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My name is Ben and I am a generalist equity research analyst for Right Wall Capital. Right Wall is a small, long-short equity, financials-focused hedge fund located in New York City. Prior to working at Right Wall I worked as an analyst at Blue Ram Capital, another long-short equity hedge fund... More
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  • Interview with an Aspiring Value Investor (Part 2)
    This is the second part of my interview with Miguel Barbosa of Simoleon Sense:

    1.       Given your background, how do you look at real estate?


    I know this is going to sound a bit strange to people who only started looking at real estate during the boom, but I look at real estate more like a bond than a stock. In other words, instead of thinking of real estate as a rapidly appreciating asset, I look at rental income as being similar to coupon on a bond. When my family invests in real estate, we don’t think about how much more we are going to sell it for in the future. What we try to figure out is how much we can rent it for, what kind of yearly increases we can negotiate, and how much time and capital need to be put in on an ongoing basis. Obviously, during the boom people weren’t interested in stable tenancies and leases that protect against the downside. They looked at real estate as if it were as liquid as stocks and thought properties should appreciate as fast as equities often do after a market correction. However, in periods when there is not excessive speculation and leverage entering the real estate market, these assets are slow growth vehicles. In theory, they should not grow any faster than the rate of increase in rents. Accordingly, when commercial real estate and housing finally do bottom, people should not expect values to recover for many years. Anyone who is holding onto a piece of real estate until the market “comes back” will likely be waiting a long time unless the Fed is able to create another asset bubble.


    2.       What has the financial crisis taught you, especially when it comes to investing? How have you evolved as an investor?


    I think when I look back on this period of my career, I will be very thankful that I cut my teeth in such adverse market circumstances. It’s much better to learn certain lessons now (when there are only a few zeroes involved) than when the stakes are much higher. The crisis has just reinforced my view of the role of a manager. As Howard Marks so eloquently says, the duty of a money manager is to protect capital and manage risk. It is really that simple. If you focus on a margin of safety, have disciplined buy and sell requirements and strategically hedge downside risk, you are fulfilling your fiduciary duty as a money manager. Along the same lines, it is imperative to remember that leverage is a killer. The common denominator in every bubble I have ever examined is excessive leverage. I am currently reading a book called Funny Money (by Mark Singer) that is about the oil lending boom in Oklahoma and Texas that led to the notorious failure and bailout of Continental Illinois. This episode represented the beginning of the too big to fail era among banks that obviously still exists today and basically defined what moral hazard would look like going forward. I’m sure you will not be at all surprised to learn that root cause of the bank’s flameout was too much and too rapid lending combined with inadequate analysis of credit. Does that sound familiar?


    3.       What financial issues concern you the most?


    Oh my, I really don’t want to depress the readers! Anybody who follows me knows that I am quite bearish in the short run but am also legitimately concerned about the long run ability of the US economy to remain vibrant and innovative. I think we have structural imbalances that need to be addressed and it makes me sick that the leaders of this country seem unwilling to face these issues. You have to remember that I am not an economist so this is not my specialty. However, it seems to me that America became a “too much and too many” country over the last 30 years or so. We have too much debt, too many stores, too many banks, too many dodgy loans, too many cars and too many big houses. We use too much energy and we pollute too much. Unless the Fed and Obama can find a way to prolong the necessary day of reckoning, I believe we may soon find ourselves living in a “too little and not enough” country. In retrospect it will be clear that we saved too little, put too little money into Social Security, invested far too little in education and did not do enough to address climate change and health care reform. I really hope that I am wrong but I am not as optimistic as Buffett is that future generations of Americans are guaranteed to enjoy a better standard of living than we do.


    4.       Do you have an opinion about inflation/deflation?


    I think this is probably the most fascinating debate going on right now and the eventual outcome will likely be the main determinant of what asset classes perform and underperform over the next decade. My current view is that at least temporarily we have seen a bizarre combination of commodity price increases, severe credit contraction and wage deflation. This seems to me to be a particularly insidious cocktail and is why Main Street is struggling so much. In the short run, despite the Fed’s attempts to pump liquidity in the system I see deflation as a much more relevant risk. But in the long run it is hard for me to see the Fed exiting their money printing in a smooth way that somehow prevents inflation and simultaneously avoids stifling a recovery. The Fed is kind of like a bull trying to walk out of a china shop. Yeah, maybe it doesn’t break all the plates but it sure leaves some collateral damage in its wake. I guess I don’t share the blind faith that the Fed can be precise in its monetary policy. So, I’m not sure if Marc Faber and Jim Grant are right about the possibility of hyperinflation, but it is hard for me to see how the dollar and our purchasing power are not the eventual casualties of the Fed’s doubling of its balance sheet.




