Saturday, December 9, 2017

Book review: "Long-Term Front-Running" by Michael Fritzell

Many stock traders try to make money by predicting the immediate future: Will tax reform spark a stock-market rally? Will Apple beat earnings estimates next quarter? Et cetera.

Long-Term Front-Running suggests a different tack: instead of guessing at the near future, investors should try to predict which companies will take off in the next few years and buy their stocks before other people catch on. By getting in before the crowd, they'll benefit both as the company's earnings rise and as investors catch on to the story and award the company a higher price/earnings multiple. In my experience, the best-performing stocks are usually a product of those two things paired together, so investors who look for “compounders” should find the book interesting.

Short-term traders should also find it interesting. Trading off immediate events can induce tunnel vision and make one's trading strategy essentially reactive. Looking past the near term should give traders both more perspective and less competition.

A big strength of Long-Term Front-Running is its versatility: it discusses both corporate fundamentals and investor sentiment, both macroeconomic and company-specific events and processes, etc. It also touches on the importance of “reflexivity,” i.e. how perception can affect reality in the financial world and create positive feedback loops.

Unfortunately, in a way the book's versatility is also a drawback. Since it covers a lot of ground in just 100 pages, its specific ideas are mostly rules of thumb, i.e. guidelines on what to do in typical situations. And as I get more investing experience, I've come to believe that many of the best investment opportunities involve atypical situations.

For instance, Fritzell writes that “The best time to bet on a commodity is when inventory is tight; future supply is likely to be low while demand is racing ahead.” This is generally true, but the shale-drilling revolution provides a counterexample. There have been times in the recent past when natural gas inventories were low, yet prices didn't rise. The shale revolution seems to have overwhelmed the traditional relationship between inventories and future prices.

Lest I seem too critical, I'll say that I enjoyed many of the book's rules of thumb. For instance, it includes a checklist for identifying corporate fraud that I found very useful. I also liked its case studies, particularly the one about Delclima, an Italian HVAC manufacturer that began life as a neglected spin-off but soon became a stock market darling.

Notable and quotable

To give you a flavor of the book, here are some of my favorite passages:

The potential to tap future customer demand can be summarized in the term “consumer surplus.” It can be defined as the difference between the price customers are willing to pay and the what the product costs. If there is a huge gap, then the company is potentially sitting on a goldmine.

Return on invested capital itself is not a useful metric: it often reflects a cyclical peak in the industry or the mature phase of the ramp-up of a particular technology.

Products that aren't particularly functional – Tamagochi, baseball cards, Beanie Babies, etc. - are fun for a while but we usually get tired of them. If the product is fashionable and also serves a real functional purpose – for example UGG shoes or Canada Goose jackets – they may survive for a longer period of time.

(In my opinion, this mix of fashion and function explains much of Apple's popularity. Apple's smartphones cost much more than competing phones—they clearly have a fashion premium. Yet they're also cheaper and more functional than what preceded smartphones—the iPhone is like a mobile phone, laptop, digital camera, watch, and GPS rolled into one. The combination of so many things in a convenient device lets people justify paying the fashion premium.)

Not every company is able to take advantage of industry growth... in a commodity industry, ruthless competition may take away most of the opportunity for gain, despite a solid underlying growth trend.

Sometimes people criticize new technology due to certain weaknesses but fail to realize that those weaknesses will disappear over time. Online streaming in the early 2000s was unbearably slow, but with the spread of fixed broadband, online streaming was almost certain to take off.

High credit growth not only pushes money into the stock market, it also improves the value of assets used as collateral in loans, improving creditworthiness and fueling further credit growth.

Whenever a particular method of investing becomes popular, flows into that strategy start to accumulate. Those flows can by themselves help that strategy perform and attract further inflows.

Thoughts on convertible bonds

A convertible bond becomes “busted” when the issuer's stock price falls so far below the strike price as to render the conversion feature nugatory. When this happens, the convertible begins to trade like a regular bond. For instance, if bonds of similar size and credit quality trade at a 9-10% yield to maturity, the convert will typically trade at a price—almost certainly a big discount to par—that gives it a similar YTM.

Busted converts were great investments during the 2001-02 market downturn and again during the Global Financial Crisis. Their strong performance during those periods of stress piqued my interest, and I read as much as I could about the convert market, assuming that it would offer similar opportunities during the next crisis.

