Wednesday, August 26, 2009

2 Reasons to Worry about the Future of America

It was only last October when Warren Buffett penned his now famous op-ed piece in the New York Times entitled “Buy America. I Am.” It feels like an eternity ago based on everything that has happened in the financial markets. In the article, Buffett discussed his reasons for being bullish on the US for the long run. True to form, he claimed no prescience when it came to timing the markets, but clearly stated that despite near term uncertainly the index averages were destined to move high over time. From the article:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up… Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

For the most part I agree with Buffett about taking advantage of distressed stock prices. I consider myself a contrarian investor and hope that in my career I have opportunities to be greedy when others are fearful and cautious when others are exuberant. The enormous wealth that has been built up in the US over the last 100 years is absolutely extraordinary and it is abundantly clear that unexpected innovations can emerge that drive prosperity and productivity. In response to these facts, Buffett optimistically says that he expects his grandkids to live a better life than even he did and therefore we should continue to invest in America. Skeptics may say that this is an example of Buffett talking his book. Being such a large shareholder in US equities, he has a vested interest in seeing stocks go higher. But I actually think that his motives are much less nefarious. I believe he is looking at the past as a relatively good predictor of the future, at least when it comes to our ability to make it through tumultuous times and create wealth despite numerous headwinds.

It is within this context (and being justifiably fearful of getting struck by lightning for disagreeing with The Oracle) that I want to highlight two concerns that I just can’t shake no matter how hard I try. These concerns were exacerbated by a recent article I read on the Prudent Bear website. In this piece, a gentleman named James Quinn aggregated some troubling stats when it comes to health care and education issues in the US. Now, I can’t confirm all of his sources, but what I have done is supplemented his research with my own so that I can verify that the astonishing trends he highlights are accurate, even if the numbers are not necessarily verifiable.

Let’s start with health care. There are dozens of different topics within health care that I could have tackled, but inspired by Quinn’s analysis I chose to focus on obesity. Specifically, the Center for Disease Control (CDC) definition of someone who is overweight or obese is as follows:

For adults, overweight and obesity ranges are determined by using weight and height to calculate a number called the "body mass index" (BMI). BMI is used because, for most people, it correlates with their amount of body fat.

· An adult who has a BMI between 25 and 29.9 is considered overweight.

· An adult who has a BMI of 30 or higher is considered obese.

According to CDC statistics sited by Quinn, 66% of Americans over the age of 20 are either overweight or obese. Let that sink in for a second. That is an extraordinary statistic. While I haven’t been able to find the source of that exact figure, I did come across this CDC study that indicates that more than 1/3rd of American adults were obese in 2005-06:

No significant difference in obesity existed between men and women. Adults 40–59 years of age were more likely to be obese compared with younger and older individuals. Approximately 40% of men 40–59 years of age were obese compared with 28.1% of 20–39 year-olds and 32.2% of those aged 60 years and older. Among women, 41.1% of those 40–59 years of age were obese, whereas 30.5% of younger women 20–39 years of age were obese.

Now those obesity stats are disturbing their own right. More than 1 out of 3 American adults can be classified as obese? The severe health problems that can result from being overweight or obese, ranging from heart disease to diabetes to hypertension cannot be ignored. More importantly though, from a broader social perspective, is the immense future cost of providing these people with the expensive health care they will need. If what Obama says about health care being the key driver of budget deficits, this data indicates that our current fiscal deficits may only grow in the future. Specifically, in a 2003 study by Finkelstein, Fiebelkorn, and Wang, the researchers estimated that health care expenses related to obesity made up 9.1% of total expenditures in 1998. I can only imagine that this percentage will only rise (if it hasn’t already) in the future.

I guess my lasting concern is that no matter what kind of health care reform is achieved by Obama or future administrations, the costs of providing health care to these individuals will be borne by consumers and employers through higher taxes and insurance costs. Plus, I am worried about long term productivity. If being overweight leads people to be sick more often, to miss more days of work, and/or inhibits their ability to do their jobs efficiently, aggregate productivity may be negatively impacted.

Unfortunately, these are the facts. Is this problem worse than climate change or the proliferation of nuclear weapons? Probably not. If we made it through the Cold War and we make it through the Great Recession, isn’t it logical to believe that we can overcome this? For sure. But, to me this is just another incremental headwind that I do not believe can be overlooked, especially when we asses the cumulative impact of all of the major concerns out there about the future of the US.

Now to the more troubling issue that I think actually threatens to de-thrown the US from being the world’s best incubator for innovation. Of course my concern has to do with the state of our education system. In determining if the US can continue to produce some of the world’s best scientists, engineers and doctors, we need to assess the educational resources that these individuals will need in order to excel. Let’s start off by looking at literacy. According to the UN Human Development Report for 2007-08, the US was tied for 17th in the world in terms of literacy rate, behind notable titans such as Estonia, Belarus and Uzbekistan. Even more troubling, among OECD countries, the US had the 3rd highest rate of people between 16 and 65 without functional literacy skills. That rate, an amazing 20%, was well above that of countries such as Sweden and Denmark that have rates in the single digits.

Furthermore, the main problem with these figures is that not only are our outcomes nowhere near the top, but we also spend the most trying to achieve those outcomes. (Where have you heard that before? Oh yeah, health care.) According to an OECD study from 2003 highlighted in USA Today (Note: this data differs somewhat from Quinn’s data):

The United States spends more public and private money on education than other major countries, but its performance doesn't measure up in areas ranging from high-school graduation rates to test scores in math, reading and science, a new report shows.

The United States spent $10,240 per student from elementary school through college in 2000, according to the report. The average was $6,361 among more than 25 nations.