    5.       Where do most value investors screw up?



    I like to think that the recent turmoil in the markets will separate true value investors from what Klarman calls value pretenders. The latter are investors who only knew appreciating markets, never really considered intrinsic value and thought that buying dips was the same thing as value investing. In a Darwinian kind of way this crisis could have a silver lining, at least in terms of separating the truly skilled from those who benefitted from the rising tide.


    When it comes to legitimate value investors, I think there are two common mistakes. The first is thinking that a stock can really be market agnostic. When there is either excessive euphoria or extreme fear in the markets, stocks that should not be correlated to one another seem to move in the same direction. The appropriate lesson is not to become a closet macro fund and try to time economic cycles. The answer is to be like Klarman: focus on company specific analysis but make sure that the macro environment is not unambiguously going another direction. Second, I think that value investors are often too quick to trust the markets to close the gap between intrinsic value and price. I am not suggesting that we all become technical analysts, but it is important not to forget that certain exogenous forces can have a tremendous impact on the markets. Last year we saw what forced and panic selling can do to stock prices and this year we have seen how Federal Reserve liquidity injections can turn a market speculative just about overnight. So I think it is useful to be at least aware of ways that overall market distortions can affect the process of value realization, especially with the number of players out there who have the incentive to manipulate the market.


    6.       You have a reputation as a diligent & structured investor. Tell us about your use of checklists.


    I am a huge fan of checklists. I soon need to sit down and write down every metric that I evaluate about a specific company. Right now my checklist exists in my mind and on an Excel spreadsheet template that I use for just about every company.   Don’t get me wrong, this is not a DCF model with specific assumptions about growth and an arbitrary terminal multiple. I clearly understand the false precision that comes with such models. I just like to aggregate all the quantitative information--from margins to insider ownership to valuation metrics—in one place. It really helps me frame the company before I engage in a longer write up in which I include the qualitative factors as well. The benefit of this strategy is that it forces me take a very comprehensive view of a company. For example, let’s say a company has an interesting product or division that you think is under appreciated by the market. Without calculating the operating margins for each subsidiary you might not notice that this very profitable division is being dragged down by a low margin business that just sucks up capital. So, even though the number of items on the checklist can lead to a bit of informational overload, I firmly believe that it helps me avoid overlooking important characteristics.


    7.       What single trait is most important to cultivate in order to be a successful investor?


    Without question being a successful value investor requires a certain temperament. It is very hard to be greedy when others are fearful. Humans are not wired to be contrarians. We like the safety of the herd. Value investors measure the magnitude of an opportunity based on how sick they feel when they make the actual investment. The more consternation establishing a position causes, the better the returns are likely to be. Accordingly, developing an even temperament in which you don’t get excited when stocks are going up or get downtrodden when your positions are moving against you requires a significant amount of discipline.  While I do think some people are predisposed to being able to control their emotions and stick to their investment philosophies, it absolutely takes practice. Even some of the best investors became paralyzed during the free fall in equity markets during the early part of this year and the ones who have been the most successful loaded up on stocks they had strong convictions about during that period. So, as Warren Buffett has said: “By far, the most important quality is not how much IQ you’ve got. IQ is not the scarce factor. You need a reasonable amount of intelligence, but temperament is 90% of it.” Along the same lines, I don’t know if I can take credit for making this up but my mantra is to be passionate about the markets but to invest dispassionately. I think if I can follow that I will end up being an accomplished investor.


    8.       What is the hardest bias for you to overcome?


    In my case, I am constantly fighting to avoid becoming a victim of confirmation bias. I am definitely guilty of searching out information that agrees with my philosophies and views on the markets. I also often too easily dismiss opinions that are contrary to mine and too readily accept those that mesh with my views. Accordingly, I make a concerted effort to read anything I can find that offers the other side of an argument. Even though it feels just as painful as being outside of the herd, it forces you to understand the contrarian position in a way that can help you make better decisions.


