Sunday, July 23, 2017

The importance of quickly eliminating bad prospects

Last year, Matt Brice wrote a nice article called Think Fast – Lessons for Dating, Investing. The article's message is that, whether in love or investing, people should eliminate bad prospects quickly so that “By spending less time with those who are not a match, you get to spend more time with the one who is a match.”

I can't comment on Matt's dating life, but this is great advice for investing. There are 10,000 publicly-traded companies around the world, far more than any one person can follow. Finding the ones that are undervalued, or are excellent businesses, means quickly filtering out the majority that aren't.

The article mentions a dozen kinds of investments he filters out out, including fashion retailers, scammy businesses like payday lenders and for-profit colleges, and companies that depend on a single powerful customer (e.g. Wal-Mart suppliers).

I agree with those, and I also like his broader point that each investor should make his own list. While some companies are intrinsically better than others, everyone has a different personality and different experiences, and investing success depends in part on finding investments that mesh well with those.

With that caveat, here's my list:

Fashion retail. I started life as a value investor and have gradually drifted toward macro investing. I don't think either methodology works for retail. Fashion retailers lack the margin of safety value investors seek: most don't have durable brands, and if they fail, their assets (leasehold improvements, ugly clothes) are worth little. And while recessions hurt retailers and economic growth helps them, they also can succeed or fail for reasons that have nothing to do with the broad economy.

Secular growth stories. These are hard to predict. Apple has experienced phenomenal growth and profitability since 2003, but from 1980-2003, its stock barely kept pace with inflation. Monster Beverage (formerly Hansen Natural) is one of the all-time great growth companies, but before its energy drink took off, it was a middling juice company that had unsuccessfully tried selling soy drinks and nutrition bars.

Declining businesses. I find these hard to predict too. A decade ago, I assumed GameStop would be out of business by now, but it's still minting money. When a business becomes obsolete and fails, there are always warning signs that it would happen, yet many companies have the same warning signs but manage to fend off obsolescence.

Venture capital. I'm a big fan of Jerry Neumann's writing. One arguments he's made is that some of the best venture capitalists have achieved success by embracing uncertainty rather than risk. E.g., they invest in companies for which the market opportunity is essentially unknown. That's the opposite of what I do: I look for situations that have definite historical precedents so that I feel the odds are knowable. VC seems to be full of opportunity, but doing it successfully would go against all the research I've done and habits I've developed so far.

Fraudulent companies. There's a well-known short seller named Marc Cohodes who publicly attacks companies he thinks are frauds. He has a strong record that includes exposing Lernout and Hauspie back in 2000. Unfortunately, many of his shorts double before they implode. He's also been sued by companies he's criticized. I think Cohodes is willing to endure these risks because he has the personality of a street brawler and enjoys fighting slimy companies. I don't and would hate to be sued.

There are other reasons why shorting frauds isn't attractive: it's popular among long-short hedge funds, so frauds usually have a high cost to borrow, and the rise of passive investing means that a growing number of investors don't care about business quality.

Health care. Health care is insanely expensive in the United States, and I think we're just one populist Democrat away from reforms that crush the industry's profitability. There's also a contradiction inherent to health care, and in particular pharmaceutical drugs: the most profitable products are rarely the most effective, while many of the best ideas get little attention because they aren't moneymakers. A cure has to be taken only once, so it's less profitable than a drug that alleviates symptoms but doesn't offer a cure and has to be taken for the rest of one's life.

Monday, July 10, 2017

Just say no to tobacco stocks

Last year, Credit Suisse published research claiming that the tobacco industry was the best-performing sector of the American stock market from 1900 to 2010. Similarly, Jeremy Siegel wrote in his 2005 book The Future for Investors that Altria, formerly Philip Morris, had been America's best-performing stock during its existence as a public company. And Altria has continued its winning ways since 2005, beating the S&P 500 by a wide margin.

Tobacco companies have achieved their strong performance despite facing many challenges: sales and excise taxes on cigarettes have steadily risen over time, the number of cigarettes consumed in the United States has fallen more than 50% over the past 35 years, and a wave of product-liability lawsuits threatened to bankrupt the tobacco industry during the 1990s.

Its ability to withstand these challenges, combined with its strong historical profitability and the addictive nature of cigarettes, makes tobacco stocks look invincible. Despite that, I believe that the industry's strong performance is coming to an end and that tobacco stocks are secular shorts.

This article will focus on Altria because it's the largest American cigarette manufacturer, but I expect the whole industry to suffer in the coming years.

