Ramblings of a Portfolio Manager 6-1-2009

Ramblings of a Portfolio Manager or Paradise by the Dashboard Light

Once the largest industrial concern on the face of the planet, General Motors filed for Chapter 11 bankruptcy protection today. It was a widely expected move. Charlie Wilson, the former head of GM during the 50’s, once told Congress “what’s good for General Motors is good for the Country.” With the Dow Jones Industrial Average soaring 2%+ in the face of news of the Company’s demise, it’s hard to fathom an era when the inherent truth of such a comment was a given, Truly, we are in a new world.

In December, 1965 the Pontiac GTO ushered in the muscle car era, and the following summer the Beatles released Revolver just before their last tour date in August. On the back of the LP cover was a photo of the Fab Four wearing sunglasses. The unintended (?) subliminal message was that, for the UK singing group, the future was so bright they had to wear shades. And so it appeared to be for GM as well. That was then.

What exactly killed GM will be a debate for the next 100+ years—be it Government regulation, unionized labor, bad management, competition, high gas prices or all or some of the above—but what is clear is that the combination of high debt levels and declining sales is a toxic cocktail that even the proudest of companies cannot consume forever. There should be a lesson here: The Market’s rally since early March has been predicated, in large part, on the assumption of a return to economic growth and the indices have benefited from a rise in the stocks of the lowest quality companies—those with high debt and volatile sales. If the Market is correct, in a rising sales environment, high debt service will turn into high earnings leverage and rapid EPS growth. If it is wrong a spate of new bankruptcies looms ahead and we are poised to revisit Dow 6000. We cautiously side with Mr. Market in this debate but are getting our exposure to earnings leverage by investing in small cap stocks: smaller companies have enough direct leverage to an improving economy due to their single-business focus and we can get plenty of EPS leverage in companies that don’t have to rely on huge debt for financing.