After a couple days of reading, I no longer think that will be the case. Actually, my reading suggests that converts will be relatively unattractive going forward, for several reasons:

The market has shrunk. Since 2007, the face value of outstanding convertible bonds has fallen from approximately $700bn to $500bn worldwide and from $300bn to $200bn in the United States. (By comparison, Apple's market cap is $870bn.) There are two reasons why the market is smaller: One, many companies issue converts to save money on interest, and historically low interest rates obviate that. Two, convertible arbitrage funds are major buyers of converts, and since the GFC they've been forced to use less leverage than they'd previously used, reducing their buying power.

With arbs using less leverage, there's less potential for forced selling to create bargains. Investor psychology has also changed. The convertible selloff after Lehman Brothers' bankruptcy was so ferocious in part because it took people by surprise. Nothing like that had happened before, at least not on the same scale. Now investors know it's within the realm of possibility, which I think makes it less likely to happen again. As the old cliché goes, a watched pot never boils.

Transaction costs during the post-Lehman selloff were exorbitant, with bid/ask spreads equal to 7% or more of the midpoint price for many converts:

(Source: The Handbook of Convertible Bonds by de Spiegeleer and Schoutens)

The market was chaotic and illiquid, with December 31, 2008 13f-hr filings showing that various hedge funds had one bond—Ciena's $300mm May 2013 issue—valued at anywhere from 48 to 53 cents on the dollar. Buying converts in 2008 was a great trade on paper, but trading costs made the true returns lower.

Convert issuers tend to be smaller, more speculative, lower-quality companies. Many of these companies also have debt that's senior to their converts—typically, converts are subordinated to all other existing and future debt issues. The GFC was painful but brief; in a protracted recession, converts would likely experience much higher defaults.

Tech industry over-represented

Technology companies are over-represented among convert issuers. I think this is because a convert is most attractive when the issuer's stock is volatile but it has low credit risk. Usually the two conditions don't go together: a company that's less likely to default will typically have a less volatile stock price. But tech companies often trade at high valuations because investors expect them to grow quickly. Hence the stocks are very sensitive to investors' beliefs about the future, and they can be quite volatile without implying anything about the companies' creditworthiness.

Issuers with net cash

In looking at dozens of convert issuers, I found a surprising number that had more cash than debt. Even more surprisingly, the net cash didn't necessarily make them safe credits.

Many tech companies issued convertibles during the dot-com bubble. In 2001, after the bubble had burst and the tech industry was suffering, some of these companies still had net cash. How their converts performed from that point on depended on how they had financed themselves. Some issuers that had raised money primarily through converts defaulted, while the ones that had raised money through a mix of equity and convert issuance almost all survived. In the latter group, many converts paid off at par even after the issuer's stock had fallen 95-99%.

A couple of tech issuers managed to stay afloat only by repurchasing most of their outstanding bonds at a big discount to par. These buybacks meant that they technically satisfied their obligations, but most of their bondholders didn't benefit.

While the dotcom-era tech issuers generally treated their creditors well, that wasn't the case during the GFC. Many issuers with net cash took creditor-unfriendly actions:

ADC Telecom bought back stock in late 2008 while its converts traded at 45 cents on the dollar.
Ciena made a big all-cash acquisition in 2009 as the GFC appeared to be ending, taking it from a net cash position to a significant net debt position. Integrating the acquisition was more difficult than expected and Ciena lost money for several years.
Energy Conversion Devices invested most of its cash in growth initiatives, only to find that its niche solar technology wasn't cost-competitive with polycrystalline solar cells.
TTM Industries made a big acquisition in 2009 that took it from having working capital in excess of all liabilities to having significant net debt, primarily bank loans that were senior to its converts.

Energy Conversion Devices went bankrupt within a few years. The other companies survived and repaid their converts, but the expectation that their net cash provided a margin of safety turned out to be wrong.

By looking at issuers' recent actions, investors may be able to find net-cash issuers that are more favorably disposed to creditors:

In 2002, Juniper Networks had $1.7bn of cash and $1.15bn of outstanding convertible bonds. That May, it acquired Siemens' networking business. Juniper had enough money to buy the business entirely for cash, but instead it paid in a mix of cash and stock, leaving it with a net cash position. A few months after the acquisition, it bought back ~18% of its converts at a discount to par. In 2003, it tendered for the remaining bonds at par.

In 2007, Arris Group acquired C-Cor. Like Juniper, Arris made the acquisition with a mix of cash and stock that left it with a net cash position. It later bought back some of its converts during the GFC and stated in its 2008 10-K that “Maintain[ing] a strong capital structure, mindful of our 2013 debt maturity” was a key part of its corporate strategy.

