Streetwise

Lauren Rudd

Sunday, June 12, 2011

A Sad Day

It is a sad day when a few supposedly rational (I use the term loosely) politicians decide that Peter Diamond, an economics professor at MIT and a 2010 Nobel laureate, is not qualified to serve on the board of the Federal Reserve.

Diamond recently withdrew his nomination in frustration over the confirmation process, stating how he had been nominated and re-nominated to fill a vacancy on the seven-member board. Senate Republicans blocked a floor vote on his confirmation and have questioned his practical experience and research.

What was most disturbing to Diamond was the Senate Banking Committee’s failure to recognize that understanding unemployment data is indeed a necessary aspect to the determination of effective monetary policy.

As Diamond so aptly pointed out, correctly knowing the process by which workers and jobs come together and separate is critical to devising an effective monetary policy. Part of the Fed’s responsibility is to properly assess the nature of any bout of unemployment in order to be able to lower it as much as possible while avoiding inflation.

If unemployment is highly correlated to the business cycle – or more specifically by a lack of adequate demand - the Fed can act to reduce unemployment without initiating a new round of inflation. However, if unemployment is primarily structural in nature, meaning that it is the result of a mismatch between the skills companies require and the skills being offered by the labor force, then aggressive Fed action to reduce unemployment could be misguided.

In his Nobel acceptance speech this past December, Diamond discussed in detail the patterns of hiring in the American economy, and concluded that structural unemployment and issues of mismatch were not important in the slow recovery we have been experiencing, and thus not a reason to stop an accommodative monetary policy. Furthermore, Diamond’s book titled, “Saving Social Security: A Balanced Approach,” makes it clear that he is also well versed on that hotly debated topic.

What we do not need is irresponsible fear-mongering. To confound and obfuscate for short-term political gain is not just irresponsible, it is reprehensible. Meanwhile, if Washington has not given you indigestion, Wall Street’s belated analysis of market activity should have you reaching for the antacids. Consider comments from one major investment house to the effect, “We could be in a correction with bouts of rallies and pullbacks.” It is little wonder that the average investor is confused.

Meanwhile, one of the hardest hit sectors of late is retailing. Out of 24 major retailers reporting May same-store sales data, 15 missed expectations, 8 exceeded expectations, and one just met expectations.

The Buckle (BKE), a retailer of casual apparel, footwear and accessories for young men and women, posted an 8.8 percent increase versus expectations for a 6.3 percent. That performance was second only to Costco. Furthermore, Buckle has a 44.13 percent gross profit margin, a 22.19 percent operating margin and a 14.18 net profit margin. And Buckle has another advantage, it has no debt.

The intrinsic value of Buckle’s shares using a discounted earnings model with a discount rate of 10 percent and a projected earnings growth rate of 12 percent over the next 10 years, and declines to 5 percent  each year after that, yields an intrinsic value of $59 per share.

The more conservative version of this model that uses the same earnings growth rate of 12 percent, but a 15 percent discount rate that falls to 12 percent after 10 years, while the growth rate falls to 6 percent, yields an intrinsic value of $63 per share.

The most conservative model and I believe the most accurate, uses a discounted free cash flow to the firm methodology incorporating the firm’s weighted cost of capital as a discount rate. That model yields an intrinsic value of $74. In comparison, the shares recently closed at $39.86.