My full notes and analysis on the Wall Street Journal from the past week: March 13-19, 2017 (Week 11). Please Enjoy.
The New Obsession: Corporate Cost Cutting
Wall Street has become obsessed with cost cutting. And when Wall Street becomes obsessed with a metric of success you can bet that they’ll take it too far.
It seems pretty clear that today’s CEOs are being measured more and more on their ability to cut costs. Articles about corporate cost cutting appear to dominate the WSJ these days. Given the focus on cost cutting, it’s not a coincidence that profit margins have soared since the financial crisis.
(Chart Via Goldman Sachs link)
While cost cutting can lead to more efficient operations, excessive emphasis on cost cutting will almost certainly lead to problems. CEOs will attempt to game the system, and cost cutting is highly gameable.
It’s easy to boost short-term profit margins and cash flow by cutting costs which are necessary, but whose harmful side-effects will not be noticed for years. For example, a CEO may;
- Neglect proper maintenance of assets.
- Reduce R&D and marketing expenses.
- Cut staff to the point that your service suffers.
- Acquire assets which you formerly leased and then depreciate them at an exceptionally slow rate.
- Become excessively short-term oriented and forego long-term investments.
Adding to an unsustainable profit margin trend, a tight labor market likely means that, as the workers gain negotiating power, current profit margins will decline.
Between unsustainable cost cutting endeavors, and a tightening labor market, corporate profits are likely to decline in the coming years. This means that the market is actually more expensive than it currently appears. The S&P 500 is trading at a trailing P/E of 24.52, and an estimated forward P/E of 18.27, while the DJIA trades at 21.01 and 17.72 respectively. (link) But after factoring in negative headwinds on profit margins, the market is likely trading at a forward “Price/Sustainable Earnings” in excess of 20x.
Here are some of the article which mentioned cost cutting:
- U.S. Army: Quote on the U.S. army’s decision to cut Burger King abroad: “We went a little too far on some of the luxuries,” (link)
- Valeant: Ackman then bought a stake in Valeant itself in early 2015, a bet on Mr. Pearson’s ability to buy up companies and squeeze profit out of them. The stock kept rising, boosting his portfolio broadly. (link)
- Fiat: “Mr. Marchionne has advocated for mergers in the car industry as a way for companies to share their fixed costs. In 2015 he began openly courting General Motors Co., which rebuffed him multiple times.”
- Hudson’s Bay Co.: “Hudson’s Bay Co., which owns Saks along with Lord & Taylor, has been looking to take over another U.S. rival to gain scale and cut costs.”
- CSX & Hunter Harrison: ” An executive familiar with his methods calls him a “savant” when it comes to spotting inefficiency.”
Standard Causes of Human Misjudgment: Examples
Charlie Munger likes to say he’s a collector of “inanities” (i.e. Stupidities”). Here’s a collection of inanities reported by the WSJ.
Consistency and Commitment Bias:
“Mr. Ackman once predicted Valeant would be the next Berkshire Hathaway Inc., saying its shares could hit $330. The stock closed Monday at $12.11.”
Charlie Munger on this kind of approach:
“When you pound out an idea as a good idea, you’re pounding it in! So by asking people for their best ideas, they were getting the stuff that people had most pounded in so they’d believe. So of course it didn’t work.” – Charlie Munger
Boston & Citco
The people of Boston identify so strongly with a corporate advertisement billboard that they want to preserve it as an official landmark. Deep down at the heart of it, it’s really crazy.
“For Boston sports fans, the luminescent Citgo sign visible above Fenway Park’s left-field wall is already a hallowed icon. They are pushing the city to add protection for the 60-foot-by-60-foot sign by making it an official landmark, saying it is an internationally recognized symbol, a target for Red Sox sluggers and an inspiring unofficial milepost for runners chugging to the Boston Marathon finsih line.”
“Boston, the Red Sox, Fenway, the Boston Marathon,” said Nicholas MacDonald, a 34-year-old Massachusetts native and concierge at a local hotel, describing what the sign means to him.
“…the Citgo name- has been dominating the neighborhood’s skyline for more than 50 years.”
“Citgo tried to remove the sign in the early 1980s but changed course amid an outcry from Bostonians. There was also a failed attempt at the time to turn it into a city landmark.”
Liking Tendency and Shared Identify:
1) Liking Tendency
“Mr. Duarte…was an admirer of the late Spanish dictator Francisco Franco, both for Mr. Franco’s ‘strength and energy’ and because, like himself, Mr. Franco had a high-pitched voice.” (link)
2) Shared Identify
Former L.A. County Sheriff was “found guilty Wednesday of obstructing a federal investigation into violent abuses by his jail guards.”…”The probe uncovered various crimes related to the local jail system including beating inmates.” (link)
General Limitations of the Mind:
When a risk is hard to understand, it will seem less likely to occur. This is true in investing as it is in medical disclosures.
