Monday, November 5, 2018

Book review: “The Myth of Capitalism” by Jonathan Tepper

The Myth of Capitalism is an upcoming book--it's set to be released later this month--that I highly recommend. The myth in the book's title is idea that Americans live in a free-market economy, while in many cases industry consolidation has eroded the competition and openness that are integral to free markets. The book's treatment of this issue is essentially microeconomic, but its analysis and arguments are also relevant to macroeconomics and investing.

In the interest of full disclosure, I need to state that Jonathan Tepper is a friend of mine and sent me uncorrected proof of the book. So when I say that it's a must-read, I'm biased. But you don't have to take my word for it: the book has received endorsements from many prominent people in and out of finance, including Paul Marshall, Kyle Bass, Josh Wolfe, Martin Wolf, Niall Ferguson, Sir Angus Deaton, Ken Rogoff, Tim O'Reilly, and Richard Lugar.

My favorite finance/investing books mix theory with explanatory anecdotes. Myth of Capitalism follows that format. It surveys the academic literature on economic concentration, citing dozens of academic papers and books that are broadly relevant. But it also has industry-specific case studies and anecdotes, some of them quite illuminating.


The basic message

When most people think of harmful industry concentration, they think of monopolies: Standard Oil and the like. Myth of Capitalism argues that this emphasis is misplaced, with duopolies and oligopolies being almost as anti-competitive as monopolies and far more common.

The book also argues against the prevailing anti-trust philosophy pioneered by Robert Bork and various Chicago School economists. At the risk of oversimplifying, the Chicagoans asserted that mergers are generally good because they lower consumer prices and increase corporate efficiency.

The book cites research suggesting that both claims are wrong: mergers are more likely than not to raise prices, especially once an industry consolidates to a handful of players, and price hikes are more important than synergies in increasing profit margins after a merger.

And even if one accepts the Bork/Chicago arguments, they ignore several things:
Business concentration doesn't just affect consumer prices; it also gives companies more bargaining power versus their workers.
The internet has given rise to several new businesses that dominate their respective niches while offering free products, e.g. Facebook in social networks and Google in internet search. A narrow focus on consumer prices ignores these companies' ability to take abusive and anti-competitive actions against business rivals.
Corporate efficiency isn't the end-all and be-all of competition. While large, mature businesses enjoy economies of scale, they also innovate far less than smaller companies, adjusting for size. I found the book's discussion of this to be one of its highlights.


Regulation and economic concentration

Tepper isn't Elizabeth Warren or Thomas Piketty, and Myth of Capitalism doesn't argue for higher taxes or against capitalism. While the book calls for greater anti-trust regulation, it points out that other kinds of regulation frequently reduce competition. In particular, large companies can bear the cost of onerous or complex regulations more easily than their smaller competitors.

In 1892, Richard Olney, then a railroad lawyer and later US Attorney General, presciently described how regulation can serve the interests of big corporations:
The [Interstate Commerce] Commission, as its functions have now been limited by the courts, is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a Commission gets to be, the more inclined it will be found to take the business and railroad view of things. It thus becomes a sort of barrier between the railroad corporations and the people and a sort of protection against hasty and crude legislation hostile to railroad interest...

The book mentions intellectual property law as another way the government suppresses competition. Since 1982, the number of patents issued each year in the United States has surged, even after adjusting for population growth. And copyright terms have been lengthened, thanks in large part to lobbying by Walt Disney Company. Ironically, many of Disney's movies are based on traditional stories that have long been in the public domain.

Yet another problem is the revolving door between regulators and the companies they regulate. For instance, patent examiners who later move to jobs in the private sector are more likely to approve patents, especially for the companies that ultimately hire them.


Highlights for investors

Of the many academic papers the book cites, two are particularly relevant for investors:

In a 2017 paper, Gustavo Grullon, Yelena Larkin and Roni Michaely find that 75% of industries in the U.S. have become more concentrated over the past twenty years and that as an industry consolidates, its constituents experience abnormally high stock-market performance.

Writing in 2006, Margaret Levenstein and Valerie Suslow find that real interest rates determine the prevalence of corporate cartels. As the book states, “the most important factor in the creation and breakups of cartels was the interest rate. Cartels are more likely to breakup during periods of high real interest rates, presumably because higher interest rates require higher immediate rates of return for collusion. [Levenstein and Suslow] found the relationship was almost perfect.”


