Shock Exchange Profiled in July Issue of Black Enterprise 

The Shock Exchange had its recent invesment meeting on March 16, 2008 and it was truly a star-studded event.  Jessica Jones and Jerry Jack of Black Enterprise were on hand to meet the team and to get a better understanding our investment process.  In her article Round ball and Round Lots, Ms. Jones documents the various enticements used to teach kids about saving and investing, with sports being one of them.  The article goes in depth about the Shock Exchange's basketball program and the performance of the Shock Exchange Fund.  I encourage everyone to pick up the July issue of the magazine.  

Foreword

There has been a lot of changes to the economy since July 2006 when the Shock Exchange made its first investments.  At March 2008 the US is suffering from declining economic activity, rising unemployment, and record foreclosures caused by real estate speculation.  The economy is in the midst of "stagflation" - rising unemployment and rising costs (oil), which is the economic equivalent of the perfect storm.  Rising oil prices are caused by external forces such as (i) the war in Iraq and which has lead to a decline in Iraqi oil production, (ii) reduction in oil production from key producers such as OPEC, Russia, and Venezuela, and (iii) some say oil speculators who may be influencing the price (I'm not sure I buy this one).

2008 represents one of the worst U.S. economies since the last time we experienced stagflation - the 1970's when Richard Nixon was in office.  Though it is also eerily similar to 1990 which experienced (i) a declining economy and rising unemployment, (ii) the Gulf War which also involved Iraq, (iii) oil price shocks due to a cut in Iraqi oil production, and (iv) the after effects of irrational exuberance from the LBO lending craze and defense spending of the mid to late 80's.  What makes the situation even more dire is that there does not seem to be any relief in sight.  Our presidential candidates have not acknowledged the situation or devised any concrete steps to address it.  If the next President wants to accomplish something concrete then he/she should: 

Reign in U.S. Oil Consumption

We cannot control price shocks caused by OPEC or price increases caused by demand from developing countries.  However, we can control our own use of oil and gas consumption.  With gas prices at $5/gallon in some places, it is almost wasteful to have some Americans driving Hummers and other SUVs through our inner cities.  There is a limited supply of oil and such conspicuous consumption costs everybody.  Oil/gas is an inelastic good in that demand is not sensitive to its price.  

High oil prices hurt lower income consumers even more because unlike a Mercedes Benz or a pair of Air Force 1's, purchasing oil/gas is a necessity in order to heat homes, drive to work, etc.  I am not sure if the solution is a gas guzzler tax or higher emissions standards for automobiles but somehow those who use it inefficiently should pay more for it.  

Reign in Healthcare Costs

Healthcare costs are spiralling out of control, with almost no end in sight.  Healthcare benefits are some of the largest costs borne by employers and companies are  limiting some employees to less than a 40 hour work week in order to avoid paying for healthcare.  Healthcare professionals would respond that (i) people are living longer, so they require more complicated healthcare procedures over longer periods as compared to previous generations, and (ii) several procedures, laser eye surgery for instance, have been developed that do not address life threatening illnesses but help people live better and are billed as "in-network" procedures. 

The first issue is sort of a fact of life.  The second issue is a case where certain individuals are "taxing" the healthcare system to improve their quality of life, in this case, a procedure to allow them to forgo having to wear glasses.  Yet the increase in healthcare costs due to such procedures are borne by everyone, including low income individuals who can bare afford the cost of basic healthcare.  Again, healthcare is another inelastic good where demand is not much affected by the cost.  I am not suggesting that certain quality of life procedures be paid for "a la carte" outside of the HMO network, but what I am suggesting is that that a plan can be implemented to make basic healthcare more affordable. 

Invest in Infrastructure

The U.S. infrastructure, bridges and levees in particular, is in disrepair.  Hurricane Katrina, in which the levees protecting New Orleans broke and flooded the city should have been a wake-up call for America.  But everyone was too busy assigning blame than to look ahead to attempt to prevent potential future disasters.  Repairing our infrastructure should be a high priority for the next President.  It is embarrassing that with the U.S. financial might and engineering prowess we are witnessing bridges and levees falter from poor engineering or disrepair.  It does present thorny issues as to who will pay the cost for such investment - the federal government or state goverment(s).  Get creative - reallocate some of the federal budget to this initiative in the form of low interest loans to the states which can be paid back over time.  