Why tobacco has outperformed

Determining why tobacco companies have prospered for more than a century is beyond the scope of this post, but I think there are three reasons why Altria's stock done well over the past 15-20 years:

Price hikes. Although cigarette sales volumes have fallen steadily, manufacturers have more than offset this by increasing their profit per cigarette. According to Horseman Capital, cigarette prices have tripled since 1998 and "British American Tobacco has seen its net profit margin rise from 5% in 1998 to 25% [in 2013]." The 1998 Master Settlement Agreement between the US states and large tobacco companies enabled these price increases by turning the cigarette market into an unofficial cartel.

Rising valuations. Altria traded below 6x earnings in 2000, and it trades at 22x earnings today. Initially, its valuation rose as the threat of ruinous personal-injury lawsuits receded. Later, falling interest rates increased the multiple investors applied to Altria's stable cash flows and made its dividend more attractive to yield-seekers.

Rising leverage. In March 2008, after spinning off Philip Morris International, Altria's tangible book value was $1.6 billion. Today it's -$5.2 billion. The main reason why Altria's net worth declined is its cash acquisition of UST in early 2009, which it financed by issuing $9.7 billion of debt. Offsetting that is Anheuser Busch's cash-and-stock acquisition of SABMiller, in which Altria held a major investment, which resulted in billions of cash proceeds to Altria and an upward revaluation of its remaining brewery investment.

Excluding acquisitions and sales, since 2011 Altria has paid out slightly more than 100% of its earnings in dividends and stock buybacks. The company's ability to operate with historically high leverage and a 100% payout ratio is, in my opinion, key to its popularity with investors.

Why it can't go on

For several reasons, I expect cigarette volumes to continue declining, but without the compensating price hikes that cigarette manufacturers have effected in the past:

• Nicotine may be addictive, but contrary to popular belief, addicts are capable of making trade-offs and delaying gratification. In one experiment, crack addicts who were offered a choice between drugs and delayed cash payments often chose cash.

• In the United States, cigarette smokers are disproportionately poor and uneducated. Their ability to pay more for cigarettes is limited, so further price hikes may prompt them to quit smoking or roll their own cigarettes.

• The Centers for Disease Control conducts surveys to measure teenage smoking. Historically, the percent of high school students who had used tobacco in the previous 30 days exceeded the percent of adult who smoked. The teen smoking rate fell below the adult rate ten years ago, however, and it has remained lower since then. I believe this presages an accelerating decline in the adult smoking rate.

• E-cigarettes allow for the ingestion of nicotine without any of the toxic byproducts that burning tobacco produces. This has made them increasingly popular among smokers:

Paradoxically, e-cigarettes' superiority gives public-health agencies a reason to demonize them. If public-health advocates and bureaucrats define themselves as crusaders against the evils of tobacco, then replacing cigarettes with e-cigarettes eliminates their reason for being.

Accordingly, the Food and Drug Administration took steps last year to impose onerous new regulations on e-cigarette manufacturers. The Trump administration has dramatically reduced the growth of federal regulations, however, including delaying implementation of the FDA's rules for e-cigarettes. I believe the administration's hostility to regulation makes the continued growth of e-cigarette usage likely.

Summing it up

Over the past couple decades, a virtuous cycle has lifted Altria's stock: swiftly rising cigarette prices have boosted its earnings, which has allowed it to operate with more debt and distribute more of its earnings to shareholders. Key to this dynamic is the cartelization of the tobacco industry, which e-cigarettes and falling youth smoking rates now threaten.

If cigarette consumption continues to decline and tobacco companies are unable to effect offsetting price hikes, the virtuous cycle will go into reverse: Altria's earnings will fall, and then it will have to prioritize repaying liabilities over returning money to shareholders, and the stock will probably get a lower multiple on lower earnings.

More generally, while cigarette manufacturers have enjoyed remarkable pricing power, no company, no matter how desirable its product, can increase real prices forever. Pricing power is better thought of as a reservoir--vulnerable to being drained through continual exploitation--than a perpetual motion machine.

Sunday, July 9, 2017

Articles of interest

Harvest Investor writes about trends in agricultural productivity and their likely effect on the farm economy.

George Dimitroff describes how the 1990 recession and September 11, 2001 attack affected aircraft prices.

The Financial Post writes that Nortel Networks' multi-year bankruptcy has produced $2 billion of legal and professional fees compared to a remaining estate of $7.3 billion.

Business models
The Private Investment Brief discusses why middlemen often thrive and resist dis-intermediation.

Central banks
Vienna Capitalist argues that, contrary to popular perception, quantitative easing and negative interest rates are deflationary.

A guest commenter at Credit Bubble Stocks discusses the competing incentives that central banks have to pursue deflationary or hyperinflationary policies during economic crises.

The Wall Street Journal claims that "[as with] steel and aluminum before, Chinese oil refining overcapacity is spilling into global markets and depressing profits."

Wide Moat Investing writes that Joe Papa's compensation as CEO of Valeant is much lower than news reports have suggested.

