trying to rotate

This is an elaboration of my last post.

I’ve looked into Nicola a little bit–emphasis on little–more. Founder Trevor Milton’s resignation from the company’s board isn’t exactly a confidence builder. Even more telling for me, however, is his that his endgame for Nicola is not to make money from building hydrogen-powered vehicles but rather by supplying them the hydrogen they will consume when running.

This model is a familiar one. Copier makers, for example, are willing to sell machines at a loss; their profits come from selling ink, paper and maintenance contracts . But it’s also a very tough way to make a living, and not the kind of thing investors are willing to pay an above-average earnings multiple to own.

The revelation that Nicola’s master plan is more or less to run a chain of gas stations–even were, say, convenience stores come with them–has landed with a thud. To my mind, bare-cupboard Nicola is a clear signal that the wild speculation accompanying anything labeled tech is over.

What comes next isn’t clear. What I’m thinking, so far:

–tech itself isn’t over. But the sizzle of being the next, newest, best thing ever probably won’t be enough to drive a stock higher from now on. I think the key distinction investors will begin to draw will be between firms that have a good chance to become successful stand-alone businesses (i.e., the winners) and ones where they’ll at best be a feature on someone else’s product (i.e., the losers). The market may well spend the next few months sorting the former from the latter. This would echo what happened after the Internet bubble burst in early 2000.

–but the market will also begin to look at non-tech sectors/companies in a more serious way. The big question is in what way.

More tomorrow

mutual funds and this September

NASDAQ is down by about 10% so far in September, the S&P is off by about half that. The Dow, a primitive measure that used to be a good yardstick for the health of smokestack America but is pretty pointless today, is down by somewhat less than the S&P.

Despite all the drama about the valuation extremes separating tech from heavy industry–drama I’ll confess I’ve found myself caught up in–this has been a normal September so far. That is to say, I don’t think the market decline is about anything other than the internal workings of the mutual fund industry.

Mutual funds are exempt from income tax on their profits. In return for this privilege, they are required to distribute virtually all dividend income and realized capital gains to shareholders, where they become taxable income to the owners.

For reasons I don’t really get, mutual fund shareholders like to receive distributions, provided they’re not too large. (An aside: I once turned over a small-cap fund I’d been running successfully for a few years to an office-politics virtuoso who had risen to a high position despite having a mental cupboard bare of any trace of equity investment skill. He bemoaned my maladroitness in, for example, holding a large position in QCOM (which rose 10x over the following two years), dumped out most of “my” stocks and remade the the entire portfolio in his own image. The result: in year one, he was down, by 7% (?), in an up market and had created taxable gains equal to about 35% of NAV. Investors were not happy in this case. Hard to believe, but this guy is still working in the business, which is part of the reason people don’t trust investment companies.)

Anyway, the tax year for funds ends in October. So managers tend to sell–both to create gains for distribution and to recognize offsetting losses–from early September through mid-October.

That’s what I think is going on now.

There are much bigger issues in play, unfortunately. But I don’t think Wall Street has yet begun to factor the election results (which I think will be crucially important) into stock prices. My reading is that today’s prices are saying things will pretty much go on as they have been over the past four years. I think that’s the least likely outcome.

How so?

As the Bloomberg news service points out, Trump has been “outthought and outplayed” at every turn by China. He has brought the US economy to a standstill; the country continues to be deeply wounded by his coronavirus bungling, while China is already well into recovery; foreign students, tourists, scientists (those who are not turned away at the border) no longer find the US attractive because of civil unrest caused by Trump’s white racism, plus the high risk of coronavirus infection; tariff wars have left the farm economy in a shambles; despite his rhetoric, the trade deficit with China is significantly larger today than when Trump took office; government debt is ballooning into dangerous territory; his brainstorm of denying US tech firms access to the world’s largest market for their products has given renewed energy to China’s domestic tech research. All in all, an economic train wreck. This is basically Trump’s business career, only writ large–the sole reason to believe he’s not more than a “useful idiot”.