Criticisms

Despite its wealth of information, Myth of Capitalism isn't a dispassionate analysis of economic concentration. At heart, it's a work of advocacy, one that argues for stricter anti-trust measures. In light of that, and although I agree with its main argument, I'd push back on a couple things:

1. As mentioned, cartels are more likely to form and last longer when real interest rates are low. So economic concentration is cyclical, and we may see a decline in concentration even if anti-trust regulation remains permissive.

2. By focusing on economic concentration and cartels, the book downplays alternative explanations for some of the problems it describes.

For instance, it mentions that corporate profits' share of GDP has risen, and employee compensation's share has commensurately fallen, since the 1980s and especially since 2001. This coincides with the cartelization of American business, but it also coincides with globalization. I think it's no coincidence that China joined the World Trade Organization in 2001.

On the other hand, there are many oligopolistic industries for which globalization is irrelevant. Health care in the U.S. is mostly insulated from foreign competition, and some of the book's most striking case studies involve drug companies and other health-care players.


Conclusion

I've tried to capture Myth of Capitalism's highlights, but it has many other details readers may appreciate, for instance:

Which government was the first to issue patents
How Standard Oil's business model influenced German industrialization before World War II
How the merger wave of the 1890s-1900s differed from a second merger wave in the 1920s
How companies with abnormally high lobbying expenditures tend to outperform their peers in the stock market
Why economic concentration disproportionately affects rural areas
Why new business formation has declined in the U.S. since 2009

If this sounds interesting, you can pre-order the book on Amazon. Although given the subject, I would recommend bypassing the monopolist and ordering from Barnes & Noble instead.

Sunday, July 29, 2018

After years of underperformance, are value stocks worth buying?

Last month, Sean Markowicz of Schroders wrote an article titled "Where's the value in value investing?" Mr. Markowicz mentions that before the 2007-08 financial crisis, value stocks almost always outperformed growth stocks as measured by rolling ten-year returns, but since then growth has outperformed value on the same measure:














This is partly because "the 12 month forward price-to-earnings ratio of growth stocks has risen by 55% compared to only 11% for value stocks" and because "growth stocks, unlike value, have a greater proportion of their cash flows occurring in the distant future... This makes them akin to long-duration assets, which are more sensitive to changes in long-term rates. As a result, growth stocks have benefited far more than value stocks from rates falling to record lows."

Markowicz summarizes his message by stating that "the valuation picture seems fairly supportive of value’s relative return prospects."

While the article makes a lot of thought-provoking points and is worth reading, I disagree with its conclusion. I don't want to say that value is doomed to continue underperforming growth, but I don't think buying value stocks is a good trade ex ante, for several reasons.


Value and how it's defined

My main disagreement with the article relates to how it defines value. It calculates value's performance relative to growth by comparing a basket of stocks with the lowest price-to-book ratios (the value stocks) to a basket of stocks with the highest P/B ratios (the growth stocks). This means that the actual valuation of value stocks will vary significantly with the market's overall valuation and the dispersion of P/B multiples. So today's value stocks may be radically different from the value stocks of yesteryear, making value's historical outperformance potentially less meaningful than it appears.

I think it is less meaningful: despite their long underperformance, value stocks are noticeably more expansive than they were the last time value was out of favor. In 2000, when the technology bubble peaked, many "old economy" stocks had fallen 25-50% over the prior 18 months and were trading at low P/E ratios. For instance, Autozone and Sherwin-Williams traded at 10-11x earnings despite growing their earnings per share steadily for years. Some companies with more mundane financial results traded at even lower prices, e.g. Universal (UVV) and Ball Corp (BLL) traded at 5x earnings in March 2000.

Maybe I'm not looking hard enough, but I don't see anything like that today. Most companies with steady EPS growth are trading at or above the market's P/E multiple, and the ones trading at single-digit P/Es tend to be cheap for good reason: the business is cyclical, they're failing retailers, they were part of a leveraged buyout and carry a huge debt load, etc.