Thursday, November 30, 2017

Articles of interest

Auto lending
The Wall Street Journal reports that used-car prices have been resilient in 2017 despite a sharp increase in expiring leases.

Brad Setser critiques the popular argument that China's credit growth is losing its stimulative power.

The Wall Street Journal describes how HNA Group's international acquisition binge has faltered, writing that "Instead of targeting profitable companies, HNA sought assets with considerable revenues that would hasten its rise up the Fortune 500."

According to Dow Jones Newswires, Chinese house buyers are using consumer loans to get around restrictions on real-estate lending, with one researcher estimating that "at least one third of short-term consumer loans issued since March have gone toward property purchases."

Caixin Global speculates that Chinese microloans' risk of default is higher than it appears, noting that many borrowers are in the habit of repaying debts to one lender by borrowing from another.

Reuters reports that a Chinese coal miner has amassed a $3bn long position in copper futures, presumably contributing to the metal's year-to-date price rise.

Alpha Vulture argues that Bitcoin is overhyped and describes some of its inherent flaws.

Cole Frank of the Council on Foreign Relations states that while Chinese capital outflows might have contributed to Bitcoin's rising price in 2015-16, that has not been the case this year.

Emerging markets
Miguel Kiguel, a former Argentine government official, writes about the aftermath of Argentina's 2001 debt default.

Al-Monitor reports that many of Turkey's large infrastructure projects are earning poor economic returns.

In a two-part interview (part one and part two) Porter Erisman discusses his new book Six Billion Shoppers, offering his thoughts on how e-commerce has developed in emerging markets and how and why it differs from e-commerce in developed countries.

Ockham's Notebook writes about Goodhart's Law and how it contributed to problems at American Realty Capital/VEREIT.

Investing strategy
The Wall Street Journal interviews Joel Tillinghast about his investing principles.

Giles Parkinson of Aviva offers some potential explanations for why American stocks have outperformed their foreign counterparts over the past thirty years.

Vanity Fair reports that Amazon "is poised to spend around $4.5 billion on their video streaming this year... only $1.5 billion less than Netflix’s $6 billion budget for their 2017 content."

Similarly, Variety reports that the cost of producing streaming video programs has surged as an increasing number of deep-pocketed companies produce an increasing amount of streaming content.

John-Paul Burke of Horseman Capital argues that OPEC's actions are responsible for oil going into backwardation and that this will constrain shale production growth.

IHL Group argues that news reports of a "retail apocalypse" overstate the problems retailers face.

Short selling
Russell Clark of Horseman Capital describes his short-selling strategy in a public presentation. I consider this a must-read because Clark's strategy is radically different from the ones that most short sellers use.

Crescat Capital's latest investor letter includes a lot of sobering statistics about the stock market's valuation.

Monday, September 25, 2017

Articles of interest

Anti-trust law
Lina Khan from Yale Law School describes how Amazon is vulnerable to changes in anti-trust philosophy.

Wired reports that as leading internet companies become more powerful, some anti-trust officials are arguing that "privacy is a competition issue."

Bloomberg interviews Aliko Dangote, Africa's richest entrepreneur.

Intrinsic Investing describes the things that have traditionally made large consumer brands successful and looks at the forces that are now eroding those brands' market power.

Dim Sums descibes the fraud and lack of trust that pervade China's food distribution system.

On a more positive note, The New York Times looks at China's advanced and rapidly growing system of mobile payments.

Trivium China gives an overview of the Chinese Communist Party's upcoming congress.

Andrew King and Baljir Baatartogtokh offer a balanced critique of Clayton Christensen's theory of disruptive innovation.

Master limited partnerships
SL Advisors explains why MLPs have underperformed other kinds of dividend-paying investments in 2017.

Medical devices
UndervaluedJapan has a nice writeup of Fukuda Denshi, a Japanese medical-device maker. He writes that the company trades at an abnormally low valuation despite a history of earning consistent profits and returning capital to shareholders.

Oil and gas
Reuters describes how shale energy players are using financially-creative joint ventures to raise money for drilling.

The Wall Street Journal reports that Enervest, a $2 billion private-equity fund that makes energy investments, has lost nearly all its money.

Petrichor Capital provides an overview of a lecture that Richard Hamming gave to the Naval Postgraduate School. Although the lecture is about Hamming's academic career, many of the concepts seem relevant to investing.

Ockham's Notebook shares some excerpts from Ray Kroc's autobiography Grinding It Out.

The New York Times describes how Best Buy has improved its operations to better compete with Amazon.

Saudi Arabia
Reuters reports on the palace coup that removed Mohammed bin Nayef from the royal line of succession and made Mohammed bin Salman Saudi Arabia's heir apparent.