Stem-Cell Clinic’s Treatments Left Three Patients Blind, Doctors Say: “The patients involved did not understand the risk they were taking by going to this clinic,” (link)
“Many experiments have shown that the harder a risk is to understand, the less it will seem likely to occur.” (link)
Fast Solutions to Big Problems = Big Money
We pay a big premium for fast solutions to big problems. This is true for corporations, governments, and consumers. Here are two examples from this past week:
1) Warren Buffett & AIG
Warren Buffett met with the CEO of AIG earlier this year, and ultimately agreed to a $10 billion insurance contract with AIG. This insurance deal was largely based on the need for a fast solution to a big problem (i.e. Activist Investors)
“The AIG directors feared disruption if they didn’t quickly address concerns from Mr. Icahn and some directors about the CEO’s ability to complete the turnaround, people familiar with the matter said.”
2) Tesla’s battery solution for Australian government
“Very impressed. Govt is clearly committed to a smart, quick solution,” – Elon Musk (link)
3) Intel & Qualcomm acquisitions
“Intel Corp. agreed to buy Israeli car-camera pioneer Mobileye NV for $15.3 billion, one of the chip maker’s biggest acquisitions ever and the latest bet on Silicon Valley’s vision of cars as turbocharged computers on wheels.” (link):
” Intel is joining a race to create autonomous vehicles that has accelerated recently as unconventional auto companies have jumped in, sparking bidding wars for companies that specialize in self-driving gear or software.”
“Qualcomm Inc. bought automotive chip supplier NXP Semiconductors NV for $39 billion.”
Investment Lessons: The need for fast solutions to big problems creates fantastic profit opportunities.
1) Look for companies which may help companies, governments, or consumers, address the “big problem + fast solution” market.
2) Be patient and capitalize on forced selling.
Budget Doctors. Just as good as High Spending Doctors? (link)
Fascinating article detailing how doctors who spend less on their clients have the same results as high spending doctors. Major implication: “The results suggest high-spending doctors could do less without harming patients, the researchers wrote.”
“U.S. Medicare patients whose doctors spent more on tests, scans and consultations were as likely to die within a month of leaving the hospital as patients with more parsimonious physicians, new research shows.”
“Patients of high-spending doctors were also as likely to return to the hospital within a month, according to the results, published by JAMA Internal Medicine.”
Buyout Firm Acquires Own Assets
Private equity firm Novel who is raising funds to buy $800 million of its own assets. Novel wants to extend its holding period of its assets beyond its lock-up period. This behavior is a dangerous trend. Here’s what’s happening:
1) Heeding to Competitive Pressure: “Investindustrial, founded by Italian deal maker Andrea Bonomi, has decided on this course of action as it responds to greater competition for assets from institutions such as sovereign-wealth funds, which don’t have restrictions on how long they can own companies. The competition is pressuring buyout firms to devise new ways to own companies.” (link)
2) Subjecting Themselves to Naive Extrapolation: “Investindustrial’s move to hold on to PortAventura park for longer comes as fierce competition is pushing up prices for companies, meaning it increasingly makes more sense to hold on to assets than to sell.”
I’ve often thought that the historical success of private equity owes much of its success to the use of lock-up periods, and to eliminate them is very dangerous. That’s because the lock-up periods help prevent two psychological biases which generally destroy investment returns.
First, it prevents buy high and sell low behavior. Being in a lock-up period, clients must ride the ups and downs with forced equanimity.
Second, lock-up periods prevent ‘naive extrapolation’. Naive extrapolation happens when investors unrealistically assume that favorable investment results will continue indefinitely. Lock-up periods help PE firms avoid this problem because they must exit their investment before a certain date. As a result, private equity groups look forward to favorable market conditions as opportunities to sell, and not as justifications to hold their position even longer. (i.e. They’re forced to sell their position when it becomes over-priced. A feat which is easier said than done.)
By eliminating lock-up period as Novel is doing, they are no longer are exploiting naive extrapolation, but instead have become the victims!
Poor Temperament + ‘Risky Assets’ = Trouble
Low interest rate policies by global central banks have pushed many individuals into stocks and other risky assets. This may prove ruinous for many investors who don’t have the psychological temperament to handle the wide swings in asset prices that occur during a bear market.
Here’s one such example: (link)
“His five children, including current White House counselor and chief strategist Steve Bannon, had often joked growing up that their devout father, a product of the Great Depression, would sooner leave the Catholic Church than sell those shares. The stock symbolized his deep trust in the company and had doubled as life insurance for his children.
“As he toggled between TV stations, financial analysts warned of economic collapse and politicians in Washington seemed to mirror his own confusion. So he did the unthinkable. He sold.”
Marty Bannon, now 95 years old, still regrets the decision and seethes over Washington’s response to the economic crisis”
- “However, retail sales clocked the slowest increase in 11 years, with a 9.5% rise in the two-month period,”
- “Car sales surged 10.1% in 2016, as tax cuts for car buyers aimed at stimulating the economy encouraged consumers to move forward their purchases, economists said. The tax cuts have since been partially rolled back: auto sales fell 1% year over year in the first two months of 2017, data showed. “They’ve overdrawn part of consumers’ purchasing power,”
- “Investors pulled a net $342.4 billion from U.S.-backed actively managed funds last year, while pouring a record $505.6 billion into U.S. passively managed funds,”
- “Addiction to painkillers and other opioids such as heroin has caused U.S. overdose deaths to reach all-time highs.”