    9.       Where do you see yourself after business school?


    My goals are very simple. After I graduate I hope to have the opportunity to work for a value fund in which I have access to a portfolio manager who is willing to be my mentor. I anticipate that my research skills will get better with more practice. However, I have never had the luxury of being able to watch a skilled value-focused manager navigate the markets. It is not hard to analyze individual stocks. Managing my own portfolio is a challenge, but nowhere near as nerve wracking as managing other peoples’ money. Thus, if I am lucky I will be able to find a job with a value manager in which I can spend a lot of time observing and learning how to run a portfolio day to day. Eventually my goal is to be a portfolio manager myself and the dream is to run my own fund. I am aware that I am probably many years from reaching that milestone and have more to learn than I can possibly even describe. But I look at business school as a conduit for developing relationships that will help me along the way. I also plan to continue doing a significant amount of company specific research outside of the classroom so I can continue to further my skill set.


    10.    What message/advice would you give to readers of SimoleonSense?


    My advice to readers is to look in the mirror before you decide how to allocate your precious capital. Investing is black and white in one way: either you have the skills and time to become a professional investor or you don’t. Honestly, while I hope I am qualified I am still working every day to figure out which camp I fit in. The truth is that it is OK if you don’t have the time, the temperament or the skills. You have plenty of wonderful value managers that you can entrust with your money. You can also buy an index and do better than most mutual fund managers. Managing a portfolio of individual companies is a full time job. Please, never forget that. The attention to detail and time required to follow and understand a portfolio of stocks are not trivial. If you cannot perform deep and comprehensive bottom’s up analysis on specific companies I would suggest that you are better off letting someone else manage the equity portion of your portfolio.  I worry that CNBC and Jim Cramer lead far too many people to think this is a game that anyone can play. It is unquestionably not. Just like you wouldn’t want someone performing open heart surgery on you after watching a TV show about doctors, you should not be trying to pick individual stocks after doing a minor amount of research. Let someone who will act as your fiduciary do that for you. 

    1. Thank you very much for taking the time to interview with us.

    Thanks for the wonderful opportunity to present my ideas. I hope everyone finds my responses valuable. I look forward to having another chance to share my thoughts with your readers.

    (Dislcosure: No Positions)

    Sep 09 1:08 AM | Link | Comment!
  • Interview with an Aspiring Value Investor (Part 1)

    And the subject of the interview is.....well, me. I want to thank my good friend Miguel Barbosa of Simoleon Sense for giving me the opportunity to share my views regarding value investing with his readers. Miguel came up with some fabulous questions and I hope I was able to do them justice with my responses. I am very excited about this unique opportunity to share the lessons I have learned and describe both my background in and passion for investing. For those of you who are relatively new to value investing I like to think it offers a valuable review of some the most basic tenets and principles.

    Due to the length of the post I am going to split it up into two separate parts. As always, feedback is welcome and appreciated. Hope you enjoy.

    1.       When did you first become interested in allocating capital?


    The funny thing about me is that I was a value investor before I had ever heard of value investing as a discipline. In my former life I was a commercial real estate professional and one of my duties was to be a steward of my family’s capital. In that role I analyzed hundreds of opportunities to purchase existing buildings or develop new properties. I think it is a testament to my discipline that from 2003 to 2007 there was only one deal that I actually advised my family members to invest in. During that span I had dozens of what turned into contentious discussions with real estate brokers who were desperately trying to convince me that this was a great time to buy and that paying a 4% cap (which is like an earnings yield on a stock) for a Walgreens in Indianapolis made ultimate sense. I feel bad for the people who were swindled by these brokers and bought near the peak of the bubble. Luckily, even before I had heard of Ben Graham I understood that the return you receive has to compensate for the risks you are taking.


    When it comes to stocks, the indoctrination into value investing that has led me to want to manage money professionally all started when I read Ben Graham’s The Intelligent Investor. I know it sounds almost cliché, but there is something about the investment philosophy that Graham details in this book that just clicked with me. If you look at my blog site, I have two quotes from prominent investors that articulate my attraction to value investing better than I ever could:


    Seth Klarman (Baupost Group): “It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.”


    Mohnish Pabrai (Pabrai Funds): “Warren Buffett has said many times that people either get value investing in five minutes or they won’t get it in five years. So, there is something in the human brain--that for some of us--makes all the difference in the world right away and the patience it requires is part of the wiring process.”


