Tag: The Wall Street Journal

Wall Street Recap: Part 2

/ Richard Lewis / 2 Comments

Part 2 of my full notes and analysis from the past two weeks: September 3-16, 2017.  Periodicals covered in this Wall Street Recap include the WSJ, FT, NYT, and LA Times.

The “Burned Cat” Phenomenon

Investors who get burned by an asset bubble often develop a learned apprehension towards that asset class, regardless of its future economics or valuation.  In other words, they go about acting like Mark Twain’s cat who, after sitting on a hot stove lid, never sat on a hot or cold stove lid ever again. (link)

Learned apprehension can lead to depressed asset prices as well as severe under-investment in new supply.

1) Depressed asset prices

Investors may develop an irrational resistance towards an asset which has burned them before.  Making them reluctant to invest, even at very attractive prices.  Example:

Elon Musk

Elon Musk experienced this “Burned Cat” phenomenon while working for a bank early in his career.  He found Brazilian debt trading for 25 cents on the dollar, which was guaranteed by the U.S. Treasury for 50 cents on the dollar.  He presented this investment idea to the Bank’s CEO who promptly rejected it saying, “the bank had been burned on Brazilian and Argentinean debt before and didn’t want to mess with it again.” (link)  Taken aback, Elon tried to explain that you couldn’t lose unless you thought the U.S. Treasury was going to default, making it an effective “no-brainer”.  The CEO still declined.

2) Severe under investment in new supply

During an asset bubble, investors eagerly build out new supply, over-extend themselves, and set the ground for their own demise.  Following the bust, investors may become hesitant to develop new supply, even when favorable economic tailwinds present themselves.  As a result, an industry that was once defined by chronic over-supply, can shift into one defined by chronic under-supply.  Examples:

Ethiopian Famine

This feast or famine industry cycle contributed to Ethiopia’s 1983-1985  famine.  Having been burned by  a bountiful harvest and low prices the year before, “Ethiopian farmers produced less grain and more cash crops or livestock, reducing food production in the following year.” (link)

Ireland Housing

Ireland’s real estate market is experiencing the after-effects of the “Burned Cat” phenomenon.  Leading up to the financial crisis, Ireland produced one of the most severe housing bubbles in the world.  The subsequent bust resulted in years of under-investment in new housing.  The country has since developed a chronic shortage of new homes and property prices are rapidly rising.

As the Financial Times described: (link)

“With Ireland facing a chronic shortage of homes and property prices again rising rapidly,”

“Builders are struggling to meet 10 years of pent-up demand for new homes, while rents are rising and Dublin faces a growing homelessness crisis.”

“Housebuilding, which declined to a trickle after the crash, has stepped up markedly yet acute strains remain.  Although private builders are projected to complete 18,000 homes this year, industry figures estimate 30,000 units will be required for years to come.”

“Figures this week showed annual property inflation on a national basis is advancing at 12.3 per cent.” 

Misjudgment underpinning the Burned Cat Phenomenon:

“Burned Cat” investments are influenced by a lollapalooza of human misjudgment, including:

  1. Extra-Vivid Evidence: Investors who have been burned by an investment won’t soon forget.
  2. Pavlovian Association: Through negative reinforcement, investors learn to reflexively avoid an asset class.
  3. Over-Influence from Authority: News coverage of a “burned cat” investment is likely to be prominent, negative, and pessimistic.
  4. Social Proof: No one else is investing in it, so that reinforces the notion that it’s the right thing to do.
  5. Bias from the non-mathematical nature of the human brain: Investors tend to naively extrapolate past returns which contributes to extreme valuations during bubbles and busts.

Investment Lesson: Actively look for assets that have burned investors.  They may present excellent opportunities due to;

  1. The market’s unwillingness to invest in the asset, even when favorable economics and valuations exist.
  2. Severe under-investment in new supply, which sets the stage for future supply shortages.  (Pay special attention to areas where supply cannot ramp up quickly.)

Standard Causes of Human Misjudgment

Social Proof: Rationalized/Normalized Terrible Behavior

At Home Among the Giants (link)

Wllie McCovey: “I tried working as a bus boy in a whites-only restaurant, but I quit after a week.  All the things that make you cringe was normal talk then.  You took it or you walked away.”

“The five most dangerous words in business are: ‘Everybody else is doing it’.” – Warren Buffett

Social Proof: Fear of Missing out

Leveraged Loans too Popular (link)

 “Some companies that reprice loans have cut debt-to-earnings multiples. But for many, nothing has changed other than the strength of investor demand for debt.“

“When demand is strong, any investor that declines the lower yield risks seeing another buyer take their place, and many are battling to keep their money invested.”

Deprival Super-Reaction Syndrome

That Airline Seat You Paid for Isn’t Yours (link)

“Political commentator Ann Coulter…erupted in a Twitter tirade earlier in July after Delta moved her from a preferred aisle seat to a window seat in the same extra-legroom row.”

 “…passengers think they can buy the rights to a specific seat…Airlines say that legally, you don’t.”

Contrast Caused Distortion

Passive Migration: Denver Wins Big as Financial Firms Relocate to Cut Costs (link)

 “If you’re talking to someone who’s been in Denver, they’ll say it’s getting unaffordable, but if you’re coming from San Francisco, the reverse sticker-shock is wonderful,” said Ms. Droller. 

“And while Denver home prices reached a record in June, they are still far below San Francisco.”

Incentive Caused Bias 

Wall Street Needs You to Borrow Against Your Stock (link)

“Morgan Stanley’s finance chief said, ‘that the bank expects more clients to take out loans in the months ahead. ‘That’s been a real key driver of our wealth business.‘”

“The Massachusetts securities watchdog last year accused Morgan Stanley of developing a sales program that encouraged brokers to pitch these loans regardless of whether clients needed them.“

“Several Merrill Lynch brokers said they have asked long-standing clients to open a securities-backed line of credit to help them hit bonus hurdles,”

“The guy tells you what is good for him…So you’re getting your advice in this world from your paid advisor with this huge load of ghastly bias.” – Charlie Munger

Lesson: Watch out for rapidly growing products and services on Wall Street.  They likely are associated with massive incentive-caused bias.