Jeremy Reimer from ArsTechnica provides a fascinating history of OS2, the IBM operating system that lost out to Windows 95.

Venture capital
TechCrunch describes Softbank's new $100 billion venture-capital fund.

A critical reappraisal of "Margin of Safety"

A few years ago, I wrote a favorable review of Seth Klarman's Margin of Safety. I recently re-read the book, and today my opinion of it is far less charitable. There are three reasons for that:

1. It's derivative of Ben Graham
When I originally read Margin of Safety, I wasn't familiar with Graham's work. Since then I've read Security Analysis, which made me realize that MoS is essentially a carbon copy of SA. Some of the commentary in SA is specific to the stock market of the 1920s and 1930s, and some of the commentary in MoS is specific to the stock market and junk-bond boom of the 1980s, but beyond that Klarman lifted MoS's writing style, its layout, and even its title from SA.

The main difference between the two books is that SA is longer and more detailed. Anyone who's interested in Klarman's ideas can get a more sophisticated treatment of the same topics from Graham.

2. The writing is moralistic
Klarman is an old-school value investor who buys stocks that trade at low price-to-earnings and price-to-book ratios. There's nothing wrong with that--I prefer to buy statistically-cheap stocks too--but he's dismissive of other investing strategies, and the dismissal has a distinct moral element. He presents his style of value investing as the one true way and portrays speculation as nothing more than a "greater-fool game." There's no acknowledgement that riskier stocks can have positive expected value. Klarman calls art and rare coins "rank speculations" and denigrates short-term traders. The moralistic tone is grating.

When I started investing in 2002, I was a regular reader of Bill Fleckenstein's column on MSN Money. Fleckenstein was a permabear and dogmatically argued that the stock market was overvalued. Despite that, he had great trading instincts. On several occasions, he wrote that the market was due for a bounce right before it did, in fact, bounce. But as far as I know, he never acted on these instincts. He seemed to think that buying high-P/E tech stocks was immoral and that the only legitimate way to trade them was to bet on prices falling back to fair value.

I'm sure that attitude kept his returns far lower than they could've been, and for me, his column was a powerful argument against having ideological biases in investing. MoS evinces the same kind of rigid ideological thinking.

3. Many of the case studies were value traps
Klarman illustrates his investing philosophy with short case studies of stocks that he bought during the 1980s and early 1990s. The case studies are too brief to give a sense of why these investments were successful, but they piqued my interest, and I looked online for more information about the stocks in question.

What I found suggests that many of them had major risks that MoS doesn't mention, while others were classic value traps.

Bucyrus was the recipient of a leveraged-buyout offer in July 1987. After the October '87 crash, investors worried that the offer would be withdrawn, and the stock traded at $10 versus the offer's value of $14 in cash and new securities. At the time, Bucyrus had $9 per share of net cash and an "unprofitable but asset-rich mining-machinery business," and Klarman reasoned that the stock was "a real bargain."

The buyout was consummated, and the stock might have been an intelligent gamble on the deal going through, but the net cash provided less of a margin of safety than one might assume. Sales of Bucyrus's mining equipment had surged in the 1970s, but this gave way to an extended downturn in the 1980s and '90s as demand fell and coal miners reused surplus machinery from the '70s rather than buy new equipment. The company finally filed for a prepackaged bankruptcy in 1994 after years of operating losses. Its 10-K for that year states that "meaningful new machine shipments to domestic coal customers cannot be expected until after the mid 1990's."

City Investing Liquidating Trust
City Investing Company decided to liquidate in 1984, and the following year it put a hodgepodge of assets that it couldn't sell into a liquidating trust. The trust's units traded at $3 compared to tangible book value of $5 and distributions of $9 per unit over the following six years. Sounds great, except that much of the trust's return came from distributing its ownership interest in General Development Corp, a Florida land developer whose stock surged while the trust was liquidating but later became worthless.

GDC was a glorified Ponzi scheme. It sold plots of land on installment, promising that it would improve the land once the buyer had finished paying off the installment loan. GDC underpriced the land and lost money on every sale, but as long as the volume of new installment contracts exceeded the volume of maturing contracts, the company was cash-flow positive. When the U.S. entered a recession in 1990, the number of new installment contracts plummeted and GDC experienced a cash crunch. It filed for bankruptcy in 1991.

An investor who recognized the flawed nature of GDC's business could have hedged the trust's interest in GDC by shorting its stock proportionally, but in doing so, the investor would have tied up more money for a much lower profit.