    2.       Currently you work as an analyst and run the Inoculated Investor Blog. Why did you start the blog? Where do blogs like yours fit in among the financial journalism and equity research spaces?


    Well, my days as an official analyst are over, at least until I graduate from UCLA with my MBA. However, I plan to continue working on the blog as much as I possibly can. The reason I started the blog was that I literally had a running dialogue about the markets and economy in my mind. It was actually driving me a little crazy and I badly needed an outlet. Fortunately for me I was able to launch the site with content that was quite unique. I attended this year’s Berkshire Hathaway annual meeting and I was literally the only person out of the thousands there who was crazy enough to try to write down every word that Buffett and Munger said. As a result, my meeting notes were more complete than those of others and after I posted them the entire value investing portion of the blogosphere was linking to me.  It was a very good way to start off my blogging career.


    Since then I have focused solely on adding value to my readers. My goal is to try to make what can be very difficult material accessible to non-professional investors as well as people who work in the markets. I think my particular niche lies directly in between the financial articles you read in the Wall Street Journal and the equity research created by analysts.  I often find the articles in the financial publications to be incredibly cursory and that the research barely scratches the surface. On the other hand, in depth company specific equity research is really only compelling to professional investors.  So, as opposed to using my blog as a glorified version of Twitter, I try to walk the line between boring readers with too much detail and offering insight that any novice could come up with. For example, I often post links to other sites with commentary so that I can expand on the topics covered by others. But I also have a section of my site that has samples of the actual equity research I presented to my bosses. I like to think that this makes my site somewhat unique.


    3.       Mark Sellers stresses the importance of clear writing as proxy for clear thinking. You’re a fantastic writer- How does this skill translate into thinking through investment ideas?


    What I love about Seth Klarman and Howard Marks is how articulate they are. Something about the way they talk about value investing resonates with me. Along with Buffett, they are my role models as a writer. For me writing is the best way to present my ideas. I readily admit that I am nowhere near as articulate or persuasive when I speak about investing. It is something that I obviously hope to get better at. I have seen firsthand that the way portfolio managers talk about their investment philosophy and discipline can dictate whether investors are comfortable or not.


    Until I am fortunate enough to have investors of my own, my focus will be on presenting my ideas in written form. As an equity research analyst, you are only as good as your written research. You have to be able to present your ideas and recommendations concisely without sacrificing the obviously necessary depth.  PMs are often very busy and you must avoid wasting their time or even the best idea will get pushed aside. For me, I sometimes don’t even know how I feel about a stock until the write up is complete. Until that point everything is so abstract and the information is so segregated in my mind that I don’t have a complete picture. But, once all of my research is aggregated I feel much more comfortable making recommendations and explaining the investment thesis.


    4.       Which investors do you admire? Besides these investors who else has influenced you?


    I have already discussed this to some extent but I am happy to elaborate. In my young career I have been most influenced by Buffett and Klarman. I actually launched my blog with a post in which I discussed my vision of the optimal portfolio. Ideally, it would contain some Buffett stocks (great companies at a fair price) and some Klarman stocks (fair companies at a great price). I think these men frame value investing in a way that no other people can. It is not a surprise that the best quotes I have ever read regarding investing come from these two luminaries. I also lump Howard Marks in that group even though Oaktree does not focus on equities. The fact that Marks’s words strike me as so profound even though he invests in another asset class is more proof that value investing is a universal discipline that does not necessarily require a specific context. It also shows that the language translates well across asset classes and can even teach some very valuable life lessons.


    5.       What is it that you like about value investing specifically? In other words, what about it attracts you?


    This is an easy one for me. Anybody who knows me is aware that I am a little cheap. I have been so ever since I can remember. While that translates into plenty of backhanded complements in my social life, I think it makes me uniquely predisposed to value investing. I am just not geared toward taking large risks or investing based on an optimistic future. I know that humans are terrible at forecasting and I would rather focus on what a company is worth right now rather than what it could be worth if all these assumptions prove to be right. I think that is why Graham’s analysis was so intriguing to me. He searched for $.50 dollars almost exclusively by focusing on the balance sheet and refused to pay up for growth. I am generally very cautious when it comes to money and Graham’s investing style that focuses on a margin of safety is perfectly suited for a careful and deliberate person like me.   