Consistency & Commitment Tendency

Wall Street Needs You to Borrow Against Your Stock (link)

Merrill Lynch brokers asked long-standing client to open lines of credit “assuring that clients wouldn’t need to use it or pay any fees for opening it.”

“Brokerage executives have said the longer a client has one of these loans tied to their account, the more likely they are to use it.”

“People think if they have committed to it, it has to be good.” – Charlie Munger

Lesson: Beware of commitments, even seemingly harmless ones.

Lollapalooza Effect: Examples

“I would say the one thing that causes the most trouble is when you combine a bunch of these (causes of misjudgment) together, you get this lollapalooza effect.” – Charlie Munger

LIBOR: Incentive Caused Bias, Pavlovian Association, Social Proof, Envy/Jealousy

The LIBOR was a terribly flawed benchmark.  It was easily to manipulate and bankers were highly rewarded for doing so.  Everyone around them was doing it, and they were all getting rich.  Hence, “studies have estimated that hundreds of trillions of dollars of financial contracts around the world were created based on the benchmark.

Libor: A Eulogy for the World’s Most Important Number (link)

“It turned out that banks were skilled at getting Libor to move in favorable directions.  After all, it was their employees who were guesstimating their borrowing costs, so it was simple enough to skew those figures in helpful directions.”

“But government investigations soon showed not only that manipulation was wide-spread and easy to pull off, but also that government officials and central bankers had known for years about Libor’s vulnerabilities but failed to act.”

“If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you’d be causing a lot of bad behavior, and the bad behavior would spread.” – Charlie Munger

Fire Ants in Japan: Stress-Induced Mental Changes, Social Proof, Extra-Vivid Evidence

The sudden stress from the arrival of fire ants in Japan, along with extra-vivid coverage from the media prompted faster and more extreme reactions.  Furthermore, Social-Proof amplified the power of this reaction.

Evacuate the Sandbox! Japan Is Freaking Out About Fire Ants (link)

“The mild panic here is partly due to sensationalism in the mass media, with some reports falsely depicting fire ants as murderous,” said Mr. Hashimoto.

“Better safe than sorry, said one wrestler.”

“He drew a parallel in Japan’s experience with how U.S. fire ant infestations in the 1950s were caught up in fear about communism.”

“Shares of pesticide makers have surged on the Tokyo Stock Exchange, and one manufacturer started selling ponchos made from industrial-strength material that allegedly protects the wearer from fire ants.”

“He added, ‘It is necessary for everyone in the nation to recognize correctly the characteristics of fire ants and address the matter calmly.'”

“One consequence of this tendency is that extra vivid evidence, being so memorable and thus more available in cognition, should often consciously be underweighed while less vivid evidence should be overweighed.” – Charlie Munger

Wall Street Journal Recap: March 13-19, 2017

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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

Pavlovian Association:

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”

China

  • “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,”

Market Developments

  • “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.”

Wall Street Journal Recap: March 6-12, 2017

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My full notes and analysis on the Wall Street Journal from the past week: March 6-12, 2017 (Week 10).  Please Enjoy.

Central Banks & NDF Contracts: Have your cake and eat it too!

‘Shore up your currency, No money down!’  It sounds like a bad late night television ad.  It’s also what many central banks around the world have been doing very actively in recent years.

Traditionally central banks will buy and sell foreign currency to manage the strength of their currencies.  This process leads to large fluctuations in foreign exchange reserves. But it appears that many central banks have started to rely heavily upon Non-Deliverable Forward (NDF) contracts.  NDFs provide central bankers a way to both keep their foreign currency reserves and manage inflationary and deflationary pressure.  Additionally, NDFs suppress foreign exchange volatility, and even allow central banks to increase reserves.

But these benefits are largely illusory.  Foreign exchange volatility isn’t lower, rather NDFs have simply removed it from the central bank’s books.  In this way, NDFs are not much different than Credit Default Swaps used by banks before the financial crisis, or Special Purpose Vehicles used by Enron to manipulate its balance sheet.

You could say that NDF contracts have allowed Central Banks to have their cake and eat it too.  China, Mexico, and India are all indulging in this cake-eating-and-holding paradox.

At the moment, NDFs appear to be effective when used in stable markets, but during times of stress, the complexion of these derivatives will almost certainly change.  So the more the central banks rely on NDFs, the more pain will be felt in periods of turmoil.

P.S. I would love to find information regarding the size and growth of non-deliverable forward currency contracts (NDF).  But it’s hard to get.

China

Since the financial Crisis, The People’s Bank of China has significantly increased their reliance on NDF’s.

“The People’s Bank of China has been using derivatives to prop up the yuan without actually spending its stash of dollars.” (link)

“The derivatives, however, make the picture look rosier than it really is.”

“Derivative interventions are considered quite unorthodox despite having a long history. One of the pioneers was the Bank of France, which in 1927 famously resorted to buying sterling in forward markets because it wanted to quell inflows into the franc without having to issue more notes. It wasn’t very successful back then, and results have remained mixed ever since.”

Feb 17 2015: “the average daily trading volume across all NDF currency markets has grown from about $20 billion to $60 billion over last five years. The rise in activity in NDF markets is particularly noticeable for the rupee, the Brazilian real and the Chinese yuan. These economies are becoming increasingly important in the global trade.” (link)

Mexico: A Dollar-Hedgeing Program Is Started

“The Bank of Mexico launched a dollar-hedging program placing all $1 billion in forward contracts as it opens a new front in efforts to support the peso without draining foreign reserves.”…”The nondeliverable forwards are settled in pesos.” (link)

“The use of derivatives gives the central bank ammunition to support the peso without selling dollars from its foreign reserves, as it has done in recent years.”