Esco Electronics
Emerson Electric spun off Esco, its military electronics unit, in 1990 when the outlook for defense spending was bleak. After the spinoff, Esco traded at less than 15% of tangible book value even though it was profitable. Over the next five years, the stock doubled, which would normally be a good return, except that every other defense stock performed better. Northrop Grumman and Alliant Techsystems quadrupled, while General Dynamics was up 550%.

I'm sorry if it seems churlish to criticize Klarman for recommending a stock that doubled, but Esco's underperformance despite the astoundingly low valuation suggests the company had problems he doesn't acknowledge.

Intertan operated RadioShack's international stores. In 1986 its stock traded at $11, which was less than its tangible book value and equal to its net working capital. The stock was cheap because losses in Europe were offsetting healthy profits in Australia and Canada. Klarman mentions that the company turned around its European division and that by 1989 the stock was trading above $60.

Unfortunately that was the high point, and Intertan spent most of the 1990s trading below $10. The company never paid a dividend. Circuit City eventually acquired Intertan for $14 per share in 2004, giving shareholders a total return below the inflation rate.

Obviously I don't recommend the book, but if you're still interested in reading it, here's a PDF copy.

Sunday, August 6, 2017

The permabears are right about buybacks and ZIRP

As the stock market has moved from record high to record high, a small but vocal group of permabears has argued that the market's strength is unsustainable. Two claims they've frequently made are that 1) corporations have artificially boosted their stock prices and earnings per share by engaging in large-scale stock buybacks, and 2) central banks have created a stock bubble by suppressing interest rates.

Last week, Lawrence Hamtil from Fortune Financial Advisors wrote an article called What You Probably Believe About the Bull Market Is Wrong. The article argues that the bears are wrong on both counts. They claim that the market's strength is illusory, but Mr. Hamtil thinks that the bears themselves are creating an illusion with misleading arguments.

Since the stock market has risen so much and so consistently over the past eight years, ridiculing permabears is easy. But I think they're mostly right about both buybacks and central banks, and I want to defend my fellow pessimists from some of Mr. Hamtil's criticisms.

Corporate stock buybacks

Hamtil argues that corporate buybacks are less anomalous than the bears claim:

ZeroHedge recently published an article bemoaning the fact that since the bull market began in 2009, households and institutions (which largely act on behalf of households) have been net sellers of shares, while corporations themselves have been by far the biggest buyers of shares...

It is certainly true that corporations have been borrowing heavily in recent years, using a good portion of the proceeds to buy back their shares.  Again, however, this is completely normal corporate behavior. In the Anglo-Saxon corporate model, executives are employed by shareholders first and foremost to maximize shareholder value, and part of that is returning cash to them, generally in the form of dividends or buybacks.

I agree that buybacks are normal, but their magnitude isn't. Before 2004, corporations allocated more money to dividends than buybacks. In 2005, that pattern reversed:

(Source: Leon Cooperman)

In 2009-10, buybacks shrank drastically as financial crisis made companies more cautious, but that proved to be an anomaly. Excepting those two years, buybacks have consistently exceeded dividends since 2005:

And as buybacks have grown relative to dividends, dividends themselves have grown as a percentage of corporate earnings. They were 40% of earnings last year, compared to ~33% in 2000 and less than 30% in 2007:

The proportion of corporate earnings distributed to shareholders through dividends and stock buybacks has risen steadily since 2010 and is now over 100% for the Standard & Poor's 500. But the aggregate figure doesn't tell the whole story: large technology companies like Apple and Google hoard cash, so there must be many other companies in the S&P 500 that distribute far more than 100% of earnings.

Hamtil also writes:

[B]uybacks have little or no effect on valuations. Consider a comparison of the S&P 500 Buyback index with the S&P 500 index.  The buyback index is composed of the top 100 stocks with the highest buyback ratios in the S&P 500, so it is a pretty good yardstick... it is notable that by every major valuation metric, the buyback index trades at a significant discount to the broader market...

If you are still not convinced, just look at the valuations of large companies such as Gilead Sciences or IBM, which have spent tens of billions on share repurchases, yet trade at well-below market multiples, while Tesla, a company notorious for large secondary equity offerings, trades at a significant premium.

This comparison is unfair because the companies that buy back stock and the ones that don't generally have different circumstances. Companies that repurchase stock often do so because they have limited opportunities for growth and reinvestment, and are valued accordingly, whereas companies that have major growth plans need to invest in those plans and often can't afford to buy back stock. For example, sales of Gilead's biggest drug are declining, while Tesla is a hot growth stock in a capital-intensive industry.