    6.       What’s your approach to fundamental analysis? What’s your edge?


    The development of my edge is a continual process but based on early returns I would suggest that my edge is made up of my willingness to dig and to look where few others are looking. Regarding the former, I don’t look at companies as single entities. Most companies have a number of different operating units or products that have different costs and margins structures. Accordingly, as I dig my goal is to understand each individual business component in terms of what drives profitability, what generates costs and what the opportunities or headwinds are.  More and more I have become a margins guy in that I assess the quality of a business based on the operating margins it produces. There is no question that for the company as a whole free cash flow is paramount to me. However, before I can determine whether cash flows are sustainable, I need to understand a company’s competitive advantage. This is an element that I believe can be evaluated using operating margins. Thus, I think it is the granular knowledge that I require in order to be comfortable with an investment that distinguishes me from investors who focus mostly on earnings.


    Additionally, I am not foolish enough to think that I can add a whole lot of value to an analysis of Microsoft. I see huge companies that are well covered by the sell side and are widely owned and researched by institutional investors as basic proxies for the S&P 500. In other words, these stocks are by in large going to move with the market, barring extraordinary company specific news. While large cap stocks can become mispriced, I think it is better to fish in a pond that is more likely to see lasting and significant dislocations between intrinsic value and stock price. Therefore, I like to look at spin offs and companies that are not covered by many sell side analysts. Plus, I have no problem investing in small and mid caps as long as there is ample liquidity in the stock. If you take a look at the companies for which I have research posted on the blog you will see my bias. Hurco, Movado, Ceradyne, IPC Holdings: these are not necessarily household names but they are still successful companies that at certain times have generated attractive returns on capital. So, this is where I think investors are most likely to find compelling value.


    7.       Give us an example of your best and worst investments? What did you learn?


    Since I am not a portfolio manager, I think it is more appropriate to discuss my best and worst recommendations. As an analyst my job is not to invest for myself but to come up with ways in which my fund or other investors can make money. First, my best recommendations have come in the regional banking sector. The two short calls that proved to be the most prescient were on Wachovia and Guaranty Financial. For those who are not familiar with these banks, Wachovia was forced into the arms of Wells Fargo as the share price neared $0 and Guaranty recently filed for Chapter 11 and the remnants were picked up by Spanish bank BBVA. These stocks were trading in the mid teens and my analysis of their balance sheets and credit deterioration led me to believe that both had the potential to go to $0 (and in fact they both basically did). Neither of these were obscure names. Wachovia was a household banking name and Guaranty had attracted famous investors such as David Einhorn and Carl Icahn. What I learned from my experience with these companies was that if you can develop an edge in a certain industry you can take advantage of the market not fully understanding the prospects or fundamentals of certain stocks. During the boom years investors did not focus on bank credit or capital, they just saw the prices going up, solid ROEs and stable dividends. Accordingly, when things got bad very few people had the experience or the ability to scrutinize the balance sheets of these banks. As a result they either did not sell quickly enough or bought after dips and got clobbered in the end. This showed me that investment opportunities can be hiding in plain sight. It also taught me to never trust that the $100 bill lying on the sidewalk is not actually there just because the Efficient Market Theory says that someone would have picked it up if it were there.


    On the flip side my worst recommendations had to do with underestimating the extent of the financial crisis and consumer spending downturn. I remember after the $120 a share Harman buyout by Goldman and KKR fell apart I thought the broken deal could lead to an interesting opportunity. The stock was around $70 and looked like quite the bargain when compared to buyout price. Well, the stock is $27 now as companies who rely on auto sales have been absolutely crushed. My biggest mistake was becoming anchored to the $120 offer price as if that were a measure of intrinsic value. I now understand that the presence of excessive leverage (hence the term leverage buyout) can skew the price of any asset. Additionally, despite the fact that I had a negative macro outlook, especially when it came to discretionary auto sales, I thought Harman had a stable business model that would not be harmed by the coming recession. Accordingly, I failed to adequately follow Klarman’s strategy in which he invests bottom’s up but worries top down. As a result of this and other similar mistakes I am now fully aware that even value investors cannot completely ignore what is going on in the broader economy. In other words, there are very few companies whose fortunes are completely independent of the business cycle or wholesale movements in the stock market.


