After Missing The Latest Quarter, Cisco Shares Are Dirt Cheap

There is no doubt that earnings season is my favorite time of year from an investing perspective. Every quarter Wall Street overreacts to dozens of seemingly disappointing profit reports and punishes stocks in the process. For a deep value, contrarian investor like myself, it’s Christmas, Hanukkah, and Kwanzaa all wrapped into one. One of this month’s best holiday doorbusters has to be networking giant Cisco Systems (CSCO), whose shares have fallen 20%, from $24 to $19, after the company guided down for the current quarter.

Now, I understand that investors hate quarterly misses, especially for larger companies like Cisco whose businesses typically have far more visibility than smaller upstarts. That said, Cisco’s current valuation (12x trailing earnings, 7x trailing cash flow, and 11x 2011 profit estimates) makes it seem like this company is barely growing at the rate of GDP. That does characterize some mature tech forms such as IBM (IBM), which only grows sales at 3%-4% and also fetches about 11 times earnings.

Despite recent softening in some of their businesses (especially sales to governments), Cisco is still growing sales and earnings at double digit rates and should continue to do so. This is a classic case of getting to buy a company that is growing faster than the S&P 500 at a discount to the market’s overall valuation. Not to mention that Cisco is a leading company in an excellent and highly profitable industry. I would be quite surprised if Cisco shares didn’t reclaim all of the recent losses sometime over the next 12-18 months.

Full Disclosure: Peridot Capital was long shares of both Cisco and IBM at the time of writing, though positions may change at any time.

Finally, A Concrete Income Tax Simplification & Reform Plan That Makes Sense!

Continuing the post from yesterday about the ideas put forth by the co-chairmen of the Obama Administration’s deficit reduction commission, I skimmed through the 50-page presentation (you can do the same here if you would like to) and there is a lot to like in it. One of my favorites is a real, well thought out plan to simplify the U.S. income tax code. I mentioned in my last post why I think the mortgage interest deduction is ridiculous, but the whole code is too complicated with so many brackets, schedules, and deductions.

One of the things that bothers me the most is that income is taxed differently depending on how you earn it. Shouldn’t a dollar of income be considered a dollar of income, regardless of whether you are an employee earning a fixed salary, a CEO who cashes out stock options, a retiree who lives off of dividend payments, or a hedge fund manager who trades stocks for a living? Our current tax code essentially tells us that certain ways of earning a living are better than others by rewarding them with lower tax rates. It doesn’t make sense that George Soros or Warren Buffett should ever be in a lower tax bracket than their secretaries, but today they are.

But maybe there is hope. The co-chairs of the commission put forth three options for fundamental simplification of the tax code and one of them really stands out to me. They propose eliminating all tax deductions, treating all income as ordinary income (rather than having dividend income and capital gains income be taxed at lower rates), reducing the total number of tax brackets from six to three, and best of all, dramatically reducing income tax rates for everyone to make up for the loss of deductions.

Here is the slide in the presentation that summaries this option:

As you can see, we are left with three individual income tax brackets (8%, 14%, and 23%) along with a reduction in the corporate rate (which will serve to boost stock prices and declared dividends).

Does anyone else think that treating all income the same and taxing it at 8, 14 or 23% makes a lot of sense? I know people will have to give up their standard deduction or several itemized deductions (such as mortgage interest and charitable donations) but look at those rates! Not only would it be hard to argue that the government was taxing us too aggressively, but without deductions you can bet that your tax return will be confined to a single page and take a lot less time to prepare. And most importantly, this recommendation is included in a comprehensive plan that reduces the deficit to 2.2% of GDP by 2015 and eventually balances the budget.

I know it will never fly with the politicians but I am going to hold out hope anyway as it is exactly the kind of plan that I would create if given the power to do so.

Bipartisan Deficit Reduction Commission Brings Some Sanity to Budget Debate

According to a story from the Associated Press, it appears that President Obama’s bipartisan deficit reduction commission is ready to bring some realism and logic to Washington on ways to reduce the federal budget deficit. Of course, the odds that politicians will support these ideas are low since they have proven lately that they believe in magic (on one hand calling for deficit reduction while on the other refusing to support entitlement spending cuts or tax increases — both of which are needed to balance the budget).

