructure. 

Now we must each find out own Erie Canal to back.  The risks today are too big to manage; commodities and alternate investments, even oil, may turn down quite a bit by 2008, and so one’s investments must drift into areas that will mature some time well over the horizon.  Running around in present day markets, busily turning over your portfolio to look for gain or to avoid risk, is probably a zero-sum game that will run down your assets.  The wise Bernstein cautions you not to press too hard: 

The day-trader phenomenon would not have developed out of a population that was thoughtful about how the stock market works.  And I don’t think that many individual investors have learned that the more you press, the more problems you’re going to get into.  They have not learned that, and maybe they never will.  A lot of investors feel it isn’t hard, they just don't know how.  After 50 years I still haven’t got it all clear.  And that’s okay, because I understand that I haven’t got it figured out.  In a hundred years, I won’t have it all figured out (http://money.cnn.com/

In the present environment where there is no safe house: you had best not scurry about like a trapped rat but, instead, find a way to settle down for a while out of the turmoil. 

Infrastructure.  As we have mentioned in previous letters, there is almost no aspect of our national infrastructure that is not worn out.  Moreover, what we have is engineered for yesterday and is in no way suited to the challenges ahead.  For instance, our electric power grid was built in a time when our power plants were near the people who would use the electricity.  Now we transport power over long distances which means we need a system with national controls, standards, and technology that looks much different from the grid we have today.  We will have more blackouts, not just because we have under-invested in our electric power structure, but also because our concepts and policies have not kept pace with the realities of our marketplace.  In every way, we need to rebuild the foundation of our country so as to provide underpinnings for our society and to secure our national destiny.  What then are some examples of “infrastructure”-type things where investors can take a long-term plunge? 

Alternate Energy.  Most of the captains of industry and policy wizards in Washington claim that alternate sources of energy outside of oil and nuclear fission can only provide a drop in the bucket of our power needs.  That said, as we have said in several places in Big Ideas, alternate energy is beginning to make a difference and some of it is even becoming cost competitive with fossil fuel. See our entries on “Shale,” “Oil, Oil, Everywhere?,” “Fusion Time,” “Manure Power,” “Solar Power Revisited,” “Running on Empty,” “Water Batteries,” “Blackout 2003 Equals Blindness 1990,” “Power and Water,” “Wind Power,” and “Ocean Power.” 

In general, General Electric is a substantial play in alternate energy if you want exposure to wind, solar, and other types of energy development.  See “GE and Alternate Energy.” The trouble here, of course, is that you are buying into all sorts of businesses, not just alternate energy, when you invest in General Electric. 

Windpower alone may be a more interesting investment where you can find interesting companies solely focused on whirling blades.  Wind energy is slowly becoming rather cost competitive with fossil fuels, and many countries are making commitments to it, from China to tiny Denmark.  Denmark, in fact, now derives 15% or so of its energy from the wind.  For a good introduction to wind energy and its possibilities, see www.windustry.com/basics/01-introduction.htm.  Perhaps the world’s leading windpower company is Vestas (www.vestas.com/uk/Home/index.asp), which supplies turbines to power companies around the globe.  It has had some financial bumps but has an outstanding market position.  Its homebase is, incidentally, Denmark, the very nation that has made such a deep commitment to windpower.  Though the U.S. showed early enthusiasm for windpower, as it has for many new technologies, its engineering was weak; the Europeans have since overcome some of our design flaws (www.economist.com/displaystory.cfm?story_
id=3850262).  The hopeful outlook for wind energy in the United States is summed up at www.economist.com/displaystory.cfm?story_id=526754.  Windpower is a very good example of how one should invest in future ideas: pick a future niche where the economic model and profit potential are almost right today.  Even if the affluent around Cape Cod are stridently resisting windpower in their backyard, we are going to have a whole lot of it (see “Tilting at Windmills”). 

We still consider sunpower to be a speculative arena.  We have, nonetheless, listed a host of providers on the Global Province and find it interesting that Germany and Japan have make more progress in solar development than the United States.  Despite the fact that the cost per kilowatt is still tres cher, the demand for solar panels has suddenly bolted upwards, and manufacturers currently have not been able to keep up with demand from contractors. 