    8.       How do you look at risk & uncertainty?


    To me, risk is nothing other than the potential for permanent capital impairment. Risk is not volatility. If a stock goes down 50% it likely is not more risky than it was at the higher price. If your favorite cereal is on sale for 50% off at the grocery store you don’t refuse to buy it because the price has fluctuated.  As long as you still like it you should be comfortable buying twice as much. In this way stocks aren’t a whole lot different from boxes of cereal. My goal as an analyst and investor is to avoid situations that involve obvious risk or capital impairment but to take advantage of uncertainty. Uncertainty comes about when market participants have very little visibility into a company’s future and it can lead to severe dislocations between price and intrinsic value. Whether fear is caused by potential government regulation, concerns about demand, or changes in management, value investors who have in depth knowledge regarding companies can often find ways to benefit from uncertainty. What you don’t want to do is buy something that looks certain because you are likely to pay a premium price.

    (Disclosure: No positions)

    Sep 08 12:56 AM | Link | Comment!
  • The Potential Impact of Swine Flu on Productivity

    With Q2 productivity figures being released today, I thought it might be interesting to take a look at the results and try to assess the trend in terms of sustainability. According to the data released by the Labor Department, in Q2 productivity increased at an annual rate of 6.6%, the most rapid increase in six years. The AP article points out that increased productivity often (in more normal times) leads to a higher standard of living as wages rise as output increases. However, these are not normal times. With unemployment at 9.4% (and counting) and businesses struggling as a result of the drop in consumer spending, it is unlikely that we will see increased wages any time soon. Plus, much of the gains in productivity were a result of drastic cost cutting that may have been prudent in the short run but could end up mitigating the strength of the eventual recovery. Therefore, it might be a bit premature to celebrate this impressive increase in productivity for a number of reasons.

    Accordingly, the question going forward is whether these productivity gains are onetime events or are symbolic of an ongoing trend. One factor that may influence the outcome (at least over the next 2-3 quarters) is the swine flu. Let me remind you that I am not an economist so this is not meant to be anything more than a general assessment of the potential impact of H1N1. What I do know is that sick workers are not productive workers. In addition, people who are forced to stay at home, either because they are sick or they have to take care of sick children, certainly do not add to aggregate productivity.

    Plenty has been written about the risks associated with an outbreak of swine flu. In his daily musings, David Rosenberg of Gluskin Sheff often cites H1N1 as one of the reasons he thinks the market could pull back. While I tend to agree with Rosenberg on a number of issues, I don’t think it is particularly useful to cite such a nebulous threat as a major risk without looking at some actual numbers. So, I thought I would do just that. Most of the following calculations are back of the envelope in nature but should be useful in quantifying a range of potential outcomes.

    The most official analysis of swine flu in the US has been done by the very important sounding President’s Council of Advisors on Science and Technology (PCAST). Apparently the US government statisticians got tired of issuing overly optimistic budget estimates and decided to make some alarming projections about the number of people who might be infected by or killed by swine flu. Here’s a brief summary from the New York Times:


    The report posited an epidemic that could produce symptoms in 60 million to 120 million people and cause as many as 90 million to seek medical attention; up to 1.8 million could be hospitalized, 300,000 could flood into crowded I.C.U.’s, and 30,000 to 90,000 people could die.

    Even some members of the advisory panel think their estimates may be a bit high. In any case, this is a virus that is no more lethal, and possibly less lethal, than normal flu strains.

    In the initial outbreaks last spring, an estimated 800,000 New Yorkers, 10 percent of the city’s population, developed symptoms attributed to the swine flu virus. Only 54 died — an encouragingly low death rate. Most infected people got better without medical treatment.

    Let’s do same math to see what this all means. First I am going to take all these estimates at face value. Who knows how many people actually came down with swine flu or how many really died in NY? There are probably thousands of people who had swine flu and didn’t even know it. There are probably just as many (if not more) who saw the news regarding H1N1 and convinced themselves that their allergies or run of the mill flu were actually the dreaded swine flu. With those distortions in mind, using the data from last spring in NY, the kill rate was .00675%. Assuming the full 120M people in the US get the flu, the government’s projections indicate a kill rate of .025% on the low end (30K deaths) to .075% on the high end (90K deaths). But if we apply the NY kill rate to the 120M figure, we get only 8100 deaths. That’s a big discrepancy. Not that 8100 deaths would not be horrible, but that outcome is a lot better than 30-90K. Let’s hope the government’s pessimistic assumptions about deaths resulting from swine flu are as far off as they are when it assumes 4% GDP growth in 2 years.