I believe that Gilead and its ilk would trade at even lower valuations if they didn't buy back stock. I say that because of my experience following Japan's stock market. Many small-capitalization Japanese companies have few growth prospects but earn decent profits, which they hoard rather than paying dividends or repurchasing shares.

These companies tend to trade at low, or even negative, enterprise-value-to-earnings multiples because investors assume they will continue hoarding cash indefinitely and won't distribute it to shareholders. Value investors who would normally love to buy stocks at such low valuations are repelled by the companies' indifference to shareholders' interests. If they began paying large dividends, buying back stock, or making tender offers, in many cases their stocks would quickly triple.

A final note on stock buybacks and valuation: buybacks are very pro-cyclical. Companies do them most aggressively near market peaks, when corporate profits, the ability to borrow, and stock valuations are all relatively high, and the demand from buybacks helps push stock prices and valuations even higher. By contrast, corporations often suspend stock repurchases during recessions and crises, when stock prices are falling, thereby exacerbating the decline by removing demand. So I agree that buybacks aren't unique to today's market: they've amplified stock-price moves ever since they became widespread.

Central banks and interest rates

Hamtil argues that fundamentals play a larger role in the market's rise than central banks:

Another myth that will not die is that quantitative easing ("QE"), and zero-percent interest rate policy ("ZIRP") have fueled the bull market since 2009.  This is easily disproved. Fundamental factors such as robust profit margins and commensurate earnings growth have been the biggest contributors to equity gains, not easy money.

The flaw in this reasoning is that ZIRP and earnings growth aren't discrete phenomena. Low interest rates make corporate borrowing cheaper, raising earnings and returns on equity for leveraged companies.

Low interest rates can also benefit companies indirectly. In my opinion, Apple is a major beneficiary of low rates. Many people who own iPhones can't afford to buy them outright, so they effectively lease them through a contract with their wireless carrier. In a typical contract, the buyer pays more on a monthly basis than he otherwise would pay but gets to buy an iPhone at a drastically reduced price. ZIRP lowers the cost of this "lease" to little more than depreciation.

To be fair, central banks aren't necessarily the only reason why interest rates have fallen. Demographic trends in many countries are deflationary and may contribute to low rates. Nonetheless, central banks have done a great deal to push interest rates lower, both through their control of the short end of the yield curve and through QE. Central banks also influence investor sentiment: many stock bulls believe in the existence of a central-bank put that supports asset prices.

Hamtil states that:

If easy money were the main driver of equity performance, then areas of the world with proportionately larger central bank stimulus programs, like Japan, would have fared much better than areas with less stimulus.  It is worth noting that the Fed ended its quantitative easing program in October of 2014, and ended its "ZIRP" program in December of 2015, yet the U.S. has outperformed both Europe and Japan (in dollar terms) since, despite much looser monetary conditions in those regions.  

This presupposes that monetary stimulus stays in its country of origin, which isn't necessarily true. Macro traders have long joked about Mrs. Watanabe, the proverbial Japanese housewife who invests her family's savings in the carry trade because she can't earn attractive yields in Japan.

And Mrs. Watanabe isn't alone. Russell Clark from Horseman Capital has written about Japanese retail investors buying American REIT funds with enhanced yields and bond funds that generate extra income by buying Turkish lire.

I think that US stocks began to outperform their European and Japanese counterparts in late 2014 precisely because the Federal Reserve tightened monetary policy before other central banks. Continued unconventional monetary policy in Europe and Japan ensured that there would be many investors looking for yield; the U.S.'s comparative tightness made it an attractive destination for those investors. On Twitter, Jonathan Tepper writes that "Euro portfolio managers have told me they can't earn a living buying EU bonds after QE. Had to buy riskier or US bonds."

My last point of contention with Mr. Hamtil is his claim that:

The idea that low rates have compelled would-be savers into riskier assets is another myth that will not die... if this were the case, one would reasonably expect that negative interest rate policies in Europe and Japan would compel savers to empty their bank accounts and pile into equities at least to collect a modicum of yield.  Yet this has not been the case... equity ownership in Europe and Japan is little changed over recent years...

All the while, equity exposure among American individuals is well below pre-crisis highs, having fallen from 62% to 54%.

As Horseman Capital has shown, many Japanese individual investors do reach for yield.

And individuals investors aren't the only force in the stock market. Hedge funds account for a disproportionate share of trading relative to their net assets. Corporate and governmental pensions are major stock investors, and many of them are under-funded, which pressures them to invest more aggressively and take greater risks. Many insurance companies are in a similar situation: they need to earn high returns to meet their future liabilities, so they too may feel compelled to invest more aggressively.