As for the United States, it finished in the middle of the pack in its 15-year-olds' performance on math, reading and science in 2000, and its high-school graduation rate was below the international average in 2001…

This means that from kindergarten to senior year in high school (13 years, assuming a student makes it through), the US spends over $133K per student on education. That is quite an investment in a student’s future. In all honestly, I have no problem with the magnitude of the expenditure as long as we are developing literate and productive members of society. However, that does not look to be the case: From Quinn:

A study of public school students from 1991 to 2002 by the Manhattan Institute for Policy Research generated disturbing results:

· Nationally, the percentage of all students who left high school with the skills and qualifications necessary to attend college was 34% in 2002.

· The states with the lowest graduation rate in the nation were South Carolina (53%), followed by Georgia (56%), Tennessee (57%), and Alabama (58%).

· About 40% of white students, 23% of African-American students, and 20% of Hispanic students who started public high school graduated college-ready in 2002.

After all that time, money, and effort, only 1 in 5 Hispanic and less than 1 in 4 African American students graduate with the skills needed to go to college? Yikes. So the US spends the most per child and achieves what I would call mediocre results. What is the lasting impact of this? Here is some more data from Quinn:

Of the approximately 111 million households in the United States, only 5.6 million earn more than $167,000. On the other end of the scale, 36.6 million make less than $30,000. The bottom is occupied by high school graduates or dropouts. The top is occupied solely by college graduates.

The result is an increased stratification between the haves and have-nots that increasingly is making the US look like a developing country in which there is an entrenched elite class, a disillusioned poor class and no middle class whatsoever. Without some kind of major education reform the trend toward the haves attending private schools that provide an excellent education while everyone else is left helplessly behind will only accelerate.

As Quinn suggests, a lot of this inequality stems for graduation rates. What does the data look like on that front? Check out this great chart from that presents data from sources funded by the Bill and Melinda Gates Foundation. According to the data from 2005-06, on average only 69.2% of people in this country graduated from high school. While that is up from 66.4% in 1995-96, the percentage is actually down from 70.6% from the 2004-05. This is the most recent data I can find but it sure doesn’t look like things are moving the correct direction as costs continue to climb. How much more does it cost? In 1991, the US spent 5.1% of GDP on education. As the data from the table shows, that percentage went up to 5.9% in the 2002-2005 period. In contrast, Finland, which is highlighted by Quinn as a success story when it comes to education, spent 6.5% of its GDP on education in 1991 and in the 2002-05 period and attained the highest standards of literacy in the world for 15 year olds.

Getting into why the US spends so much on education in relation to other countries is for the most part beyond the scope of this analysis. Quinn argues that teachers unions, tenure arrangements, and what he feels is exorbitant teacher pay in relation to other professions are the main determinants of the high cost of education. My concern is more about the potential impact of the combination of such large expenditures per student and flat to declining results. First, Quinn offers the conspiracy theory-like argument that the less educated people are, the less curious they are and the less likely they are to try to rise up to change the status quo:

The dumbing down of America has allowed the intelligentsia to retain power and increase their control over the country. Lack of educational achievement doesn’t automatically mean you are easily manipulated, but it sure increases the odds. If you weren’t motivated enough to do well in school, you are unlikely to take your civic duties of voting, understanding national issues, and getting involved in your community seriously.

This is a little bit extreme for my tastes so I will let the reader evaluate Quinn’s conclusion on his or her own. Instead I focus on questions such as where are those engineers that are going to lead a green energy revolution going to come from? Or, coming from this educational backdrop, who is going to develop the next technology that changes our lives as much as the Internet has? Maybe most importantly, how are people in the workforce going to be able to support others who are not only uneducated, but also obese? I think the answers to those respective questions are from abroad, a foreigner, and through much higher taxes. In the long run what we have to worry about is that eventually the US may not be the destination of choice for talented foreigners and that innovation will increasingly be achieved at foreign universities and within non-US companies. While this new technology or process may eventually benefit Americans, the breakthrough may not emanate from the US. In other words, as a result of an underperforming, expensive educational system and uncompetitive tax rates, the US could lose its seat as the world’s leader in innovation. This is the crux of the argument that makes me hesitant to immediately agree with Buffett’s undeniably optimistic outlook for the US.

Finally, I think I should briefly discuss what this could mean for stocks. The following are not particular purchase recommendations. They are just suggestions that are meant to inspire more research. When it comes to obesity, after looking at the data it is hard to imagine that health care costs are going to go down no matter what type of reform is on its way. When obesity trends are combined with an ageing baby boomer population, what the health care and drug companies may lose on margins they may make up for in volume. So I would say that the drug companies, health service organizations and the device makers have to be interesting on the long side, especially considering that the recent reform debate and current recession has hurt their share prices. For investors who don’t want to bet on individual companies, iShares offers ETFs such as IHF (for health providers), IHI (for medical devices) and IHE (for pharmaceuticals).

Turning to the education issue, I see two potential ways to profit. On the innovation front, maybe it is time to start looking for multi-national or foreign companies that will no longer lose their homegrown talent to the US and subsequently benefit through further technological breakthroughs. Off the top of my head companies such as ABB Ltd. (ABB), Siemens AG (SI), Charlie Munger’s favorite BYD Company, and possibly even Sony (SNE) could be compelling at the right valuation. Finally, on the demand for better education front, there are a number of for profit education companies such as Apollo Group (APOL) and Strayer Education (STRA) that offer post-secondary diplomas. I am a bit cautious on these companies due to lofty valuations and not particularly good graduation rates, but in the future they could play a major role in educating Americans.

In any case I think it is important for investors to analyze these secular trends and figure out ways to protect their portfolios from the potentially negative derivative effects.

(Picture courtesy of