    So, if the probability of an epidemic that kills tens of thousands or even millions of people is relatively low, then what is the main risk of an outbreak? According to the PCAST, it has more to do with the infrastructure available to handle millions of sick people:

    The report concludes that the 2009-H1N1 flu is unlikely to resemble the deadly flu pandemic of 1918-19. But in contrast to the benign version of swine flu that emerged in 1976, the report says the current strain "poses a serious health threat" to the nation. The issue is not that the virus is more deadly than other flu strains, but rather that it is likely to infect more people than usual because it is a new strain against which few people have immunity. This could mean that doctors’ offices and hospitals may get filled to capacity.

    Our health care system has not recently been tested by a mad rush of people to emergency rooms, hospitals and clinics so it is hard to know how effective the response would be. With the current state of the system I am not optimistic. However, as discussed by Naomi Klein in her book The Shock Doctrine, after 9/11 and the bird flu crisis in Asia, George Bush and Congress made it a point to allocate a significant number of government dollars to the stockpiling of vaccines. (Of course, true to form in the Bush years this was a nice windfall to the pharmaceutical companies that make these vaccines and to any Homeland Security contractors who would be called upon to help facilitate the distribution of these products.) The only problem is that the particular vaccine that (in theory) protects against swine flu is still being tested and may not be ready until October. By that point schools will have re-opened and the prospects for mass contagion will be much higher than they are now.

    For the purposes of this discussion, I believe that the most important impact to analyze is that on business productivity and stock prices. If companies have millions of sick workers absent every day between now and the end of the Q1 2010, I am inclined to believe that the recent positive productivity increases may not last or at least will not be as robust. According to this data from the Census Bureau, there are around 298.8M people in the US. I have seen other data that claims this number is projected to be as high as 306M, but since this data is broken down by age it serves my purposes without much potential skewing.

    Pop data

    So, now let’s do some math and make some very simple assumptions. First, if the work force includes people ages 20-64 then there are 179.6M working age Americans (60.1% of the population). Oddly enough, the swine flu seems to infect people under the age of 65 disproportionately. While that certainly affects more people in the work force, it may also be a reason why there will be a limited number of deaths as younger people tend to have stronger immune systems. Despite this anomaly, I am going to assume that working age adults also make up 60% of infections; with the reduced infection rate among older people being offset by an increased rate among school kids.

    So, using the estimates from PCAST, the number of workers who could become infected by swine flu ranges between 36M (60% of 60M) on the low end and 72M (60% of 120M) on the high end. Based on the July 2009 data from the BLS, the average nonfarm workweek was 33.1 hours. Thus, if each of these people were forced to take off one half of one work week between now and the end of Q1 2010, the number of lost hours could be between 600M and 1.2B. These numbers do not even include days off that are taken to take care of sick kids. If people under 20 make up 30% of infections (with people over 65 representing the 10% balance) then that could add between 18M (30% of 60M) and 36M (30% of 120M) kids out of school that need to be watched over by at least one parent. Even on the low end, if those parents were to take half of a work week off it would translate into another 300M in lost hours. You can see how quickly this toll adds up.

    Now these are obviously very crude estimates. They also don’t include the impact of deaths, prolonged illnesses that require hospitalization, the decreased efficiency of sick workers or offsets such as people recovering over a weekend. However, I think when these swine flu estimates are combined with regular flu-induced sick days, there could be a sizable impact on Q3, Q4, and even Q1 2010 productivity. However, any suggestions that the fall swine flu season is similar to a grim reaper hanging over the US stock market seem to be exaggerations. Despite the initial media-exacerbated scare regarding H1N1, it does not look like it will cause an alarming number of deaths, at least not any more than the average flu. Therefore, with the Armageddon scenario seemingly off of the table, it is important to recognize that the most likely outcome is an overly strained health care system and a lot of people missing work. If we are lucky all swine flu will cause is longer waiting periods to receive medical attention, some reduction in economists' future productivity estimates, and cuts of EPS targets by a penny or two by sell-side analysts. In other words, from what I can see there is certainly no need to panic about the health implications of H1N1 or the negative derivative effects on the market.

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    Sep 02 3:28 PM | Link | Comment!
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