By buying stocks cheaply, value investors try to create a "margin of safety"--they hope that even if the underlying business disappoints, they'll avoid losing money because the price they're paying for the stock discounts a lot of potential bad news. In my opinion, absolute valuation is what creates a margin of safety, not relative valuation or relative performance. If investors buy a stock at a discount to its net working capital, they won't suffer crippling losses even if the company has to liquidate. If they buy a stock at 5x earnings, they'll earn back their investment in five years, freeing them from the need to make assumptions about the distant future.

Obviously, that's an oversimplification: companies that trade below their net-net value occasionally incur large operating losses, and companies that trade at low P/Es can squander the E on ill-advised acquisitions. But in general, buying absolutely cheap stocks is both safe and rewarding in a way that relative-value investing isn't.

Energy stocks provide a good test of absolute versus relative valuation. After the price of oil collapsed in 2014-15, many energy bulls made relative-value arguments: energy stocks had become an unprecedentedly small part of the Standard & Poor's 500 index, their underperformance vs. the index had reached extreme levels, etc. At the same time, most energy stocks weren't particularly cheap when valued individually: the ones that had earnings traded at high P/Es and would trade at high P/Es even assuming oil rebounded. Many were also poorly managed and prioritized production growth over shareholder return. Ultimately the relative-value arguments didn't matter: energy stocks kept falling until the oil price bottomed, and since then they've barely kept pace with oil futures despite their significant financial and operational leverage to higher oil prices.


Implicit macro and sector bets

Buying value stocks involves making implicit macro and sector bets. Interest rates are a major influence on value's relative performance:


(Source: Claus Vistesen)

This influence works in a couple of ways. One is the dynamic that Markowicz mentions, in which growth stocks tend to be longer-duration while value stocks tend to be shorter-duration. Another is that value stocks, as measured by price to book, disproportionately belong to the financial sector. Since banks borrow short and lend long, i.e. they typically borrow money through overnight deposits or short-term certificates of deposit and make multi-year loans, the shape of the yield curve affects their profitability. All else being equal, banks should earn higher profits when the yield curve is steeper.

So long as the European and Japanese central banks practice ZIRP and financial repression, I doubt the US yield curve will steepen dramatically. When foreign institutional investors buy US bonds, they often finance the bonds by borrowing dollars on a rolling three-month basis. This hedges their currency risk. If the US curve steepens while the European and Japanese curves stay relatively flat, longer-term US debt financed with short-term USD borrowing becomes more attractive to foreign investors, and any movement they make into US debt should re-flatten the curve.

This doesn't mean interest rates--and by extension bank profitability and value stocks--can't rise, but it makes a sustained rally less likely.

I believe that the preponderance of banks among value stocks has also affected value's relative performance in another, more obscure way.

Banks have two unique risks that don't affect other industries. One, they depend on the trust of their depositors and lenders and can quickly fail if they lose that trust. Two, regulators can force them to issue new equity during a crisis or at the bottom of an economic cycle, diluting shareholders at the worst possible time. These risks hit many banks in 2007-09. E.g. Washington Mutual failed, and Citigroup had to massively dilute its shareholders to survive. Despite rising 600% from its 2009 low, Citigroup shares are still 87% off their 2007 high.

I believe that value's underperformance since the financial crisis is partly a byproduct of these risks hitting banks. Bank stocks declined during the crisis, failure and dilution made the decline permanent, and this has depressed the rolling ten-year returns for value stocks. This dynamic isn't supportive of mean reversion. If a bank underperforms the broad market because it had to take a "hard reset" by issuing new equity at the bottom, that doesn't imply it will subsequently outperform.

To be fair, the article touches upon this, but it's something that I would have emphasized more. The article also mentions that the value's underperformance vs. growth shrinks when the value and growth indices are adjusted to reduce the financial and technology sectors' respective weightings.


A couple of final comments

• I think the stock market is more competitive than ever before and that this will suppress returns for many styles of investing including value. Academic research into "investing factors" has increased interest in statistical-value strategies, and the proliferation of hedge funds means that cheap small- and micro-cap stocks that institutional investors traditionally ignored are no longer ignored and are less likely to stay cheap. Don't assume that value will outperform growth in the future just because it typically has.

