Wal-Mart (WMT), economic indicator and investment

WMT and the economy

WMT is the largest retailer in the US (Costco (COST) is #2).  Despite its very large size, WMT has a distinct economic focus, one based in its roots as a chain of quasi-department stores for small towns.  About a third of its customers are relatively low income blue-collar workers, whose personal fortunes tend to be very highly linked to the strength of the overall economy.  Because of this, when WMT profits start to rise, as they have been over the past several quarters, it’s a sign that economic recovery is strongly rooted and has spread relatively widely.

WMT as an investment today

In the past, periods like this have also been good ones to own WMT shares.  Two factors, however, suggest to me that this time could be very different:

the dollar stores.  During recessions, consumers tend not only to cut back on expenditures but also to trade down, that is, to patronize less expensive retailers.  In the case of many WMT customers, that means turning to the the dollar stores, whose target  customer has been a single head of household who earns $20,000 +/- a year, who walks to the store and who visits several times a week.  During the last downturn, the dollar stores decided to shift their business model and expand their product offerings in hopes of holding onto their new, more affluent former WMT customers when the economy improved.  The industry has also consolidated into a smaller number of larger firms, to the same end.

As a result, WMT has new competition for the low end of its market demographic, a segment that becomes more important as customers who have traded down to WMT from, say, Target, return to their former niche.

–like many traditional retailers, WMT hasn’t paid enough attention to the internet.  Its recent decision to acquire jet.com for $3 billion+ is evidence that WMT realizes it has to play catchup.   I think jet.com’s most important asset is its innovative top management.  Whether it will mesh well with traditional WMT executives remains an open question.

keeping nominal GDP growth above zero

A reader asked a question about this after my Stephen King post from last Friday.  I think the best place for an answer is here.

In most circumstances, what counts is real GDP, not nominal.  That latter is, after all, just real GDP + inflation.  However, what comes to mind when people start to look for instances where nominal GDP shrinks is the Great Depression   …or maybe Japan during the series of Lost Decades it has been experiencing since 1990.

A potentially huge economic problem during a period of declining nominal GDP is that virtually all borrowing contracts–bonds or bank debt–are written in nominal terms.    In many places, labor contracts are also framed the same way, with an x% increase in wages yearly over the term of the agreement.

The revenues that businesses generate to meet these obligations are a function of unit volumes and price changes.  If real GDP is falling by, say, 3% and prices rising by only 1%, overall revenues are contracting.  Given that operating costs are typically fixed over the short term, this means firms in the aggregate will have less income to meet debt repayments and salary obligations.  For highly operationally or financially leveraged companies, even small declines in revenues can be deadly.

If, on the other hand, volumes are down by 3% and prices are rising by 4%, then revenue growth will still be positive.  On the margin, at least, this means fewer layoffs and fewer insolvencies to act as an economic drag during a time  when governments are trying to stimulate demand.

 

The situation where nominal prices are actually falling–which we’re not talking about here– is far worse.  Consumer soon learn that waiting a month, or two or three, before buying will mean a lower price.  So they just stop buying.  Given that consumers make up the bulk of economic growth in developed economies, they can ill afford to get the idea in consumers’ heads that purchasing anything today is a bad idea.

Stephen King on productivity and monetary policy

The Stephen King I’m writing about is an economic advisor to HSBC who was formerly the bank’s chief economist.  He’s one of the most interesting economists I’m aware of.  For instance, he was one of the first to warn of excesses in the US housing market a decade ago, and perhaps the most vocal in doing so.

Last week he weighed in on the issue of productivity in an Opinion article in the Financial Times.  His main points:

1. The current low level of productivity–+1% yearly in the US, flat to down elsewhere–may not be due to lack of infrastructure spending (Lawrence Summers) or that most productivity-enhancing inventions have already been made (Robert Gordon).  It may be instead that we’re seeing now is normal.  It’s the generation that rebuilt after WWII, creating high growth in productivity in the process, that’s the outlier.

2.  If #1 is true, then many of the mainstays of orthodox macroeconomic policy need to be reexamined.  In particular,

–if the world is being flooded with money, then capital is equally available at cheap prices to high productivity enterprises and low ones.  The result may be that the very process thought to be increasing economic growth is neutralizing the competitive advantage of high-productivity enterprises

–in a low-inflation, low-productivity world, interest rates will be “dragged down to incredibly low levels,” meaning recession-fighting monetary expansion may be difficult to achieve

–cultural expectations built over the past half century of ever increasing prosperity may prove to be too high.  This would be trouble for, say, pension or social security schemes around the world whose ability to deliver promised benefits assumes the robust real economic growth of the past can be extrapolated into the future.