India: Reserve Bank steps in to rein in runaway rupee

“Besides traditional dollar buying from the domestic spot market, there was a tweak in the intervention strategy, dealers said.” (link)

“State-owned banks made ‘sellbuy’ derivative deals, converting spot dollar buying transactions into forward deals, dealers said, deferring delivery of dollars through such forwards deals. Banks sell dollars they bought in the spot market and then they buy the same unit in the next leg as a forward transaction, keeping the net position at ‘buy’.”

“‘The approach is aimed at limiting rupee liquidity in the system,’  said the head currency dealer of a mid-size bank.”

ZTE Warning Label: Official Sponsor of North Korea

Last week, Chinese telecom company ZTE plead guilty to supplying North Korea and Iran with telecommunications equipment over a six year period.  They orchestrated an elaborate system to circumvent U.S. sanctions and supply these countries with U.S. technology.  For its actions, ZTE was fined $892 million. (link)

But I don’t think a fine is enough.  ZTE is the #4 maker of smart phones, by volume, in the U.S.  As a consumer products company, I think U.S. citizens should be warned that ZTE illegally circumvented U.S. policies and sponsored the governments of North Korea and Iran.

So I propose adhering a warning sticker to all of their consumer products.  Much like you’d find on a pack of cigarettes.  I imagine it would look something like this.

They couldn’t give those phones away.  And it would serve as a very high-profile warning to all other companies.

The Inhaler Checklist

When looking to avoid catastrophic mistakes, checklists have be proven to be extraordinarily effective.  Whether in hospitals, airplanes, or investing.  Another application: Inhalers.

“Studies have found that patients make at least one mistake as much as 70% to 90% of the time.  The result: only about 7% to 40% of drugs is delivered to the lungs.”

“Coordination was the biggest and most series error…Even half a second late in inhaling and you press the inhaler too soon you get only 20% of the medication.”

Problems:

  • Coordination: Holding breath at the proper moment
  • Forgetting to shake the inhaler.
  • Exhaling too quickly

Investment Lesson:

Use checklists:  They have the universally accepted benefit of helping us avoid catastrophic decisions or actions.

Trump’s stock market rally: It’s not how you start. It’s how you finish.

Interesting history on stock market performance over Presidential terms.  (link)

“Other presidents had misleading starts. Herbert Hoover presided over a nearly 44% total return in his first 10 months for the predecessor of the S&P 500.  But the index dropped 31% on an annualized basis during his entire four years in office.  Unsurprisingly he wasn’t re-elected.”

Barriers to Entry: Lobbying & Political Self-Interest

Lobbying & Political Self-Interest make it very challenging to enter or disrupt some industries.  When threatened by a new entrant, old corporate hegemons will use their vast lobbying resources to prevent upstart competitors from displacing them.

Meanwhile, self-interested politicians will be motivated to fight on behalf of the old hegemons who supply their state with massive employment and tax revenue.

Here are some examples from this past week.

Self-Driving Tech Companies vs. GM (link):

“After falling behind in self-driving cars, GM has unleashed its powerful lobbying team to cultivate relationships with statehouses. The largest U.S. vehicle maker by sales has a long history of backing legislation to preserve its interests, including a bill in Indiana last year that would stop electric-vehicle maker Tesla Inc. from operating its own stores there.”

Airbnb vs. The Hotel Industry (link):

“The hotel industry has been at the forefront of lobbying for stricter regulations on Airbnb that it says are needed to put the service on a level playing field with traditional hotels.”

Avoid “National Champions”

Avoid direct competition with companies which are national champions of socialist and communist countries.  Specifically in industries which sell commoditized products; i.e. China & Steel.  These companies will likely have a lower cost of capital than you and make your life a nightmare.

GM recently exited Europe with its sale of Opel.  Among the problems they faced in Europe was the existence of car companies labeled as “national champions” who received support from their respective governments.

Mary Barra, GM’s CEO, addressed these issues in a statement:

“Our overall philosophy is every country, every market segment has to earn its cost of capital, has to be contributing.” (link)

“Europe, which has always been cutthroat due to a glut of capacity and national interests in auto makers, became even more difficult from political, regulatory, and consumer-preference standpoints in recent years,”

Carlos Ghosn, Nisan’s CEO, talked about Renault being treated as a national champion.

” Mr. Ghosn, speaking in an interview Thursday, said a merger is off the table as long as French officials see Renault as a national champion, with interests that are separate from the Japanese partners. “Nissan has been very clear during discussions with the French state that they are not going further in terms of a merger, or anything else, with the French state as a shareholder of Renault.”” (link)

Market Developments

Multi-year Highs and Lows

There were lots of multi-year highs and lows occurring last week.

“The U.S. posted its biggest monthly trade deficit in nearly five years in January,”

“The downtown Miami market is expected to see the most new condos delivered this year since 2008, roughly 3,500 units in all,”…”at the peak, developers could finance up to 75% of the cost to build a project, not that is down to 50%.”  (link)

“This week marks the bull market‘s eight-year anniversary, the second-longest on record.  Since the March 2009 bottom, the S&P 500 has surged more than 300% including dividends.” (link

“65,500 metric tons of copper flowed into exchange-approved warehouses Monday and Tuesday, a surge of 33%, the biggest two-day rise in 20 years,” (link)

“The price-to-earnings ratio of the S&P 500 based on analyst forecasts for the next year is near 17.7, the highest since 2004,”

“There were a total of 279 insider buyers in January, the lowest number going back to 1988,” (link)

“Short positions across stocks, exchange traded funds and equity futures last week fell to near their lowest levels in 10 years,” (link)

The yield on the two-year note, closed at 1.329%.  That was the highest since June 2009.” (link)

“In 2017, with global equity funds posting record net inflows in the week ended March 1 based on data going back to 2000,” (link)

Effect of Proposed House Tax Plan

“Under the House (tax) plan, Goldman figures it would drop (corporate taxes) to 24%, boosting after-tax earnings by about 10%…The market currently trades at about 18 times analysts’ expected earnings for 2016,…Raise earnings by 10% and that price/earnings ratio slips to a more reasonable but still expensive 16.4.” (link)

Central Banks Ratchet Up Reserves (link)

“Central banks around the world are increasing foreign-currency reserves, highlighting the fragile underpinnings of the global economic recovery despite a bullish mood in financial markets.