Finally, I think there are two psychological reasons why individual investors aren't chasing the market higher.

One is the disposition effect. Investors, especially smaller, less sophisticated investors, tend to sell winning investments and hold on to losers. The PowerShares QQQ Trust, an exchange-traded fund for the NASDAQ 100 Index, demonstrated this during the dotcom bust. During 2001 and 2002, as the NASDAQ 100 plummeted, traders poured money into the ETF and its outstanding shares surged. In 2003, as the NASDAQ rebounded, traders steadily sold the ETF:

Another reason is that traumatic events can destroy investors' willingness to respond to incentives.

A few years ago, I read a biography of Aristotle Onassis, the famous shipowner. Onassis entered the shipping industry at the end of the Great Depression and became a major player after World War II. His early success was a result of two things: 1) he was able to borrow money to buy oil tankers on very favorable terms, and 2) the major oil companies were capital-constrained, so they had to offer advantageous terms when they chartered tankers.

Despite these propitious circumstances, few of Onassis' rival shipowners were willing to leverage up and buy more tankers. Why not? Because they were older than Onassis and had either gone broke during the Depression or nearly gone broke, and that experience had permanently scarred them. They knew that the post-WWII market was very favorable to tanker owners, but leverage had hurt them before, so they weren't willing to use it again.

While the past few decades are nothing like the Great Depression, I believe that many individual investors have experienced a similar psychological trauma.

The Japanese stock market peaked on the last day of 1989. It's dropped 50% in the 27 years since then, and at various times it was down more than 75%.

American stocks have performed better than Japanese stocks, but they've still experienced gut-wrenching volatility. Since 2000, the S&P 500 has fallen 50% twice. And many individual investors have locked in those declines by buying near the top and then panicking and selling near the bottom.

Any investor who's lost money over 27 years, or who's endured two 50% declines in order to earn a measly 4% annual return, will be tempted to swear off stocks for good. Central banks can give investors enormous incentives to touch the stove, but if they've already burned their fingers twice, even the best incentives won't convince them to touch it again.

Sunday, July 23, 2017

Five reasons not to buy Amazon

I think Amazon is a bad investment at today's price of $1025 per share, which is 157 times its estimated 2017 earnings, and I recommend that investors either avoid buying it or, if they already own the stock, sell it now.

To preempt likely criticism: yes, this is a superficial article, and no, I haven't done a thorough analysis of Amazon's subsidiaries or its expansion efforts. I believe the best arguments against owning Amazon are general and don't require a deep understanding of the company, especially with its stock trading at such a high valuation.

Here are five reasons not to buy Amazon stock.

1: Amazon faces intense competition
Over its life as a public company, Amazon has grown dramatically. From its start as an online bookseller, it's expanded rapidly into other retailing categories and eventually into non-retailing businesses, most notably Amazon Web Services.

The single biggest concern I have with Amazon is that it's now expanding into many “hot” areas with intense competition. Content and streaming media, cloud infrastructure, transportation and logistics, and grocery retailing are all priorities for Amazon. They're also priorities for many other deep-pocketed companies.

History shows us that companies with high asset growth underperform companies with low asset growth in the stock market. Simply put, higher investment leads to lower returns. The same dynamic holds for industries as a whole, as Marathon Asset Management describes with its capital cycle theory.

Jeff Bezos was far ahead of the curve when he realized that cloud computing would change IT and capitalized on that by launching Amazon Web Services. This foresight let him build a large, profitable business before tech rivals like Google and Microsoft could respond with their own offerings. But now, in my opinion, Amazon bulls are extrapolating that success to areas where Amazon won't have a first-mover advantage and the competition will be much fiercer, suppressing returns.

2: Acquisitions are fraught with risk
Last month, when Amazon announced that it would buy Whole Foods, investors reacted with enthusiasm. They generally felt that Amazon was making a good acquisition because its customer base overlaps with WF's customer base and because WF's grocery stores complement Amazon's non-grocery retailing business.

I'm less sanguine. While Amazon and WF have many of the same customers, they have very different ways of doing business. For instance, Amazon is obsessive about efficiency and reducing costs, while WF spends a lot of money (both capital and operating expenditures) to position itself as an up-market retailer. And acquisitions of complementary businesses fail far more often than one might expect. According to Billion Dollar Lessons by Carroll and Mui:

[Bain & Company's] five-year study of 1,850 companies concluded that most sustained profitable growth comes when a company pushes out the boundaries of its core business into an adjacent space. Unfortunately, the research also shows that adjacency moves usually fail. Of the companies Bain studied, 75 percent saw their moves into adjacent markets fail. Only 13 percent achieved what Bain called “even a modest level of sustained and profitable growth.” These companies grew earnings and revenues at least 5.5 percent a year (adjusted for inflation) and earned their cost of capital over ten years.