3.  The ability of governments to create inflation may become increasingly important, as a means of keeping nominal GDP growth above zero during an economic downturn.  Monetary theorists around the globe have assumed that doing so involves only the simple expedient of increasing the money supply.  The past eight years in the US, however, have shown that creating inflation is much easier to theorize about than to do.

 

His overall conclusion:  the Lawrence Summers idea of secular stagnation–which can be addressed through increased infrastructure spending–is a much cheerier outlook than it appears at first blush.

Warren Buffett and Dow Chemical (DOW)

Today’s Wall Street Journal contains a front page article that will be widely viewed on Wall Street, I think, as a bit of comic relief.

In times of financial stress, cash-short companies have tended to go to Berkshire Hathaway for financial assistance.  If successful, they receive both money and the implicit endorsement of Warren Buffet.

In 2009, it was DOW’s turn.  It wanted to acquire Rohm and Haas, another chemical company.   The best deal it could find for a needed $3 billion was in Omaha, where Berkshire took a private placement of $3 billion in DOW preferred stock, with an annual dividend yield of 8.5%.  The preferred has been convertible for some time now into DOW common (yielding 3.4%), at DOW’s option, provided DOW has traded above $53.72 for a period of at least 20 trading days out of 30.

DOW shares were trading below $20 each when the deal was struck seven years ago.

On July 26th, the shares breached the $53.72 barrier and traded above it for five consecutive days–the final two on extremely heavy volume–before falling back.  At the same time, according to the WSJ, short interest in the stock has risen sharply.  In other words, someone has been a heavy seller, using stock borrowed from others.

Who could that be?

Although nothing is stated outright, the strong implication of the article is that the shortseller is Berkshire, which stands to lose $150 million+ a year in dividend income on conversion.

Part of the Wall Street humor in the situation is that the playing field isn’t level.  It’s perfectly legal for Berkshire to sell DOW short, although it does seem to cut against the homespun image Mr. Buffett has been at pains to cultivate for years.  On the other hand, however, DOW would run the risk of being accused of trying to pump up its stock price (and the value of management stock options) if it went out of its way to absorb any unusual selling.

 

hedge funds and uncorrelated returns

beta     

One of the initial topics in my first investment course in graduate school was beta, a measure of the relationship ( generated from a regression analysis) between the price changes of an individual stock and those of the market.  A stock with a beta of 1.1, for example, tends to move in the same direction as the market but 10% more strongly.  One with a beta of 0.9 tends to move in the same direction as the market but 10% less strongly.  The beta of a stock portfolio is the weighted average of the betas of its constituents.

the beta of gold stocks

At the end of the class, the teacher posed a question that would be the first item for discussion the following week.  Gold stocks have a beta of 0.  What does that mean?

The mechanical, but wrong answer, is that gold stocks lower the beta, and therefore the riskiness, of the entire portfolio.  If I have two tech stocks, their combined beta may be 1.2.  For two utility stocks, the beta might be 0.8.  For all four in equal amounts, then, the beta is 1.0, the beta of the market.  Take two tech stocks and add two gold stocks and the beta for the group is 0.6. But this doesn’t mean the result is a super-defensive portfolio.

A beta of 0 doesn’t mean the stock is riskless.  It means that the stock returns are uncorrelated with those of the stock market.  So adding one of these doesn’t lower the risk of the portfolio.  Instead, it introduces a new dimension of risk, one that may be hard to assess.

a painful lesson   

Portfolio managers who embraced beta in its infancy didn’t get this. They assumed uncorrelated= riskless, learned the hard way that this isn’t true when their supposedly defensive portfolios imploded due to sharply underperforming gold issues.

uncorrelated redux      

I’ve been looking at marketing materials for financial planning firms recently.  Allocations to hedge funds are being touted with the idea that their returns are uncorrelated to those of stocks or bonds. This is substantially different from the original claims for this investment form. Over the past fifteen years or so, the hedge fund pitch has gone from being one of higher-than-market returns, to low-but-always-positive returns, to the present uncorrelated.

The reason is that in the aggregate hedge fund returns have consistently been lower than those for index funds for many years and that they do have years where their returns are negative.  What’s left?   …uncorrelated, just like zero-beta gold stocks.  I guess it has been revived because the last “uncorrelated” investment disaster is so far in the past that few remember it.

why hedge funds?

Why have hedge funds at all in a managed portfolio?  They must have some marketing appeal, sort of like tax shelter partnerships or huge fins on the back of a car, that are aimed at the ego–not the wallet–of the client.  A darker reason is that the sponsoring organization may also run the funds, and would miss the huge fees they generate for their managers.