“Two-thirds of the 30 biggest emerging markets increased reserves last year,”

“Switzerland’s holdings of foreign assets jumped last month at their fastest pace in more than two years,”

“In January, Russia added $13 billion to its $390.6 billion in reserves, its largest monthly increase in more than four years.“

“In Europe, big increases in reserves are often associated with periods of global stress….External reserves are a form of insurance for sovereigns against crisis and defaults,”

 China News

There were lots of fascinating news stories regarding China developments over the past week:

China’s Steel Cuts Aren’t as Deep as They Appear (link)

China cut steel capacity by 10.5% last year.  But it was practically meaningless as most of it was long-since idled.  Furthermore, despite the capacity reductions, steel production rose 1.2%.

“Chinese mills make half the world’s steel but depend on state subsidies and bailout mergers to survive.”

“From 2011 to 2015, global steel prices fell 70% as Chinese companies flooded the market with cheap steel.”

Beijing Tightens Grip on Internet Portals (link)

China’s theme for this year is “stability”.  That means cracking down on internet-based political commentaries.  Is this a signal of coming instability?

“Ending practices that skirt regulations fits with the ever tightening control the government has exerted on the internet since President Xi Jinping rose to power in late 2012.  Targeting outright political dissent has expanded to include critical commentaries.”

“Any company whose service could potentially trigger social unrest should brace itself for more regulation-or at least greater scrutiny, industry insiders say.”

Chinese Lenders Tap the Brakes (link)

How can an economy be so herky-jerky?  One month they have near record lending, the next they slam on the brakes, and so on.

“Chinese banks sharply scaled back lending last month, after a near-record tally in January, as Beijing tries to strike a balance between boosting economic growth and containing financial risks.”

U.S. TV Foray Ends for China’s Wanda (link):

There have been several Chinese deals halted suddenly since the Trump election.  Here’s another one.

“Dalian Wanda Group’s $1 billion deal to buy Dick Clark Productions Inc. is dead…Beijing’s scrutiny of overseas investments, stemming from fear that too much capital flight could weaken the yuan, also killed takeover talks between several Chinese companies and Metro-Goldwyn-Mayer Studios late last year.”

China Logs Rare Trade Gap (link)

“China recorded its first trade deficit in three years last month, driven by higher commodity prices, an unexpected drop in exports, and the effect of the Lunar New Year holiday.”

Beijing’s Numbers Are Difficult to Reconcile (link)

“Tuesday brought a surprise increase in foreign-exchange reserves.  Wednesday, it was an unexpected trade deficit – China’s first in three years – which made the rise in Beijing’s currency hoard even harder to account for.”

“A trade deficit ought to put additional pressure on the People’s Bank of China to support the yuan, by selling down its foreign-currency reserves-but the evidence shows the central bank spent less on defending the yuan last month than in the recent past.”

The Economic Costs of Ideology

Several articles address the economic costs of ideological polices.  I found it rather fascinating how economics and ideology interplay in shaping legislation.

  • Legislative Hearing Held on Bathroom Bill: “Major players in Texas’ business community have also argued the bill will hamper their ability to draw workers and investment.” (link)
  • Ivanka Trump’s Billionaire Landlord: The proposed mine is opposed by environmental groups and by Minnesota Gov. Mark Dayton, a Democrat. It is supported by Minnesota officials of both parties who cite potential job creation.  S. Rep. Rick Nolan, a Democrat who represents the area, in a news release attacked the lease decision as “anti-mining, anti-jobs“ and urged Mr. Trump’s administration to overturn a related move by Mr. Obama’s administration to place a 20-year moratorium on mining in the area.” (link)
  • Hawaii’s Lawsuit On Travel Order Set for a Hearing: “The state says the travel restrictions are a blow to tourism, to in-state employers who need foreign workers…” (link)

“Forecasting” Oil Prices

In January bullish oil bets hit a 10 year high.  Two months later U.S. inventory levels his a record and oil prices rapidly sunk.  This shows the difficulty of forecasting such things and the euphoria and panic that can grip market participants.

January 31, 2017: Bullish Oil Bets Climb to Record (link): ” Long positions exceeded shorts by such a degree that it’s the largest net bullish position in 10 years of data from the CFTC.”

March 9, 2017: Crude Logs Biggest Drop in Over a Year (link): “Oil prices suffered their biggest one-day plunge in more than a year after U.S. crude stockpiles hit record levels, raising concerns that even after recent production cuts, the world remains awash in oil.”…”US. inventory levels have risen for nine weeks in a row.  They hit a record of 528.4 million barrels last week as imports and U.S. production increased.”

March 10, 2017 (link): U.S. crude fell below $50 a barrel for the first time this year, in the biggest two-day sell-off since June.

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” – Warren Buffett

Quote of the Week:

“Borrowers were more likely to receive aid if they threatened to go to the media with their complaints, one former employee said.” (link)

Wall Street Journal Recap: February 20-26, 2017

/ Richard Lewis / Leave a comment

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.

