My full notes and analysis on the Wall Street Journal from the past week: February 20-26, 2017 (Week 8). Please Enjoy.
Donald Trump: Pre-Suasion genius?
Is Donald Trump a Pre-Suasion genius? He is constantly criticized for being too vague about the details of his plans and chronically leaving people in a state of uncertainty. But that might just be the key to his success.
Stock markets typically reject uncertainty as a negative force. But in the case of President Trump, markets have embraced a sort of “positive uncertainty”. In his book Pre-Suasion, Robert Cialdini provides a compelling insight which may explain Trump’s strong positive influence on the stock market:
“During the experiment, the men who kept popping up in the women’s minds were those whose ratings hadn’t been revealed, confirming the researchers’ view that when an important outcome is unknown to people, “they can hardly think of anything else.” And because we know, regular attention to something makes it seem more worthy of attention, the women’s repeated refocusing on (the guys whose ratings remained unknown to the women) made them appear the most attractive.” – Robert Cialdini
Now let’s look at an excerpt from an article the other week titled “Federal Reserves Eye Aggressive Rate Increases.” (link)
“President Donald Trump’s plans for tax cuts, new spending and deregulation have buoyed market hopes of faster economic growth and higher corporate profits. But Fed officials at the meeting underscored their uncertainty about the details and effects of the potential policy changes, according to the minutes.”
“A few policy makers also worried that investors betting on tax cuts “which might not materialize” had pushed up equity prices too much.”
Post-Mortem: Glencore and Copper (link)
Copper prices surged more than 30% in the last year and shares in Glencore have more than tripled in the past 12 months. The two biggest drivers in copper prices over this time-period were:
1) China Stimulus: “The metal’s resurgence partially has been driven by a government economic stimulus program in China, where over 40% of the world’s copper is consumed.”
2) Labor Disputes: There have also been “snags at two of the world’s largest copper mines-labor problems at Chile’s Minera Escondida, and a permit dispute with the Indonesian government for Freeport-McMorRan Inc.’s Grasberg mine.”
So I’m curious…how many investors in Glencore identified “China Stimulus” and “Labor Disputes” as the main parts of their investment thesis? My guess is very few.
Charlie Munger once mused about The Kellogg Company that there’s nothing keeping cereal producers from going crazy over market share and tearing each other apart. (link) So when investing in an industry, you have to seriously consider; What force is maintaining rational economic decision-making in this industry?
The CEO of Glencore appeared to be surprised and upset when his competitors weren’t acting rational in the wake of declining commodity prices.
“(Glencore) CEO has long criticized his competitors for ramping up supply in the face of falling prices.” (link)
Such a reaction seems to indicate a lack of understanding of human psychology and the forces that drive rational economic behavior. After all, there are many reasons management would ramp up production in the face of declining prices. Here are four such reasons:
1) Incentive-caused biases linked to executive compensation or job security.
2) Prisoner’s dilemma and the Fear of Missing Out. Which explains why two rational individuals might not cooperate, even when doing so is in their best interest.
3) Social Proof. You look around and no one is cutting production, so this must be the right thing to do.
4) A genuine economic desire to survive. i.e. They keep producing at a loss in order to cover massive fixed costs.
Expanding upon the first point of Incentive-caused bias, management may have a personal economic incentive to manage earnings based on compensation packages. I like to think of this behavior as “Histogram Management.”
When commodity prices are declining, the easiest way for a mining company to show stable and growing profits is to rapidly increase sales in the wake of declining margins. This strategy of channel stuffing may provide stable earnings figures in the short-term, but it will exacerbate the problem for the entire industry over the long-term.
(Image via Latticework Investing)
1) Management often won’t behave in economically rational ways. Therefore, watch out for industries which allow for competition to intensify to the point of mutually ensured destruction.
2) Poorly designed executive compensation can make or break a company/industry.
In other words, don’t give them the rope with which to hang you.
Car Sales Eating into Macy’s Business?
Macy’s CEO said that record U.S. car sales indicate consumers have spent a bigger portion of their budget on bit-ticket items lately.
“At some point in time you’ve got to believe that everybody’s going to have a brand-new car,”…”There’s dollars that are going to be freed up for other categories of spending.” (link)
It makes sense too. Car purchases are highly interest rate sensitive. A majority of new cars are purchased with debt. Today the APR on an auto-loan starts at 3.12%. Meanwhile the APR on a Macy’s credit card is 24.5%. It’s no wonder that sales of goods that can be bought with debt have done well, while cash-based retailers have struggled.
(Image via Interest.com)
1) Home sales booming on historically low inventory (link)
January home sales reach highest level since February 2007, on the back of the lowest inventory levels on record (circa 1999).
“Home sales rose in January to the highest level since February 2007, a sign that last year’s momentum extended into 2017 despite a limited supply of properties for sale and rising prices.”