• Good relative performance doesn't guarantee good absolute performance. Value stocks could outperform growth stocks while actually falling, for instance if glamour stocks like Facebook, Amazon, Netflix, and Google fell 25-30% during a correction while value stocks fell 10-15%.

Thursday, July 26, 2018

The new Nifty Fifty: today's one-decision stocks

On Twitter, Ryan P. Dolan asks, "If we are in a Nifty Fifty 2.0 environment, beyond the obvious members (AAPL, AMZN, GOOG, MSFT, FB, NFLX, TSLA, MA/V, etc), what other companies would you include?"

It's a good question. I agree with Mr. Dolan that today's stock market echoes the Nifty Fifty era of the early 1970s. Many large-capitalization stocks are trading at high price-to-earnings and price-to-revenue multiples, but unlike during the technology bubble of 1999-2000 and the housing bubble of 2003-06, the speculative excesses we see now aren't limited to one industry or sector of the economy.

Instead, like in the early '70s, investors are bidding up glamorous companies--ones that are growing quickly or have high returns on invested capital--irrespective of their industry. The Nifty Fifty was a mix of established-but-still-growing blue chips and newer, sexier companies; likewise for today's market leaders.

I'm going to take a stab at his question and offer a Nifty Fifty 2.0 below. The original Nifty Fifty was an informal, unscientific list, and so is mine. For instance, Apple doesn't trade at exorbitant valuation multiples, but it's undeniably a market leader and glamour stock, so I'm including it. Notwithstanding that, each company on my list has a market cap is $10 billion or more, along with some or all of the following characteristics:

• It's popular among hedge funds
• It's been described as a quality business, compounder, or disruptor
• Its leader has been described as an outsider CEO or a great capital allocator
• It has a price-earnings ratio above 25
• It has an up-and-to-the-right stock chart
• Much of the stock's performance since 2009 has come from multiple expansion



The new Nifty Fifty

Activision Blizzard (ATVI)
Adobe (ADBE)
Align Technology (ALGN)
Amazon (AMZN)
Apple (AAPL)

Autodesk (ADSK)
Automatic Data Processing (ADP)
Berkshire Hathaway (BRKA, BRKB)
Blackrock (BLK)
Boeing (BA)

Booking Holdings (BKNG)
Broadcom (AVGO)
Charter Communications (CHTR)
Copart (CPRT)
Costco (COST)

Danaher (DHR)
Electronic Arts (EA)
Facebook (FB)
Fiserv (FISV)
Google (GOOG, GOOGL)

HCA (HCA)
Home Depot (HD)
Idexx Laboratories (IDXX)
Intuit (INTU)
Intuitive Surgical (ISRG)

JP Morgan (JPM)
Lowe's (LOW)
Marriott (MAR)
MasterCard (MA)
Microsoft (MSFT)

Netflix (NFLX)
Nike (NKE)
Nvidia (NVDA)
Palo Alto Networks (PANW)
Paypal (PYPL)

Rollins (ROL)
Roper Technologies (ROP)
Ross Stores (ROST)
Salesforce (CRM)
Sherwin-Williams (SHW)

Take-Two Interactive (TTWO)
Tesla (TSLA)
Texas Instruments (TXN)
TJX Cos. (TJX)
Transdigm (TDG)

United Health (UNH)
Verisk Analytics (VRSK)
Visa (V)
Wayfair (W)
Workday (WDAY)



Honorable mentions

Interactive Brokers (IBKR) is a cult favorite that's grown steadily, has a revered CEO, and trades at a high multiple, but I excluded it because its free float and trading volume are relatively small.

I wanted to limit the list to American companies, but Alibaba (BABA), ASML (ASML), Brookfield Asset Management (BAM), Constellation Software (CSU), JD.Com (JD), Shopify (SHOP), Spotify (SPOT), and Tencent (TCEHY) are foreign companies that are beloved by American investors, have well-known growth stories, and trade at rich valuations.

Thursday, June 28, 2018

Will tight monetary policy and loose fiscal policy push the dollar higher?


I recently read Jack Schwager's trader-interview book The New Market Wizards, which includes an interview with Stanley Druckenmiller. Many people consider Druckenmiller one of the best investors alive, and he lives up to his reputation in the interview, sharing a number of fascinating anecdotes and ideas.