 

 

 

 

 

 

August-October in mutual fund/ETF-land

 August has traditionally been a slow month in financial markets, for two reasons:

–Europe, including European factories and stock markets, pretty much closes up for the month and everyone goes on vacation

–on this side of the Atlantic, high-level Wall Streeters head for the Hamptons, leaving behind cellphone numbers and assistants who have less authority to make independent decisions–and who certainly don’t execute changes in strategy.

Yes, in today’s world the EU is much less significant than it used to be and Industrials as a group are a mere shadow of their former selves.  But the vacation effect is still a powerful soporific.

 

In September, mutual fund/ETF minds turn toward the end of the fiscal year, which occurs on Halloween.

Mutual funds/ETFs are special-purpose corporations.  Their activities are restricted to investing; they’re required to distribute to shareholders as dividends each year virtually all of the profits they recognize.  (In return for these limitations, they’re exempt from corporate income tax on their gains.)

About thirty years ago, with government encouragement, the industry moved up the end of its fiscal year from December to October.  This gave funds two months post-yearend to put their books in order and get checks in the mail in December, so the IRS could collect income tax from holders on those distributions in the current year.

Because of this, fund/ETF preparation for the October 31st yearend typically begins in early or mid-September.  It invariably involves selling.

How so?

For reasons that completely escape me, mutual fund holders like to receive distributions. They regard it as a mark of success.  And they seem to like a payout of around 2% -3% of asset value.

For most of the year, the tax consequences of their decisions are not in the forefront of portfolio managers’ minds (strong industry belief is that taxes are tail that shouldn’t be allowed to wag the portfolio dog).  As a result, distribution levels most often require fine-tuning.  This means either selling to realize an additional gain, or selling to realize an additional loss.  Either way, it means selling.

At the same time, this occurs close enough to the end of the calendar year that PMs often use the opportunity to begin to make major portfolio revisions in anticipation of what they think will play out in the following calendar year.  This means more selling.

 

October often sees the beginning of a rally that lasts into December, as the fiscal yearend selling pressure abates.  Accountants play a role here, as well.  Every organization I’ve been in requests that PMs avoid trading, if possible, during the last two weeks of the fiscal year.  That’s to avoid the possibility that a trade has settlement problems and isn’t completed until the beginning of the following fiscal year.  PMs mostly play only lip service to requests like this, but it does ensure that purely tax-related selling is over by mid-month.

 

a(n important) footnote

Like any other corporation, if a mutual fund/ETF has net losses, it carries them forward for use in subsequent years.  Virtually every fund/ETF has been saddled for years with large tax loss carryforwards generated by large panic redemptions at the bottom of the market in 2008-09.  These had to be offset by realized gains before a distribution would be possible.

Last year was the first time that enough funds/ETFs had used up losses and were able to make distributions.  During the second half of last September, the S&P 500 fell by about 5%, before rallying from  early October through late November.

 

Caesars Entertainment and private equity

I’ve been wanting to write about what might be called the private equity paradigm for some time. On the other hand, I don’t see any way for me as a portfolio investor to make money from research I might do–other than to keep as far away from private equity deals as possible–so I haven’t done as meticulous job of research on this post as I would if it involved a stock I might buy.  So regard this more of a preliminary drawing than as a finished picture.

When a private equity firm acquires a company, it seems to me it does five things:

–it cuts costs.  The experience of 3G Capital seems to show that typical mature companies are wildly overstaffed, with maybe a quarter of employees collecting a salary but doing no useful work.  Private equity also uses its negotiating power to get better input pricing, although it passes on little, if any, of the savings

–it levies fees to be paid to it for management and other services

–it increases financial leverage, either through taking on a lot of bank debt, or, more likely, issuing huge swathes of junk bonds.  An equity offering may happen, as well

–it dividends lots of available cash generated by operations and/or sales of securities to itself, thereby recovering much/all of its initial investment

–it then sits back and waits to see whether (mixing my metaphors) this leveraged cocktail to which it now has only limited financial exposure, sinks or swims.

 

Caesars Entertainment has added a new twist to this paradigm.  In 2013, its private equity masters seem to have decided that sink was the more likely outcome.  Rather than simply accept this fate, they began preparing a lifeboat for themselves by whisking away valuable assets from the subsidiary that is liable for the company debt into another one.  In January 2015, after this asset shuffling was done, they put the debt-laden subsidiary into bankruptcy.

Junk bond holders sued.  Litigation has been protracted and has reportedly cost $100 million so far.

Media reports indicate that the case is now approaching resolution–either through negotiation or court ruling.  My no-legal-background view (I was a prosecutor in my early days in the Army, but that says more about the Uniform Code of Military Justice back then than about me) is that:  these asset transfers can’t be legal; and the junk bond loan agreements should have had covenants that explicitly bar such action.  So I’m not sure what has taken this long.

Whatever the outcome of the case is, I think it will shape the nature of private equity from this point forward.

 

 

 

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