Reign in Rising Cost of Education

The cost of college is increasing at three times the rate of inflation.  This would imply that the inputs (professors' salaries, maintaining buildings & grounds, cafeteria costs, administrative costs, etc.) is also increasing at three times the rate of inflation - this is clearly not the case.  What differentiates the U.S. from the rest of the world is our ability to take the best and the brightest and give them access to education and access to capital to allow them to create better and more efficient products and services than are currently available in the marketplace.  If the cost of college keep increasing at its current rate, the only people with access to education will be those from the monied class.

What is really behind the rising cost of education?  The administrators I have spoken with say it is the additional costs of amenities that top students demand.  Current prospectives look not only at the quality of the education but also demand gourmet meals three times per day, a best in class wellness center, etc.  This implies that students who want a basic education, basic amenities and the "option" to eat gourmet meals or join a health spa are being "taxed" by those who not only demand them but whose parents can afford them. 

I have another theory on another key driver as well - the availability of credit.  When I went to college (way back when) there were a couple of student loan marketing agencies.  Today there are too many to count.  A college education is another one of those inelastic goods - you may not be able to afford college but you cannot afford not to go either.  Moreover, a student's ability to pay for college is often directly related to how much he/she can borrow.  A student's borrowing capacity has increased dramatically, hence so has the cost of education.  A similar phenomenon is LBO lending in the '80's.  Oftentimes the amount buyers would offer for a target company was tied to the amount they could borrow - if a bank would lend them $300 million they would offer $375 million . . . if a bank was willing to lend $400 million then they would offer $475 million, and so on.

A solution to these conumdrums (and others) will require having to tell the American people that they cannot have their cake and eat it too.  This is obviously not what the American public wants to hear and the presidential candidate who suggests  such a plan will need backbone and the courage of his/her convictions . . . key attributes of great leaders and of people who have never gotten elected.

Results of the Meeting 

Below is a presentation handed out to the kids by Mr. Neverson which updates changes in economic forces that may be affected earnings and share prices of portfolio companies.

NYSE Power Point Presentation (Zip, 25K)»

Below are fundamentals of the stocks chosen by the team.  The prices have declined from a year ago, which is not inconsistent with the broader market.  We provided the kids with a presentation (attached above) of the macroeconomic forces affecting Apple and Gamestop.  At March 2008 the PE ratio of Apple is lower and GameStop is slightly higher than that of August 2006.  But the outlook on both warrants multiples north of 20x.

We opened the meeting to revisit which stocks we owned, which ones we wanted to trade out of and which companies, if any, we wanted to add.  In general the Shock Exchange acknowledged that kids have the potential to be the best investors.  They have the ability to spot trends before adults do because in large part, they are the trendsetters.  Advertisers therefore place a premium on entertainment vehicles who can attract young adults (age 18-24) because they are more likely to try new things.  Older adults are less likely to be switch brands and are less likely to switch brands in response to advertising.

Apple

Upside

Mr. Barksdale of Ledgemont Capital was pleased by the performance of Apple and optimistic about its additional upside.  With Apple the kids have identified a trend that Mr. Barksdale thinks will last for a while.  Steve Job's ability to create gadgets with lots of technology and information and make them easy to use is unmatched.  Apple's success with the iPod has been been a key driver of earnings in recent years.  Yet its future growth will be driven by the iPhone.  The iPhone has been another hit for Apple and the fact that Apple is signing pacts with the major telephone companies gives Apple a recurring revenue stream outside of phone equipment.  However, the growth will come from developing countries like China and India - two virtually untapped markets for the iPhone.  Based on per capita income in those markets, the iPhone is very affordable, unlike other products like televisions and automobiles.

Risks 

Mr. Baker mentioned that the iPod and iPhone technology not be be "open-source" and the possibility of a competing technology gaining more market share in the future.  Everyone felt that Apple's alliances with the major phone companies would be a deterrent to this.

GameStop 

Upside

GameStop's same store sales growth has grown consistently, even in a declining economy.  The growth and popularity of computer games among kids and adults is not expected to abate any time soon and GameStop should be a beneficiary of that growth.  Ms. Cunningham (Marquise's mom) mentioned that the staff she encounteed at GameStop had clearly video game heads and very knowledgeable about the products.  The knowledge of the staff is a competitive advantage which will continue to drive traffic to the stores for consumers (especially parents) who need comfort around what they are actually purchasing.