And Amazon is buying Whole Foods in a cash deal, which will require it to issue $14 billion of new debt, so the acquisition involves financial as well as operational risk.

3: Amazon's current earnings are minimal
As mentioned, Amazon trades at 157x estimated earnings for its current fiscal year. This is much higher than its competitors' earnings multiples: Google trades at 29x current estimates, Microsoft trades at 22x, and Wal-Mart trades at 17.5x.

Amazon's earnings are artificially low because the company constantly reinvests its cash flow in growth efforts, which require high current expenses. But even if Amazon pared back its expansion to boost earnings, it would still trade at a rich multiple.

And the strategy of constantly deferring earnings makes Amazon's stock risky for a couple of reasons. One, run-rate earnings are one of the basic metrics that investors use to value stocks. If a company's earnings are irrelevant, as Amazon's are, then investors will have difficulty valuing the company. And if valuing it is difficult, then the stock will tend to trade on investor sentiment, which is far more volatile.

Two, it makes Amazon vulnerable to rising interest rates. With real rates at historically low levels, the present value of Amazon's expected future earnings is relatively high. Conversely, if real rates increase, its future earnings will be worth less. I'm not arguing that a 1.5% rise in the ten-year rate will destroy Amazon, but I think that ZIRP has artificially boosted its stock price.

4: The stock's appreciation creates an unstable feedback loop
Amazon gives its employees a lot of stock compensation. I believe the high stock comp creates an unstable positive feedback loop: while the stock is rising, stock comp becomes more attractive to employees and potential employees. This allows Amazon to pay less compensation in cash, which boosts its cash flow, and the higher cash flow enables it to grow more quickly, which boosts its stock further, and so on.

If Amazon's stock tanks, this dynamic will likely reverse: stock comp will become less attractive, and Amazon may have to pay more compensation in cash, pressuring cash flow and growth and tanking the stock further.

5: Sentiment is extreme
From talking to other investors and reading financial commentaries, I feel that sentiment on Amazon is extremely, unsustainably positive. Some value investors have bought Amazon even though it's a world apart from traditional value stocks. Others can't bring themselves to buy the stock at 150x earnings but admire the company's business model and Bezos' skill as a corporate leader.

One manifestation of the extreme sentiment is that people have begun measuring all other retailers by how vulnerable they are to competition from Amazon. Will Amazon start selling auto parts and put Autozone out of business? Will Amazon start distributing industrial parts and disrupt Fastenal and W.W. Grainger? Et cetera.

Retail bankruptcies in the United States have surged over the past 18 months, and Amazon has recorded strong growth over the same period, so many people understandably associate the two with each other. But I think a closer look suggests that Amazon isn't on the verge of destroying physical retailers.

Best Buy was one of the earliest purported victims of Amazon's expansion. Five or six years ago, people talked about the “showroom effect,” the idea that people would visit Best Buy to look at electronics they were interested in buying and then go online and order them from Amazon at lower prices. But contrary to pessimistic predictions, Best Buy's earnings have slightly increased over the past five years and its stock is near an all-time high.

Many of the retailers that have gone out of business, or are on the verge of doing so, are victims of leveraged buyouts gone wrong: Claire, Gymboree, J. Crew, The Limited, Nine West, Payless, Rue21, True Religion, etc. Retailers often have volatile operating income and high implicit leverage in the form lease obligations, so they're not ideal LBO candidates.

And the United States has more retail space per person than nearly every other country in the world. Some of that is justified by our higher average income and lower population density versus other countries, but I don't think that's the entire explanation. The U.S. simply has more retail space than it needs, which has pressured retailers' profitability. And that isn't necessarily a good thing for Amazon: the glut of retail space may lower rent costs for the surviving physical retailers.

In 2003, Fast Company published an article called The Wal-Mart You Don't Know (hat tip to Petrichor Capital). It portrayed Wal-Mart as an unstoppable predator that used its market power to squeeze its suppliers and competitors. Today Wal-Mart is seen as a has-been, while Amazon is cast as the unstoppable predator. Wal-Mart's stock was flat for many years after the article. I expect Amazon's stock to be a similar or worse disappointment going forward.

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-known 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 100 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.