His re-election would mean Americans are ok with becoming a white supremacist banana republic. Emigration of the best and the brightest–something I could never have dreamed of seeing–might surge, except that Trump’s coronavirus mess means other countries will hesitate to accept us.

A Biden victory would mean beginning the painful process of repairing the epic economic damage Trump has done. The “flight capital” market would probably be over (with GM-Nicola possibly being the new AOL-Time Warner). I’m not sure what would replace it, though, other than that air would likely start to come out of tech stocks. (“Concept” or early-stage stocks would be the the worst casualties, but their decline would tend to pull down stalwarts like MSFT along with them.

following the money; the fashion industry and working capital

I was reading an article in the Financial Times the other day about pandemic-created issues in the high-fashion modelling agency business–something I’ll confess to knowing virtually nothing about.

Part of my interest is just securities analyst nerdiness. Part is that the FT is a highly reliable source, providing information that’s almost always accurate. Also, I think the story illustrates the more general point for us as investors that a simple look at receivables and payables on the balance sheet can provide a lot of insight into the economic power relationships in an industry.

The main players here:

–the models. They’re freelancers. They get assignments from modelling agencies, pay all their own expenses and get paid after they do the work (in arrears, as the accountants say)

–the agencies. They’re middlemen. They get assignments from branded merchandise companies and fill them with models they’re in contact with. The agencies also get paid in arrears

–the fashion brands. After crafting selling campaigns for their merchandise, they hire agencies to fill their need for photography and runway models. The brands pay in arrears.

in general…

…in a commercial relationship the entity that receives credit (or services in advance of paying for them, which is basically the same thing) is in a stronger position than the one that supplies it.

–Models would seem to be in the worst position of the three groups, since they pay for all their working expenses in advance and get paid only after the assignment is over. In accounting jargon, they are converting an asset on their personal balance sheets, cash, into another, less valuable, asset, receivables (meaning trade IOUs)

–Agencies are in a somewhat better position. They make a few phone calls, get an assignment from a fashion brand (the money from which they list on their balance sheet as a receivable) and line up a model (whose compensation they list on the liabilities side as a payable). Assuming the agency is a money-making enterprise, the receivable is considerably larger than the payable)

–Fashion brands hold the market power. They order a model and pay the agency for services afterwards. They list what they’ve promised to pay the agency on their balance sheets as a payable.

This is the first round of analysis: having all payables and no receivables is the best position to be in; having receivables without payables is the worst. For firms with both, the net of the two–payables minus receivables–is what counts.

round two

Round one is usually enough to get a sense of market power. There are a couple of wrinkles to consider.

–not everybody pays on time; in fact, not everybody pays, period. The balance sheet reserve for doubtful accounts will reveal what a firm’s historical experience has been

–if receivables are due to be paid to you in three months but your payables are due in two weeks, you have a cash flow problem. The typical solution is a growing amount of short-term debt. This situation is also a sign of lack of market power. Customers can demand very favorable payment terms, while suppliers insist on being paid almost immediately.

about the modelling industry in particular

According to the FT, modelling agencies are facing hard times for several reasons. Fashion houses are doing what many big firms do when times are tough–they are slowing down payments to their suppliers. As well, some smaller clients have gone out of business before paying their bills, making those receivables worth little, if anything. Both developments make it harder for agencies to pay models who have already completed assignments.

more changes brewing

Worse for agencies and models, the FT says fashion brands are being forced by travel restrictions and social distancing rules to innovate away from the elaborate, model-intensive runway shows they traditionally stage to introduce new merchandise. The same for elaborate photo shoots used to generate publicity materials. In fact, Gucci and Burberry have both used their own employees as models to launch new collections.

My guess is that many pandemic-forced “fixes” by the fashion brands will become permanent. Two typical motivations: the firms will find that eliminating large in-person events and lavish photo displays will have little negative effect on revenues, so their necessity will begin to be questioned; it’s usually much easier to convince the board of directors to cut large outlays than it is to get the funds reinstated.