“Histogram Management”

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)

Investment lessons:

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)

Market Developments:

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

  1. Channel stuffing or
  2. 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.

Charlie Munger:

“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)

Wall Street Journal Recap: January 30 – February 5, 2017

/ Richard Lewis / Leave a comment

My full notes and analysis on the Wall Street Journal from the past week: January 30-February 5, 2017 (Week 5).  Please Enjoy.

Donald Trump: “I love depreciation”

Trump on Depreciation

“I love depreciation,” he said in the second presidential debate last October. (link)

“Every other country lives on devaluation,…They play the devaluation market and we sit there like a bunch of dummies.”

“Mr. Trump suggested Tuesday that Japan and China are devaluing their currencies.”

“The U.S. dollar slid to its lowest level since November on Tuesday amid weak U.S. data and new indications that the Trump administration would prefer a weaker dollar.” (link)

Japan depreciation

“The Kyoto-based company (Nintendo) reported net profit of 64.7 billion yen, more than double the year-earlier level, a figure it said was boosted by the weak yen.” (link)

Mexico depreciation

“Further peso weakness could make the country even more competitive globally.”…”A weakening peso would again give them even more of a competitive edge” (link)

Banking Moral Hazard

Should we start worrying about moral hazard at banks again?  I’m beginning to think the answer is yes.  There’s just too much incentive for banks to game the system.  Take this for example:

“Banks must pass the Fed’s stress tests in order to boost dividends or buybacks to shareholders.” (link)

Here’s what makes that simple point very worrisome:

  1. Banks are being incentivized to game the system in order to boost dividends or buybacks.
  2. They are using the same consultants who helped them avoid Basel II capital requirements before the financial crisis.
  3. The stress test models offer false precision: “What models cannot measure is the chance that banks all act as a herd — creating financial panics.” (link)
  4. The Fed is considerably intertwined with the stress tests. Should anything go wrong, they will feel responsible for bank failures and ultimately bail them out again.

Focus on What You Can Control

I always love Amazon’s approach:

“There’s always a number of things that can impact customer spending, both positively and negatively during any quarter,” said CFO Brian Olsavsky on a conference call. “What we do, is continue to focus on the things we can directly control: for us that’s price, selection, customer experience. And on those dimensions we felt we made great progress.” (link)

Exxon: Agency Costs

Exxon is unbelievably good at limiting agency costs and aligning management with long-term shareholder interests.  Just check out these two examples:

Policy on Writedowns:

“Exxon hadn’t booked a decline in the value of its assets since at least 1990.  This is due in part to the company’s practice of being more conservative when initially recognizing the value of new oil and gas that it discovers,” (link)

“The company’s senior leaders wanted to avoid writedowns because in accounting terms, they have the effect of making the company’s investments appear more profitable,”

“We don’t do write-downs,” former Chief Executive Rex Tillerson told trade publication Energy Intelligence in 2015.  “We are not going to bail you out by writing it down. That is the message to our organization.”

Policy on Executive Stock Options:

“Half of the equity award may not be sold for 10 years from date of grant or until retirement, whichever is later, and the other half is restricted from sale for five years.” (link)

Very Low VIX = Very Low Returns

Historically speaking,

“stocks have done poorly in the year following very low VIX levels.  The S&P’s annual gain has been 2.7% after the 100 lowest readings and nearly 29% after the 100 highest readings.  The overall average was 8.8%.”

“A low VIX isn’t in and of itself worrisome, but the “calm before the storm” idea has some basis in history. Some of the lowest historical VIX readings preceded sharp, unexpected stock selloffs such as the 2008 financial crisis and the 1994 interest rate scare.”

Japan and the Weimar Republic

I couldn’t help but think that Japan’s monetary policy draws parallel’s to the Weimar Republic.

When the Weimar Republic went off the gold standard, there became no legal limit as to how many notes it could print.  And print they did.

Meanwhile, the BOJ wants to buck a global tide of rising rates, and have announced “it would buy an unlimited-number of five- and 10-year government bonds at prices that translate to a benchmark yield of around 0.110%.” And buy they did.  (link)

How long can the Rising Sun fight a Rising Tide of interest rates?

Ferrari: The Boundaries of Brand Dilution

It’s less than 2 years since Ferrari’s IPO, and the race to test the boundaries of brand dilution is on.

Historically Ferrari has established brand equity through exclusivity.  Just as recently as 2013, head of Ferrari, Luca di Montezemolo, announced plans to sell fewer cars in 2013 than the 7000 it delivered in 2012.

Luca stated, ‘this is a far-sighted decision to strengthen our brand equity, from what I learned from Enzo Ferrari… We must resist people who say the competition will benefit from us making fewer cars… When others penetrate our markets, we are happy to meet this challenge.’ (link)

In 2014, the company sold 7,255 cars.  That year, Luca resigned following tension with Sergio Marchionne.

By 2016, the number of cars shipped increased to 8,4000.  Sergio Marchionne believes he could boost production up to 10,000 cars. (link)

At the moment, Ferrari cannot sell more than 10,000 cars a year because of emission standards.  I suspect however that electric vehicles will ultimately be exempt from this number, giving Ferrari an open path to even more significant brand dilution.

Ralph Lauren: Brand Dilution

As Ferrari tests the boundaries of Brand Dilution, many fashion retailers, like Ralph Lauren, are desperately trying to recuperate brand equity after years of brand-destructive strategies.

”Ralph Lauren said it remains committed to Mr. Larsson’s restructuring plan, which has included limiting discounting, lowering inventory and reducing the number of products the company is selling.”

Know the key drivers within your industry: Coal

Key Drivers within the Coal Industry.

1) Demand and Competition from China

Chinese consumption and production policies have a huge impact on coal prices.  Here’s what’s happened in just the past year:

Coal Prices Tripled: “International prices for metallurgical coal tripled in 2016 from a decade low.  Rule changes in China that limited work in mines, mine retirements in Australia and U.S. production cutbacks sparked the rally. Many troubled mines were suddenly profitable.”