Not all is lost though, according to this AP story. I say that because the recommendations being put forth by the two leaders of the commission (one from each party) are exactly the kinds of budget cuts that we should be talking about. Social security and defense spending together account for about 40% of government spending, making it imperative not to deem those areas “untouchable.” I was also happy to see that they mentioned farm subsidies and the mortgage interest deduction as other areas of focus.

While the mortgage interest deduction is a tough sell politically (if eliminated it would hit the middle class), it costs the United States about $100 billion per year and makes little sense from a policy perspective. In a day and age when many Americans believe that Washington, DC is spending money unnecessarily, why should the federal government help us out with our mortgage payments? Really, that is all the mortgage interest deduction is, the federal government reimbursing you for a portion of your mortgage. There is no reason whatsoever for a government running annual deficits of over $1 trillion to be paying some of people’s mortgages.

Let’s cross our fingers that the new Congress, filled with people who got elected by campaigning on deficit reduction, actually deliver on their promises and support some of the commission’s recommendations, because if they don’t real cuts will be impossible.

Earnings Growth Does Not Predict Stock Market Returns

Lots of readers are writing in to question my assertion that the stock market does not track corporate profits or GDP. They seem upset to learn that if you can correctly predict GDP growth or earnings growth in the short term that you can’t also predict the direction and magnitude of the market’s moves. The key here is that the market prices in certain expectations about the future ahead of time and then readjusts prices based on how the future plays out relative to those expectations. We cannot simply infer that, say, over the next year GDP will grow 3%, leading to earnings growth of 8%, and therefore the market will rise 8%. Markets are more complicated than that!

Here is an illustration I came up with to back up these claims (raw data compiled by NYU from Standard and Poor’s and Bloomberg). As you can see, correctly predicting S&P 500 earnings growth (grouped along the x-axis) for any given year does not help predict the market’s return (plotted along the y-axis) during that same year. In fact, the market does better when earnings are declining, relative to how it fares when earnings are growing by double digits. In the near future I will try and compile data that shows which figures actually have predictive value.

Political Gridlock Good for Markets? Another Common Theory Debunked

Stock markets love gridlock. This is what one would think after listening to investment pundits in the media. The thinking goes that markets hate uncertainty and with gridlock in Washington very little actually gets done, eliminating fears of new, unexpected legislation. However, a quick look at the numbers show that this theory is completely wrong.

Sam Stovall of Standard and Poor’s looked at historical U.S. stock market returns under three political scenarios, “unity” (one party controlling the presidency and both houses of Congress), “partial gridlock” (one party holding the presidency and another controlling Congress), and “total gridlock” (a split Congress). The results since 1900 show that the stock market actually hates gridlock. How this stuff gets repeated so often in the financial and political media is beyond me.

Annual Stock Market Returns Under Three Political Scenarios (Source: S&P)

Since 1900:     Unity +7.6%       Partial Gridlock +6.8%     Total Gridlock +2.0%

Since 1945:     Unity +10.7%     Partial Gridlock +7.6%     Total Gridlock +3.5%

Record Corporate Earnings Continue to Fuel Stocks, Analysts Optimistic for 2011

According to financial data collected by Thomson Reuters, 70% of S&P 500 index companies have reported third quarter profits so far and earnings are up 30% year-over-year. This compares to estimates of just 24% growth and explains why the U.S. equity market is knocking on the door of the 2010 highs made back in April. For all of the pundits complaining that Washington DC politicians have been bashing Corporate America too much, aggregate corporate profits are actually making new record highs (second quarter earnings were an all-time record) so we have to wonder exactly how tough companies really have it these days.

As we head into 2011 analysts are expecting corporate profits to keep surging, by about 13% next year. With P/E multiples about average historically, the strength of earnings will likely dictate much of market’s movement in 2011. Analysts notoriously overestimate profit growth (by a factor of nearly 2x over the long term according to studies done by McKinsey), so once again they are very optimistic about the coming year (corporate profits grow about 6% per year over long periods of time). As is usually the case, the numbers are telling a better story of reality than political and private sector commentators, which is why the market is doing pretty well despite 9.6% unemployment.

To gauge market prospects for next year, investors should continue to look at the numbers and ignore the posturing in the media and on the campaign trail. As things stand now, I would expect another gain for the U.S. equity market in 2011, but the magnitude will depend on whether the analysts are right or once again overly optimistic. That could be the difference between single digit and double digit returns over the next 12-15 months for stocks.

And on a somewhat related note, don’t forget to get out and vote tomorrow.