Perhaps most important, if I’m correct, the weakening of the scope and influence of these expensive displays, or their demise, will remove a significant barrier to entry for newer, smaller brands.

a weird Goldman report about gender and portfolio performance

I’ve only read about the Goldman report in the Financial Times, so no, I haven’t seen the original. I’m not sure how seriously it’s intended to be taken, although it certainly has gotten a lot of press coverage.

The thing that’s probably the most weird, but not such a big surprise, is that the investment world continues to be one of the last bastions of anti-woman bias. My experience during my working career on Wall Street was that female analysts and managers were generally head and shoulders above their male counterparts but didn’t receive much recognition. You’d think any results-oriented business would notice.

Of more mundane oddness:

–the study only covers the seven months from January of this year through July. This is a short time span

–both female- and male-run funds underperformed, with the former group behind their benchmarks by about 50 basis points, the latter trailing by 160 or so

–both groups were underweight technology and overweight banks. The difference between them is reportedly attributable to the size of their two wrong-headed bets. Tech was up by about 20 percentage points through July, while banks were down about 20, so the performance differential was 4000 basis points! What could these managers have been thinking?

Banks do well when the economy is humming along and interest rates are rising. What we’ve unfortunately got instead is pretty much the opposite situation, with a totally incompetent administration making things significantly worse. Yes, banks may be cheap, but there’s a pretty good reason for that–and no profit recovery in sight.

On the other hand, half or more of the earnings of most tech companies come from outside the US, where just about every leader has outdistanced Trump handily in protecting their local economy from the coronavirus (not a high bar). Also, the current work-from-home environment has accelerated adoption of new tech services and created lots of extra demand for tech devices. So, yes, tech stocks are trading at high PEs. But interest rates are at practically zero, and no chance of rates rising any time soon, so 30x forward earnings (think: MSFT) shouldn’t be a problem. That’s the multiple arguably justified with the 10-year Treasury at 3%, 4x+ the current 0.68% yield.

No wonder index funds are so popular.

is the options-driven selloff over?

My guess is that it is.

what happened

Let’s say you buy an exchange-traded call option (which is the usual kind) on XYZ stock through your discount brokerage account. This means you’re entering into a contract, typically with a big brokerage house on the other side, that gives you the right–but not the obligation–to buy (typically 100 shares of) XYZ at a specified price at any point over, say, the next three months. You pay a premium that’s basically a function of the length of time the contract is in force.

The Options Clearing Corporation Corporation makes sure that both sides have the wherewithal to fulfill their side of the bargain–in this case, that the brokerage house is able to deliver the shares if you exercise the option.

The brokerage house typically hedges its exposure by buying either XYZ shares or options or some other derivative instrument but typically not at 100%. Maybe 30% instead. As/if the price of XYZ begins to rise as new options buyers emerge, the broker not only hedges the new exposure but also boosts the percentage coverage to, say, 50%.

If the first option purchase triggered buying 30 shares of XYZ as a hedge, the second triggers buying of 70. If the stock price continues to rise, new options purchases cause the broker to buy increasingly large amounts of the underlying stock. At the same time, the pool of willing sellers of the stock begins to dry up. If this process continues, the result is a melt-up in the stock price of XYZ.

why I think it’s over

Brokers have learned that failure to follow their coverage rules immediately–on the idea that tomorrow will bring a better opportunity than today–is a recipe for disaster. So, like it or not, they act right away.

Once brokers are 100% hedged, the pressure to buy more abates.

Certainly Softbank, if not other option buyers as well, are aware of this phenomenon. Softbank may well have none its gigantic options buy with the intention of forcing, and profiting from, the meltup that happened.

Softbank quickly learned that its shareholders don’t want the company to have stock market speculation as its main moneymaker. For their part, I imagine brokers will be more fully hedged with new options contracts for a while at least, making a new meltup less likely.

what to do now

After dramatic market moves, it’s always good to reassess portfolio structure to see what went well and what didn’t–and fix problems you may find.

Looking for the stocks that are recovering strongly vs. ones that are lagging behind or still falling will give us clues to where the market may be moving next.