Coal Prices Halved: “Coal prices have tumbled by nearly half since November, after China relaxed restrictions on the number of days mines can be open…”

2) Government Regulatory Environment.

The House voted to “repeal a rule that limited companies from dumping mining waste in streams.  The coal industry views the environmental rule as burdensome regulation.”

“It’s a very optimistic time now for the coal market because those regulations are being pushed back,”

3) How fast can coal miners ramp up production and re-open plants?

“…mines world-wide have already ramped up output to take advantage of the rally in prices.”

Toshiba: Learning from Other People’s Mistakes (OPM)

Warren Buffett has said that’s it’s best to learn from “other people’s mistakes” as much as possible.  Well I think there’s much to learn from Toshiba’s perilous venture into nuclear energy.

Toshiba’s nuclear ambitions made for a great investment story.  They planned to leverage Westinghouse’s nuclear reactor design to reduce costs by cranking out many “cookie-cutter” power plants.  This low cost strategy, combined booming demand, would lead many investors towards an optimistic view of the company.

At first things started out well:

“Southern chose Westinghouse’s design for the first new nuclear plant to be built in the U.S. in 30 years, and the next month Scana also chose the AP1000 for a plant in South Carolina.” (link)

But eventually the twin pillars of Toshiba’s plan, low cost and booming demand, eventually dissolved leaving them with losses that could approach $6 billion.  How did this happen?

Their misery stemmed from two major sources:

  1. Replicating Errors: Any error in their cookie cutter power plant design was replicated throughout all the power plants they were building.  Leading to very costly mistakes. (link)
  2. Stagnation: The nuclear industry has stagnated or declined in most every country but China.  Largely as a result of Fukushima and political headwinds.  This lead to increasingly ferocious competition.

We should learn to watch out for:

  1. Very large tail risk (Fukushima)
  2. Political risk
  3. Execution risk (Difficulties of Implementing the strategy)
  4. Investing outside of your circle of competence.
    1. I would not have seen the risks of replicating design errors in the reactor design.

Other major issues from this story:

  1. Toshiba exposed themselves to unlimited losses: The deal restricted Westinghouse’s ability to “seek further increases in the contract price,” Southern said—meaning that if the nuclear plant couldn’t be completed in a timely manner, Toshiba would shoulder the costs.
  2. Toshiba had a high profile accounting scandal in 2015 (link): Warren Buffett says, “In the world of business, bad news often surfaces serially: you see a cockroach in your kitchen; as the days go by, you meet his relatives,”

This Week in Human Misjudgment: Pavlovian Association

Currently lots of human misjudgment centered around anybody involved with Trump.  For example:

“Uber Technologies Inc.’s chief executive, Travis Kalanick, said he is stepping down from President Donald Trump’s economic advisory council, saying that his participation has been misunderstood as an endorsement of the new administration’s policies.” (link)

“The announcement “follows criticism of the ride-hailing firm over perceptions that it supports the Trump Administration, with some celebrities and others using social media to call for people to delete Uber’s smartphone app.”

Under-estimating risk:

Be wary of trading strategies.  Many often underestimate the risk involved.  Here’s one example of where it may be occurring:

“It really came down to the leverage,” said Mr. Skalak on why he switched from stocks to futures.  On a good day, Mr. Skalak said he can make $600 to $1,000.  He pulls out of the market if his daily losses approach $400, a policy he adopted after some steep losses.” (link)

First: His strategy is likely dependent on being able to pull out of the market in a calm and orderly fashion.  During market panics however, liquidity can dry up and severe fluctuations can wipe out years of profits like it did to the Carry Trade back in 2008.

“These rare and unexpected changes in the market, such as the sudden devaluation of a currency, can wipe out years of accumulated gains. Thus, higher interest rates in the lent currency may be the payoff for bearing the risk of a peso event. But determining the effect of an unlikely future event is something of an experimental nightmare.” (link)

The carry trade is often described as “picking up pennies in front of a truck,”

Second: This trader sough out a strategy where he could apply a great deal of leverage, but here’s a few warnings against leverage:

  1. What Ever Happened to Rick Guerin?
  2. LTCM Case Study

Currency Swaps & Interest Rates

Very insightful article into the relationship of currency swap and interest rates.

Foreign bond investors measure investment attractiveness by the hedged yield differential.  Therefore, to understand the demand for bonds from foreign investors, you have to know both the yield differential and the cost of hedging currency risk with currency swaps.

Example: (link)

“At the end of January, a 10-year U.S. bond yielded around 2 percentage points more than its German equivalent and 2.4 percentage points more than a Japanese bond.”

“But if investors fully hedged themselves against currency exposure, the pickup in yield would disappear completely. After that cost, a U.S. 10-year bond would offer a yield 0.06 percentage point lower than a domestic equivalent for an investor with euros, and 0.7 percentage point lower for a Japanese investor.”

“The relative attractiveness hasn’t increased as much as the nominal difference in yields suggests,” added Mr. Inkinen.

“Hedging an investment mutes its impact on the exchange rate, but if Japanese and European investors want to benefit from higher yields on bonds elsewhere in the world—particularly U.S. Treasurys—they would have to buy more bonds unhedged against currency risk.”