Vili Lehdonvirta argues that bitcoin is flawed and overhyped.

The Economy
Paul Kasriel argues that slowing credit growth, in conjunction with the Federal Reserve's tightening of monetary policy, is a risk to the American economy and stock market. See also Kasriel's follow-up post discussing the relative importance of commercial and industrial loan growth versus total growth of bank credit.

Foreign investing
Back of the Envelope describes the investment merits of Apetit, a Finnish food conglomerate and potential turnaround.

Dividend Growth Investor enumerates the risks of international investing and provides an interesting overview of Russia's stock market in the decades before the Communist takeover.

Fritz Capital writes about risks to the Chinese banking system in general and Bank of Jinzhou in particular.

Investing Sidekick makes the case for Cambria Automobiles, a cheap car dealer in the United Kingdom.

Variant Perception warns about China's declining credit growth.

Paul Clikeman describes the careers of Ivar Kreuger and Philip Musica, two prominent Depression-era fraudsters.

Flexport describes California's economic development during and after the 1848 gold rush. One of the biggest beneficiaries was actually outside California: A railroad built across the Isthmus of Panama to facilitate trade between California and the Eastern United States became profitable before construction was finished and was temporarily the highest-valued company on the New York Stock Exchange. h/t Danton Qu.

Fortune provides a behind-the-scenes look at Microsoft's initial public offering.

Quartz writes about Société des Moulins de Bazacle, the world's first joint-stock company.

Jason Zweig reprints a speech that Ben Graham gave in 1963.

Talking to, John Arnold describes his trading strategy and explains why he doesn't use technical analysis.

Jim Chanos discusses some of the political risks to capitalism, corporate profits, and the stock market.

Graham & Doddsville interviews William von Mueffling and Sam Zell in its Winter 2012 edition.

Jack Schwager summarizes the key ideas of his Market Wizards series of interview books.

Texas Monthly exposes the judicial corruption that facilitated Pennzoil's successful lawsuit against Texaco in the 1980s.

The Wall Street Journal describes Glencore's influence over zinc prices.

Money laundering
Bloomberg describes how art lending can be used to launder money.

Oil and gas
Debtwire asserts that plugging and abandonment liabilities are an underappreciated risk for oil and gas companies operating in the Gulf of Mexico.

Phil Flynn argues that the Energy Information Administration has overstated inventories of crude oil in the United States.

KUT FM describes how the Texas Railroad Commission influenced OPEC.

The Guardian exposes the scam known as scientific publishing.

Institutional Investor profiles Jim Simons and Renaissance Technologies (from 2000).

Bloomberg profiles the principals of TGS, a lesser-unknown quantitative fund that rivals Renaissance in profitability.

Real Estate
The Wall Street Journal describes how the DiLorenzo family squandered one of New York City's largest real-estate fortunes in a generation.

Fritz Capital describes the incentives that Wall Street analysts face and how they can influence securities prices.

Morgan Housel discusses how personal experience can lead investors to overestimate or underestimate risks.

Jan Woeltjen writes that, contrary to what one might expect, statistically cheap stocks that score poorly on measures of business quality have outperformed better-quality value stocks.

Nicholas Vardy argues that investing will "never see another Warren Buffett or George Soros" because increasing competition among an increasing number of sophisticated professional investors limits the ability of any one investor to rise above the crowd.

David Merkel pens a critical review of Thomas Phelps's 101 to 1 in the Stock Market.

Skift chronicles Travelocity's decline from leading online travel agent to also-ran.

Wednesday, March 15, 2017

A reason for caution

I'm cautious about the stock market because credit growth has stalled. Since December, total bank credit in the United States has fallen slightly:

This is important because, in my opinion, credit is the single biggest influence on both economic activity and asset prices. Credit is like a dog, and residual securities like stocks are the tail that it wags. Right now the dog looks mangy.

On Twitter, Harvest Investor argues that falling credit growth historically hasn't predicted stock-market declines. He makes a good point, but I see several differences between today and previous periods of credit scarcity:

• Historically, credit growth stalled toward the end of recessions or after recessions. Periods of flat bank credit include 1975, 1980, 1982, and 1991-93, 2001-02, and 2009-10--all recessionary or post-recessionary years. In each instance, by the time credit had stalled, the stock market had already experienced a correction. Investors had already "digested" the prospect of falling liquidity. Today, by contrast, the market is near an all-time high.

• The Federal Reserve responded to these previous slowdowns with monetary easing. Now the Fed is shrinking the monetary base, which has fallen ~10% since 2015.

• Fueling the stock market's rally is a belief that Trump's economic policies will usher in a new era of growth. I think this optimism is premature and that Trump will struggle to implement many of his policies. In any case, flat-lining credit--along with the lower economic growth that's likely to accompany it--goes against the growth narrative that has lifted stock prices.