Risks

As mentioned in previous meetings, there is a risk that GameStop could go the way of Blockbuster if consumers start buying games online instead of through GameStop stores.  Mr. Barksdale even mentioned the trend of people competing online against other players who could be continents away, which doesn't bode well for GameStop's prospects.  However, the knowledgeable staff that parents (who make a lot of purchasing decisions) rely on is a barrier to entry in some respects.  Secondly, GameStop has created a market for used games which is a recurring revenue stream and another driver of traffic through the stores.  GameStop's same store sales growth, at least for now, appears to be harbinger of things to come.

Satellite Radio

Christopher Smith, Nick's dad, suggested we consider investing in the satellite radio industry.  Chris invested in the satellite radio industry (XM, Sirius) early on and made substantial gains as industry sales and growth expectations growth took off.  Chris also pointed out that the satellite radio manufacturers were negotiating deals to place their equipment in new automobiles and that their market share would continue to increase.  Mr. Barksdale countered that the "churn rate" or the rate in which customers bought the service and then cancelled later was higher than initial expectations.  Also the fact that XM and Sirius were contemplating a merger did bode well for the industry.  In general when companies agree to merge it is a de facto admittance that they cannot make alone. 

Mr. Baker, who was an investor in XM and Sirius in 2003, also mentioned that there were a few other events that signalled that satellite radio did not work.  When Sirius signed Howard Stern, they offered Mr. Stern a five year, $500 million pay package as an enticement.  The up front payment was staggering at the time and Sirius' stock dropped in reaction.  Moreover, the fact that Mr. Stern wanted his money up front instead of aligning his risk and reward with that of Sirius (the better Sirius does, the better Mr. Stern does) implied that Mr. Stern was not comfortable with the prospects for satellite radio.

The second incident occurred when Don Imus came under attack after making disparaging remarks about the Rutgers women's basketball team.  The public, including Al Sharpton, demanded an apology from Mr. Imus.  Mr. Baker thought Mr. Imus would simply tell everyone to "go pound sand" and take his show to satellite radio, which is probably more appropriate for Mr. Imus' brand of entertainment.  However, Mr. Imus engaged Mr. Sharpton on his radio show and also humbled himself in front of the Rutgers' team and the governor of New Jersey.  Then if that wasn't bad enough, after getting fired Mr. Imus begged for his job back and threatened to sue.  Rather than take his extremely popular show and his limitless fan base to satellite radio, Mr. Imus would rather (i) go on a goodwill tour to court the public and the Rutgers team, and (ii) beg for his job back after advertisers pulled out.  In effect, Don Imus was telling us that the prospects for satellite radio are not as rosy as investors once thought.  

Johnson & Johnson

Upside 

After deciding to nix satellite radio Mr. Baker tossed out the idea of Johnson & Johnson which been suggested from a prior meeting.  Chris liked the idea of investing in a company which had market share with the corner stores.  In these uncertain times it gives Chris comfort to know that he can walk into any bodega in the NYC and find products on the shelves made by Johnson & Johnson.  Lotion, baby powder, pampers, etc. are in every corner store year round. 

I never thought about consumer staples in this way but what Chris was voicing is that consumer staples are a safe haven during economic turmoil.  It also helps investors sleep well at night knowing that though products made by Johnson & Johnson are not inelastic, there is steady demand for them regardless of a recession.  So I guess the upside is that an investment Johnson & Johnson helps investors sleep well . . . and everyone needs his REM sleep.

Downside

Johnson & Johnson will probably not deliver the outsized gains achieved by the Fund from investments in GameStop and Apple.

Relative Value

Mr. Neverson handed out this Relative Value Chart of certain NBA shooting guards.  The chart highlights how much Mamba, Ray Allen, Michael Redd, and Dwyane Wade are paid per point, per rebound and per assist.  The chart clearly shows that Dwyane Wade is underpaid relative to his peers.  This is probably the result of the salary cap imposed on rookies, since in 2006 Wade was still under his first contract - a clear example that the NBA salary cap leads to "inefficient markets".  Wade is therefore and "outlier" and we will exclude him from further discussion.

The chart also illustrates that for the other three players, salary per point scored is in a tight range of $6,053x - $6,847x - only a 13% differential.  This illustrates that agents and league owners place a lot of emphasis on scoring in the pricing of players' contracts.  Though Redd appears to give the most value in salary per points, his production falls off when it comes to rebounds and assists where Mamba and Ray Allen lead.  The take away here is that Mamba delivers in rebounds and in assists, which I am surprised by because he has a reputation as a "chuck".  Yet the numbers reveal that he is a versatile, athletic shooting guard and he may not be getting his proper due.  Lastly, relative to his salary, Ray Allen is incredibly productive even though in 2006 he had already been in the league for 10 years.