Market Developments

  1. Bullish Oil Bets Climb to Record (link): ” Long positions exceeded shorts by such a degree that it’s the largest net bullish position in 10 years of data from the CFTC.”
  2. Strong demand for Italian commercial real estate (link): Investing in Italy “is a way to move up the risk curve and deliver returns promised to investors,”
  3. Investment Grade Bond mania: “Investment-grade companies have sold $146 billion of bonds this year, the most for any comparable period on record going back to 1995,”
  4. Systemic Risk in China’s lending environment (link): The default “rippled through the world’s largest internet investment marketplace, hitting investors who hadn’t even bought the securities.”…Individuals seeking higher returns invest in these unregulated securities with a few swipes on their phone.
  5. WeWork is just a duration mismatch? hmm… (link): WeWork’s “business model is to sign long-term leases with landlords, but take short-term rents from its own tenants, meaning that revenue is volatile and losses could pile up in a recession.”
  6. Businesses are struggling to charge more (link): The Fed noted earlier this month that “increases in input costs were more widespread than increases in final good prices” – an indication that businesses are struggling to charge more.”
  7. The Facebook IPO still haunts the Nasdaq (link): “…since the glitch-filled IPO of Facebook Inc. on the exchange in 2012, NYSE has landed the majority of the dollar volume raised in tech IPOs valued at $1 billion or more,”

Oh Mon Dieu…

Think about this the next time you examine your daily habits.

“EA said its mobile game “Star Wars: Heroes of the Galaxy” was a significant driver of digital sales, with fans now spending an average of 155 minutes a day playing it.”

In the course of a year, that equates to 16 hours per day for 59 days straight of doing nothing but playing this video game.  Over the course of 60 years, that’s 9.7 years.

Statistic of the Week

“Americans now lose $500 million a year to street crime but $8 billion a year in ATM fees.”

Wall Street Journal Recap: January 23-29, 2017

/ Richard Lewis / Leave a comment

My full notes and analysis on the Wall Street Journal from the past week: January 23-29, 2017 (Week 4).  Please Enjoy.

Ruthless pricing formula in Pharma:

When general economic principles are applied to Pharma, the outcome looks ruthless in nature.  For example:

According to this quote, drug pricing has nothing to do with cost of development, or the amount of supply, but rather the demand generated due to the effectiveness of saving lives.

“Mr. McMahon said the price was justified by the improved average survival benefit the drug provides for patients with certain cancers.” (link)

Furthermore, drugs for rare diseases have the best pricing power.

“If you have blockbuster drugs in a rare disease area that’s shown to be more immune to pricing pressure, that is a very valuable asset to have,” said Jefferies analyst Peter Welford. (link)

The Rise of the “New and Now” Consumer

A trend is emerging in retail.  Customers want it “new” and they want it “now”. Whether you’re in consumer goods, video games, or luxury goods, consumers are becoming increasingly impatient and bored.

Here are how some companies are adapting:

Unilever:

“Unilever hopes the move will make it more nimble in responding to local tastes or trends.” (link)

Supercell (Clash of Clans):

“Five months later, Mr. Paananen says Supercell has fixed problems, paying more attention to customer complaints and refreshing its handful of games more often.” (link)

“He said the episode underscores how competition has risen in the sector, increasing pressure on developers to produce ever more attractive games.”

“All the companies, including Supercell, have to find new ways to get new users,” Mr. Hiltunen said.

“When players return to their games, there should be something new,” he said.

PepsiCo:

“The clear plastic bottles will feature textured labels by emerging artists, including the street artist known as Momo, with new designs introduced every few months.”…”PepsiCo hopes the revolving designs will prompt young people to share images of the bottles on social media.” (link)

Fashion (Burberry):

“Luxury consumers, including in China, are increasingly choosing innovation over tradition.  Burberry reported last week that “fashion,” or newly designed items, outperformed sales of core products like its famous trench coats in the Christmas quarter.”  (link)

“This trend is a challenge for companies used to selling products on the basis of timeless appeal.”

Drivers of Luxury Good sales: Peace and Corruption

There are two fascinating insights from this article on luxury brands. (link)

1) Peace is good for business.  Terrorism is not.  High profile terrorist attacks reduce international travel.  When people travel they spend more on luxury goods.  “Chinese and U.S. tourists who don’t travel abroad are less likely to splurge,”

Terrorism = Less International Travel = Less Luxury Brand Sales

2) Corruption is good for business.  A Crackdown on corruption reduces luxury goods sales.  China instituted a stiff crackdown on corruption which led to less luxury brand sales.

Lower Corruption = Less Luxury Brand Sales

Are luxury brands over-extending themselves?

More and more brand names seem to be expanding the price range of their product offerings.  This strategy of offering products at lower and lower price points can increase sales in the short-term, but it can also contribute to brand dilution in the long-term.  The Range Rover Evoque & Mercedes CLA are two possible examples.

This strategy is very similar to retailers like Michael Kors and Coach who embraced the outlet store model.  It helped revenue growth (and stock price) in the short term, but the growth was an illusion and it severely damaged each of their brands.  Their outlet strategies proved to be nothing more than a complete exploitation and degradation of years of goodwill.

Ferris Bueller’s ‘Oh Yeah’ Song Seeded Investing Fortune

Got to like the Buffett-like logic of these investments. (link)

1) BVZ Holding AG:

“Mr. Meier’s banker father offered advice.  A growing middle class in Asia, he said, meant more Asian tourists would be coming to see the Matterhorn in southern Switzerland.  So Mr. Meier bought a large stake in a railway company, BVZ Holding AG, that now takes them there.”

2) Orell Fussli Holding AG:

“Another piece of fatherly advice: ‘As long as Switzerland exists, we will always print our own money.’  So Mr. Meier obtained a stake, which FactSet now values at about $37 million, in Orell Fussli Holding AG, the company that prints Swiss Francs.  He is the firm’s second-largest shareholder, behind the Swiss National Bank.”

Pricing Power:

Warren Buffett says:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Strong Pricing Power

Merck (link): “Last year, Merck raised list prices by an average of 9.6%, with an average net price increase of 5.5%.”

Weak Pricing Power

Nestle(link): “But Nestle and its rivals have struggled to boost volumes and lift prices amid consumers’ push for healthier fare and super-competitive markets.”

Declining Sales: Strategies

Here are five strategies being used to fight/cope with declining sales.