One idea in particular caught my attention. Druckenmiller tells Schwager that:

I never had more conviction about any trade than I did about the long side of the Deutsche mark when the Berlin Wall came down. One of the reasons I was so bullish on the Deutsche mark was a radical currency theory proposed by George Soros in his book, The Alchemy of Finance. His theory was that if a huge deficit were accompanied by an expansionary fiscal policy and tight monetary policy, the country's currency would actually rise. The dollar provided a perfect test case in the 1981-84 period. At the time, the general consensus was that the dollar would decline because of the huge budget deficit. However, because money was attracted into the country by a tight monetary policy, the dollar actually went sharply higher. When the Berlin Wall came down, it was one of those situations that I could see as clear as day. West Germany was about to run up a huge budget deficit to finance the rebuilding of East Germany. At the same time, the Bundesbank was not going to tolerate any inflation. I went headlong into the Deutsche mark. It turned out to be a terrific trade.


Today the United States has a similar combination of tight monetary policy and loose fiscal policy. The Federal Reserve has begun raising interest rates and shrinking its balance sheet ahead of its European and Japanese counterparts, while the US fiscal deficit is set to surge following a large corporate tax cut.

So after reading the interview, my initial reaction was to assume that the current regime is positive for the dollar. But after further research, I think the U.S. today has enough differences with Druckenmiller's two examples that any comparison is meaningless. I want to emphasize that I'm not a macro expert, so some of these arguments may be flawed, but here are what I see as the differences:


• The dollar is already relatively high.

In 1980, the dollar had fallen by half against yen and mark during the previous decade. In November 1989, the mark was off its highs versus the dollar and had been flat for the previous three years despite a large and rising trade surplus. Whereas today, the dollar's real effective exchange rate is near a decade high:


A chart of the trade-weighted US dollar index also puts the dollar's strength in stark relief:



• Anecdotally, sentiment is also high.

The consensus of Wall Street currency strategists seems to be that, since the US growth has accelerated at the same time that economic data have surprised to the downside in many other countries, the dollar can only continue to rise for the foreseeable future.

By contrast, as Druck mentions, in the early 1980s “the general consensus was that the dollar would decline because of the huge budget deficit.”

Likewise, he tells Schwager that in 1989, “[Buying Deutsche Marks] was made easier by the generally bearish sentiment at the time. The Deutsche mark actually fell during the first two days after the wall came down because people thought that the outlook for a growing deficit would be negative for the currency.”


• The U.S. current account and NIIP are weak.

In the late 1970s and early 1980s, the U.S. ran trade deficits that were relatively small by today's standards, and it had a strong net international investment position. Germany's trade surplus steadily grew throughout the 1980s.

Today the U.S. has both a weak NIIP and a weak current account. A chart from Horseman Capital illustrates how much the US NIIP has deteriorated since the early '80s:


Simply, the U.S. has less wherewithal to run government deficits without incurring major risks.

Also, my hunch—and I'll reiterate here that I'm not a macro expert, so this may be completely wrong—is that the NIIP plays a major role in determining whether deficits are good or bad for a currency. 

Most investors have a home-country bias, i.e. they prefer to invest domestically so long as domestic investments have a competitive risk/reward. So if a country increases its supply of government securities (expansionary fiscal policy) and also guarantees that those securities earn high returns (tight monetary policy), and its citizens own significant foreign assets (a positive NIIP), some of them will sell those foreign assets to buy the newly-created domestic securities, which will push the country's currency higher. Whereas if its citizens have significant international debts (a negative NIIP), this dynamic isn't possible.


• The “return on deficit” will be lower.

In the early 1980s, the U.S. experienced two recessions that kept its economy below potential. In 1989, Germany had a significant identifiable need for investment in the form of integrating East Germany. By contrast, today the U.S. is nine years into an economic recovery, the unemployment rate is low, and there are many anecdotal signs of labor shortages.

An economy with minimal spare capacity and full employment will be less responsive to fiscal stimulus than one that with significant spare capacity and unemployment, so I would expect the current US deficit to be far less stimulative than the two deficits Druckenmiller mentions.

And even before the tax cut, the U.S. government was running large deficits in the midst of a long economic expansion. This suggests that a large part of the deficit is structural, so rather than being economically beneficial it's a sign of weakness.