Streetwise

Lauren Rudd

Sunday, February 27, 2011

Ignorance Frequently Begets Confidence

When it comes to economic policy, seldom have so many said so much about a subject about which they know so little. Deriding most government spending as a drug that will bankrupt future generations is unmitigated stupidity. As Charles Darwin wrote, “Ignorance more frequently begets confidence than does knowledge.”

New York Times writer David Leonhardt recently pointed out that Germany's austerity program has resulted in the country's real economic output continuing to lag its pre-recession peak. Britain's more radical austerity program has had even more devastating results as its real gross domestic product has begun to decline. In the United States, where the stimulus program has been larger and longer lasting, real GDP has recovered.

Without the government spending of the last two years the economy would be in vastly worse shape. That is the historical lesson of post crisis austerity movements. No matter how morally satisfying austerity may be, it is the wrong answer. Presidents Herbert Hoover and Franklin Roosevelt learned this the hard way.

The difficulty is finding the political will to end the stimulus when the time comes. Democrats have had and do have difficulty with that decision. However, the current wave of Republicans will no doubt assist them in summoning up the political will should it be required.

Failure to envision the future objectively without prior prejudice is not limited to governments.  In early October, 1929, a few days before the market crashed, Irving Fisher, a well known monetary economist, confidently predicted that, "Stock prices have reached what looks like a permanently high plateau." Not to be dissuaded, for months after the market crashed, Fisher continued to assure investors that a recovery was just around the corner.

Fisher’s mistake, which is so often repeated by others, is that he was blindsided by his own biases. Although Fisher’s investment demise resulted from an overly positive outlook, the reverse can occur just as frequently, if not more so, and can be just as deadly to the overall performance of your portfolio.

Letting your emotions or personal bias drive your investment strategy can be expensive. Let me offer a more profitable approach. Search out companies you understand that have historically strong fundamentals, a solid business plan going forward and astute management.

A good example might be Bed Bath & Beyond (BBBY), the same retail chain that received tongue-in-cheek notoriety in the 2003 movie Old School, as Will Ferrell's character Frank rejects chugging a beer at a college party because he has a busy Saturday planned with his wife, stating "we're going to Home Depot - maybe Bed Bath & Beyond." It is also a company that I have not talked about for some time.

Looking at its fiscal third quarter ended November 27, 2010, the company reported earnings of $0.74 per share, an increase of approximately 28 percent over the same period a year ago. Net sales for the fiscal third quarter were approximately $2.194 billion, an increase of approximately 11.1 percent over the same period a year ago.

Comparable store sales in the fiscal third quarter of 2010 increased by approximately 7.0 percent, compared with an increase of approximately 7.3 percent in last year's fiscal third quarter.

The company also offered up earnings guidance for its fiscal fourth quarter of between $0.91 and $0.95 per share and $2.86 to $2.90 per share for all of fiscal year 2011. By way of comparison, in fiscal 2010 earnings came in at $2.30 per share.

The intrinsic value of the shares using a discounted earnings model with a five-year average growth rate of 14 percent and a discount rate of 15 percent, is $61. The more conservative free cash flow to the firm model yields an intrinsic value of $81. The shares recently closed at $47.75.