Education and Knowledge Transfer.  It’s clear that we are becoming dumber, and that our schools at all levels, both private and public, are failing to equip Americans with enough smarts to play the value-added, knowledge intensive role that lies at the heart of its increasingly service-based economy.  Just as women in Arab states such as Saudi Arabia are eroding the chains that hold them down simply by becoming better educated, education and knowledge are America’s hope of not becoming a vassal of Greater Asia.

Slowly, very slowly, private business is learning how to make a dent in this sector.  Various outfits, from Michael Milken’s Knowledge Universe, to the Edison Project, to Sylvan Systems paved the way with experiments that had limited success, Sylvan probably having the most impact (www.educate-inc.com/aboutus.html).  All have tried to supply add-ons to America’s public education colossus, though some commentators perhaps would feel they merely offered band aids for a fatally flawed system. 

Probably the key to revamping everything and reaching isolated, backward areas of America is online education.  This is dependent on the growth of cheaper access via municipal wireless.  A host of companies are committed to making a dent in virtual education, none more so that Pearson in Great Britain.  There an American, one Marjorie Scardino from Texarkana, has come in, cleaned out the ragtag of businesses that made up the Pearson portfolio, and focused it both on publishing and, more particularly, education.  Along the line, for instance, she picked up Prentice Hall’s powerful set of entries in educational publishing.  (See www.economist.com/
displaystory.cfm?story_id=372400, www.pearsoned.co.uk/Aboutus, and www.pearson.com.)  She is pushing more deeply into online education and seems to be reaping better financial results from her determined foray into education. 

An even more interesting conversion of a media company into an educational moneymaker is the Washington Post (www.washpostco.com).  Its website does not make clear just how far it has gone in education: for the first time, if we remember rightly, education has become the biggest contributor of revenues.  In any event, education revenues increased 35% in 2004 to $1,134.9 million.  The annual report, by the way, no longer features articles by and about its journalists and its flagship operation the Washington Post, which is now being overshadowed by its Kaplan education unit.  As we have said elsewhere (see the “The New Regional Daily”) there has been a challenge for newspapers everywhere to radically redefine their businesses and become very much broader content providers.  It would not be an exaggeration to claim that its education business will be the salvation of this company.  

There are interesting opportunities aplenty in both training and the knowledge transfer business which are both strongly related to education.  As for the latter, we find that companies still do not have a successful dynamic model for archiving, re-using, and sharing knowledge and experiences so as to stoke their own innovation but also to resell intellectual property to others.  In general all the companies we have talked about above are burdened with concepts and other baggage from traditional publishing and education which inhibit their potential.  Many would be advised to form joint ventures that could provide knowledge management services for several companies. 

We have long followed a stripling of a company in Boise, Idaho which has stumbled, bit by bit, into a rather different model.  We have previously written about PCS in our Agile Companies section.  Sprung out of a computer-repair business, it put up bricks and mortar schools where parents could supplement regular education with extra courses in math, science, etc.  Now all the buildings are gone.  It has migrated totally to the Internet.  Using Internet modules combined with Lego Blocks to give the education a tangible feel, it has been selling its services overseas to developing countries such as Egypt and Pakistan.  Gradually it is introducing an entirely different global educational model that even the poor in distant lands can afford (http://edventures.com/
index.html).  Virtual education, however, is as applicable in developed societies such as ours, where we clearly are no longer getting a bang for our educational buck. Obviously, however, it cannot replace  social learning that only can transpire face to face.

Collaboration.  Global markets in a post-Cold War world also have changed the shape of all economic and governmental activity.  No one nation, even the U.S., controls enough resources, people, knowledge, etc. to implement a global strategy, and there is almost nothing we can now do of any meaning that is not both global and complex in nature.  In a world where we lack enough control to get the job done, we must compulsively cooperate to move the chess pieces around the board.  Actors inside and outside our borders have to play a role in devising a new car, putting together a defense against terrorism, halting the spread of diseases that know no boundary, and so on.  As Peter Drucker has noted, strategic alliances and joint ventures are now vastly more important for forward-looking businesses than old-fashioned, wasteful mergers.  See http://www.conference-board.org/pdf_free/annualessay1999.pdf.  Now, as he says, “the real boom has been in alliances of all kinds….”  The problem is for business managers and investors alike to take advantage of this unprecedented trend. 