1) Cut costs

Caution: Cost cutting might lead to under-investment and result in (1) a further slowdown in long-term sales and (2) a need for large capital outlays in the future.

Unilever PLC (link): Reported slower sales growth last year, spooking investors…Last year, Unilever started its own cost-cutting campaign, including so-called “zero-base budgeting-a management practice based on justifying all costs from scratch each year.”

P&G (link): Years of cost-cutting only recently started to bear fruit.

Kimberly-Clark (link): Recently completed a cost-cutting plan aimed at saving $140 million annually.  But it said earlier this week it still forecasts tepid sales growth for 2017.

Norfolk Southern (link): Norfolk Southern posted a decline in revenue but notched higher profit in its fourth quarter as it cut costs, an effort it said it would continue as rival railway operators are pushed to take similar belt-tightening measures.”… “Norfolk Southern cut $250 million in annual costs in 2016 and plans to cut $100 million more this year.”

“Coal has been weighing on the railroad sector’s results”

2) Acquire high growth businesses

Caution: Often times this means over-paying.

Verizon(link): “Verizon needs to do a big deal to boost growth…The telecom giant is exploring a merger with Charter,”  “Charter’s wired broadband service passes 49 million homes and is growing even as the pay-TV market is shrinking.”

AT&T (link): AT&T’s deal to buy Time Warner is a tie-up that would transform the phone company into a media giant, helping it potentially find new areas of growth as its core wireless business has become saturated and its share of the mobile market leaves little room for acquisitions.”

Cisco (link): “Cisco is buying software company AppDynamics Inc. for $3.7 billion…at a big premium to bolster its software offerings to large enterprise customers.”

“Cisco has placed increasing importance on software.  The company has long held a dominant share of sales of the routing and switching equipment used to funnel data over the internet and between computers in data centers.  As competitors enter the market with less expensive options, Cisco has focused on other business lines such as security, collaboration and the “Internet of Things.”

3) Acquire a company to smooth revenue and profits

Caution: Impatience (time) based acquisitions are often expensive.

J&J (link): “J&J has said it has several new drugs in development that could offset any revenue loss from this rivalry, but the Actelion acquisition would more quickly help plug that hole.”

4) Spin off underperforming divisions

Caution: Beware of selling too the division too low.

Intel (link): “It also agreed to sell 51% of its underperforming security division to private-equity firm TPG for $4.2 billion.  Intel expects the two moves to create $1 billion in savings in the coming year.”

Novartis: “Novartis AG is considering spinning off its ailing eye-care business Alcon, one year into a slower-than-expected turn-around for that business.”…”The potential spinoff comes seven years after Novartis gained full ownership of Alcon (for $51.6 billion), a move that it had hoped would allow it to capitalize on the fast-growing eye-care market.”…”The decision comes as the company struggles to revive growth at Alcon.”

5) Adapt to shifting consumer demands and develop a new advertising strategy

Nestle (link): “Nestle SA is betting reduced sugar and a new advertising strategy will boost sales amid a growing consumer backlash against sweet drinks.”

Return Expectations

“With dividend yields about 2.5% for the Dow and 2% for the S&P, not far from historic lows, and stocks trading at almost 29 times inflation-adjusted multiyear profits, or well above their long-term average of about 16, it seems prudent to expect tepid-maybe even putrid-returns for years to come.” (link)

Corruption at Wells Fargo

The corruption at Wells Fargo can be boiled down to:

Past success + high draconian expectations + a lapse in oversight = Ripe environment for corrupt practices.

P.S. Why does this formula remind me of China?  Past success, draconian growth demands, large lapses in oversight…

The Wells Fargo story is pretty wild, here are some of the best quotes(link):

“Managers and employees at the bank’s roughly 6,000 branches across the U.S. typically had at least 24 hours’ warning about annual reviews conducted by risk employees,”…”That gave many employees time to cover up improper practices, such as opening accounts or signing customers up for products without their knowledge.”

“You became numb to it,…it became pretty normal.”

“Growing the business was primary: The more successful you were, the higher the goals were.  So you had to keep up.”

Investment lesson:

Pay close attention to internal corporate performance goals & oversight.  Are the demands too unrealistic and draconian?  Are there lapses in oversight?

Government Debt & Growth Assumptions: A Disaster

Thomas Jefferson said, “To preserve our independence, we must not let our rulers load us with perpetual debt.”

When governments are allowed to borrow based on assumptions of growth, they inevitably set us up for disaster.  Why?  Because they use “naive extrapolation” in their assumptions.  Naive extrapolation assumes that growth will persist, nearly indefinitely.  But the fact of the matter is that growth will eventually slow.  Economies or companies that aren’t prepared for this eventually are devastated.

This undesirable fate has now befallen the U.S. Virgin Islands.  Just check out a few of their problems:

Between 2007 to 2013, tourism feel 19%, a drop of $280 million. During that period the territory’s population shrank by almost 9%.

“With less revenue, the territory has relied increasingly on bond proceeds to pay operating costs while contributing less to pension plans. That borrowing has increased its debt to a level similar to that of Puerto Rico, on a per capita basis.”

“That pension plan has only 27% of what it needs to pay future benefits, according to 2015 financial statements; a 2015 analysis by Segal Consulting predicted the fund would run out of money by 2024.”

What might they have to do to get out of their financial predicament?

1) Sell off key assets.

2) Raise taxes.

3) Cut funding to pension plans, schools, etc.

Investing Lessons:

(1) Beware of naive extrapolation of past growth rates.

(2) Use a margin of safety

(3) Warren Buffett said, “If you buy things you do not need, soon you will have to sell things you need.”

i.e. If you’re looking for investment bargains, look at distressed countries and companies who will be forced to sell things that they need to pay for the things they didn’t.

(4) Remember what happens when you assume things?