“Inventory rose 2.4% at the end of January from the end of December, when supply hit the lowest level since the Realtors association began tracking all types of supply in 1999.
2) Banks Retreat from Apartment Market (link)
Apartment supplies are growing rapidly, as a result, loans are getting more expensive and harder to come by, and rent growth is slowing.
“Swelling supplies of apartment units are prompting big banks to pull back from new projects, forcing developers to scramble for capital.”
“I haven’t seen anything this seismically different since 2008, when credit dried up.”
“fresh supply is beginning to overwhelm demand. More than 378,000 new apartments are expected to be completed in 2017, a 30-year high,”
“Commercial mortgage brokers said they are seeing and uptick in mezzanine loans…(and) a rise in preferred equity, which also come with higher payments than bank loans…”
“Other developers are turning to smaller regional banks, such as Bank of the Ozarks, which can command higher rates,”
3) Corporate Bonds: (link)
All around the world, corporate debt has proved a popular investment class so far this year…
Asia: “Nowhere is the trend more surprising than in Asia, where money has kept flowing into even the riskiest debt. The extra yield, or spread, investors demand for holding both investment-grade and high-yield Asian corporate debt versus risk-free U.S. Treasuries has narrowed since the U.S. election last November and is heading towards its tightest levels since 2008,”
U.S.: “U.S. corporate-bond spreads are at their tightest in two years.”
Europe: “In Europe, investors also have continued to pile into corporate credit in countries like Germany and France, despite uncertainty created by key elections…”
Areas where I see potential problems with corporate debt demand:
1) Naive Extrapolation of past default rates in Asia: “The default rate on high-yield corporate bonds was lower in Asia than in the U.S. last year at 1% versus 3.6%.”
2) “Risk on”: The voracious search for higher yields: “With interest rates globally still low by historical standards, cash-rich investors are on the lookout for higher-yielding assets. Total household wealth is growing more rapidly in Asia than elsewhere globally, up 4.5% in 2016 to $80 trillion,”
4) China developments
Two fascinating highlights on China:
1) “Of the more than 11,000 public-private partnerships that China has announced since 2014-inwhich companies finance, build and manage commercially viable state ventures-88% remain in preliminary stages and none are complete,” (link)
2) “Since coming to power in late 2012, Mr Xi has eroded the consensus-driven, collective-leadership model of his recent predecessors, taking personal charge of the military, the economy and most other levers of power.” (link)
5) Equity Markets
Two fascinating highlights on China:
1) “The declines paused a rally that has sent the index to 19 fresh highs in 2017-its most records in a year since 1999,” (link)
2) “Companies in the S&P 500 traded at about 22 times their past 12 months of earnings as of Wednesday, above their 10-year average of 15.8,”
3) “The S&P 500 has a forward price/earnings ratio of 17.6, the highest multiple since 2004 and above the averages of the past five, 10, 15 and 20 years.“(link)
Organic Farming: The high labor cost problem
U.S. farmers are quite good at conventional farming where emphasis is placed on efficiency. But consumer demand has been shifting towards organic food, which is less efficient to farm, and requires higher labor costs.
(Data source: UC Davis)
Naturally countries with cheap labor will have a competitive advantage on the U.S. Consequently, U.S. farmers have been feeling the pressure from international organic farmers.
“Organic grain is flooding into the U.S., depressing prices and drawing complaints from domestic organic farmers…” (link)
Specifically, the article talks about pressure from Turkish farmers.
“Turkey vaulted ahead to become by far the biggest supplier of organic corn and soybeans to the U.S. last year…(they) shipped to the U.S. 400,000 metric tons of organic corn, nearly quadrupling its prior-year total, while soybean shipments climbed by more than eight times,”
It’s beneficial to dwell on Turkey for a moment because Turkish farming data helps highlight the competitive challenges that U.S. organic farmers face. Firstly, Turkey’s minimum wage is $6,000/year giving them a competitive advantage in labor-intensive crop production. Secondly, the barriers to entry into organic farming are nearly non-existent. From 2002 to 2014 Turkey’s Organic Farming area increased at an annual growth rate of 22.56%.
And from 2005 to 2012, organic production went from 421,934 tons to 1,750,127 tons. (link)
(Data Source: USDA)
It would seem that the shift to organic farming is akin to switching from industrial production lines to hand craftsmanship. The countries with the cheapest labor would naturally have the upper hand.
Note: Additional factors which have added to the pain for U.S. organic farmers include a strong U.S. dollar, and accusations that international organic farmers face weaker regulatory oversight.
Activist Defense Strategy?
Management can sometimes react poorly to unwanted activist investors, leading them to make poor economic/ethical decisions. The following case got me thinking about the possibility that management may revert to unscrupulous methods to increase revenue at a poorly performing unit in order to save it from activist pressures.