A host of software schemes, such as Tacit Knowledge and Croquet, have sprung up to foster cross pollination inside companies and around the world.  The predecessor to the Internet was devised by DARPA, mostly to promote scientific collaboration.  Sundry tools to integrate research on various problems have resulted in undertakings in both open source software and biotech research.  (See “Linux for Biotech”.)

We are still a long ways off from the kind of collaboration we require to move on the biggest problems of the world.  In many ways, conquering space and time is not a technical problem, but more of a psychological or ethical problem.  Independent, competitive people have to learn to meld their activities with others, putting aside their go-it-alone proclivities.  Business schools, companies, and others are now pushing courses to achieve the necessary re-treading of their managers, but only have made a start (www.economist.com/business/globalexecutive/
displaystory.cfm?story_id=1097093).  For more on the environment that promotes collaboration, see www.economist.com/business/globalexecutive/displaystory.cfm?story_id=417029

As best we know, the best tangible efforts to achieve collaboration are happening in unlikely areas.  In the bureaucratic, sclerotic world of healthcare, for instance, there is a movement called “shared decision making” where coaches try to ensure that patients are extra-informed about their illnesses so that they, along with healthcare experts, can participate in their treatment, shaping the plan for dealing with their heart condition or diabetes.  Amongst public companies, American Healthways (www.americanhealthways.com) comes to mind, it having made some efforts to engage patients in their course of treatment.  Health Dialog, a fast growing private company which we follow closely, is more formally invested in all the disciplines necessary to achieve patient collaboration.  It is heavily focused on making patients aware of the full range of clinically reputable treatments for their condition, and it drives each patient to accept responsibility for acting intelligently with the surfeit of information at hand.  See our details on Health Dialog at www.globalprovince.com/healthdialog.htm.  In fact, Health Dialog is fond of referring to its process as collaborative care (www.collaborativecare.net).  

As interesting to us is another private company called Virtual Agility, which provides a software dashboard for controlling giant collaborative endeavors that cut across time zones and a host of independent participants (www.virtualagility.com).  Its first applications involve very independent-minded government agencies that must attempt massive coordination on various questions of national security.  Interestingly it provides a tool that all sorts of people can agree to use. 

Probably the most advanced forms of collaboration now occur in the supply chain management process.  Wal-Mart, for instance, has built its low-cost, low-quality discount model on superior logistics based on digital replenishment and systematic information exchange with its suppliers.  Land’s End, now part of Sears, Roebuck, has built a made-to-order jeans system, allowing you to input your measurements and quickly get your pants back from factories in Central America or Malaysia: we waxed enthusiastic about  “Land’s End Made-to-Order”, but now, of course, Land’s End is a rounding error in the Sears/K-Mart behemoth, and we wonder if it can have much impact on the Company’s management process.   

Even in supply chain logistics, most of the interesting companies are private and not accessible to public investors.  For instance, Harry Lee’s TAL Apparel in Hong Kong (see “The Shirt King”) is doing everything from design to replenishment on shirts it is producing for a host of branded retailers in the United States, and it is reputed now to be pushing into underwear.  Clearly it has a more collaborative relationship with its customers than the Wal-Mart model allows, since the confrontational folks in Arkansas are noted for pushing their suppliers to the wall.  TAL Apparel is beginning to achieve the kind of collaborative effort that current business practices do not normally permit. 

Today the public investor wanting to get a foot in collaborative waters will probably buy a stock like Amazon, which is using its internet marketing machine to peddle a host of products it does not stock.  This has stoked its revenues and profit performance, while adding significant volume to some of the third party merchants who sell through its website.  In days to come, companies imbued with a much richer collaborative ethic will come to market and offer significant value to investors who can hold out to 2015.  Investments in collaborators are hard to come by, but this is where the big money is going to be made.   

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