ABB Hit by Fraud in South Korea (lInk): “The disclosure (of stolen funds) adds to the pressure on CEO Ulrich Spiesshofer as he tries to fend off Swedish activist shareholder Cevian Capital. ABB in recent weeks announced a string of large orders at its power-grid unit, including a $640 million project to deliver an electricity-transmission link in India, but Cevian has been urging ABB to sell the unit.
From the management’s perspective, it would be easier to defeat activist shareholders if the under-performing unit started “out-performing”. Incentives of this kind may increase the likelihood of unethical revenue enhancement tactics like
- Channel stuffing or
- Signing sweetheart contracts that are overly generous to clients.
Both of these tactics would make the unit appear more successful just long enough to win over shareholder support and stave off activist shareholders.
I’m not saying that ABB is doing this, but from a standpoint of “incentive-caused bias”, it’s more apt to happen. I’d like to see a study on this topic.
Don’t try to “out-Bezos Bezos”
“We’re not going to out-Bezos Bezos,” Buffett said, in response to a question about the effect of online retail on traditional retailers.
It feels like a lot of retailers are trying to out-Bezos Bezos these days.
Wal-Mart: “The retail behemoth is investing billions to raise U.S. store worker wages, lower prices and expand e-commerce sales to better compete with Amazon.com Inc.” (link)
Target: “Target’s CEO vowed to invest billions of dollars to lower prices and remodel hundreds of stores, an admission that the retailer’s focus on trendy merchandise wasn’t enough to attract shoppers.” (link)
Charlie Munger: Slime Pricing Theory
Great example of pricing theory under pavlovian association and information inefficiencies.
Knead Slime? These Business Girls Can Fix you Up (link)
“Just now, she is puzzling over price theory. She asks 50 cents an ounce-a generous handful-but some friends charge more than twice that. ‘They’re getting more sales and I’m not sure why,’ says the seventh-grader in Issaquah, Wash. ‘My slime is the same quality'”
Charlie Munger: Bias from pavlovian association
“In many cases when you raise the price of the alternative products, it’ll get a larger market share than it would when you make it lower than your competitor’s product. That’s because the bell, a Pavlovian bell — I mean ordinarily there’s a correlation between price and value — then you have an information inefficiency. And so when you raise the price, the sales go up relative to your competitor. That happens again and again and again. It’s a pure Pavlovian phenomenon.” (link)
Social Change becomes Economically Viable
Corporations are rarely agents for social change…even if they pretend like they are. Rather they’re economic agents who weigh supply and demand issues carefully. Demand for a socially beneficial product or service usually needs to hit critical mass (aka “The Tipping Point“) before companies “make that change“. Here are some social changes which have reached critical mass and have become economically viable.
1) Large increases in organic farming (link)
2) Coca-Cola reducing its sugar footprint (link)
3) Tyson eliminating antibiotics (link)
Charlie Munger: The prognosticator of Brazilian graft
I read this article on Brazilian graft and I couldn’t help but be reminded of a talk Charlie Munger gave back in 2003. The scenario he gave for bribing a purchasing agent is almost identical to the problems which were uncovered in Brazil 12 years later.
“Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?…Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent?” (link)
Now here’s what happened in Brazil…
“As part of Operation Car Wash, Brazilian prosecutors have accused executives from Petrobras, the state-run oil company, and some of the nation’s largest construction firms of colluding for more than a decade to inflate the price of contracts, kicking back a portion of the ill-gotten gains to lawmakers and other political officials.”(link)
Caution: A.I. will be programmed to exploit your psychological biases
Watch out for a future where Artificial Intelligence is programmed to exploit your psychological biases better than any human can. Charlie Munger warns heavily about this kind of psychology manipulation:
“Now if the human mind, on a subconscious level, can be manipulated that way and you don’t know it, I always use the phrase, “You’re like a one-legged man in an ass-kicking contest.” I mean you are really giving a lot of quarter to the external world that you can’t afford to give.” (link)
It has already started on a small scale:
“Stanford University found a male computerized voice was perceived to be a better teacher of computers, while a female one was preferred for guidance on love and relationships.” (link)
“There’s also the potential subconscious influence. Are we more likely to buy Alexa’s Valentine’s Day gift suggestions if they’re delivered by a female voice? Will a male voice convince us to spring for an expensive leaf blower?”
Teens Use Video Chat to Hang Out (link)
Fascinating insights into teen smartphone use:
“73% of teens have access to a smartphone…Those teens are checking their phones on average more than 80 times a day,”
“Packed schedules, helicopter parenting, and the decline of walkable neighborhoods…The net effect is that teens are spending more time indoors, and les active, than ever.”
“Young people today are sedentary for more than 10 hours a day,”
“Gracie says she’ll turn off the TV and talk to friends if they turn up on Houseparty ‘because that’s just better.’
“who wouldn’t want to be able to check in with their best friends whenever they felt like it?
Quote of the week:
“There were no negative tweets, so that’s a good sign.” – Portfolio Manager in response to Bayer’s CEO meeting with Mr. Trump. (link)