Monthly Archives: June 2015

market leadership and relative market share

June 16, 2015 By in relative market share Tags: , , , Leave a comment

In looking for companies to invest in, market leaders are very often a good place to start.  They have the advantage of their large size, high visibility to existing and potential customers, and likely scale economies.

Of course, there are some common sense caveats to this.  We have to ask ourselves, for instance, whether the market a company claims to be addressing actually exists or is worth the effort to dominate.  If, say, a restaurant chain says it rules the market for left-handed diners in Cleveland, we might scratch our heads on either count.

Once we get past silliness, though, there is an important market attribute to consider–market concentration.  A useful way to approach this issue is through relative market share..  Relative share can be calculated in a number of ways, the simplest (and therefore my favorite) is to calculate the market share of a given competitor–usually either the firm you’re interested in or the number two in the market–as a percentage of the market leader’s.

In a market where the leader controls 60% of the market, #2 has 30% and #3, 10%, the relative market shares are 1, .5 and .17.  This is usually a very favorable situation for the leader.  Unless the overall market is growing at warp speed–in which case every firm is staking out territory as fast as it can and not worrying about what competitors are doing, #3 had better had a good niche strategy or else it’s toast.  #2 may be in a better position than #3 but may also be vulnerable to market share loss from #1.

A market where #1 has 35%, #2 has 33% and #3 has the rest is far different.  The relative market shares are 1, .94 and .91.  This is most likely an incredibly competitive market, where #1’s “leadership” may only be a function of its greater willingness to cut prices.  While the dynamics of such a market may be theoretically interesting, for investors–except, again, in the unusual situation of hyper-growth, it’s usually one to watch from the sidelines.

 

 

 

business development companies

June 15, 2015 By in business development companies, family owned companies, securities markets, stock market Tags: , , , , 1 Comment

Last week, a reader commented on business development companies(BDCs).  I said I’m not a fan.

I’d like to elaborate.

BDCs are SEC-regulated closed-end investment companies that typically invest in small- and medium-sized firms.   In one sense, they can be regarded as a poor-man’s private equity.  In another, they can be viewed as the successor to the “blind pools,” a type of IPO that was in vogue when I entered the market in the late 1970s.  The issuer usually had no specific use stated for the funds raised;  the pools often ended in tears for sharehlders.

BDCs are often not SEC-registered.  That is, they aren’t subject to the detailed disclosure that publicly traded firms are.

They do have a tax advantage over ordinary industrial or service firms.  As investment companies, provided that they satisfy restrictions on the scope of their operations, including that they distribute virtually all their net income, they–like other investment companies, such as mutual funds, ETFs and REITS–are exempt from corporate tax on their earnings.

This is a powerful plus.  Because of it, BDCs tend to focus on owning mature, cash-generating businesses and they tend to have high dividend yields as their main attraction.

What’s not to like about this?

My issue is that the analysis of BCDs is a lot more complex than finding out what you need to know before buying the stock of an individual company or a mutual fund or ETF.  You’re not only becoming a part owner of a company, you’re investing side by side with the BDC operator, who has an extremely large degree of control and influence over the companies you own together.  Because of this, you have to not only understand the companies, but you also have to know and trust the people running the BDC.

In my experience, this second task takes a long time and considerable work.  Even when you’re satisfied, holding a BDC also involves accepting a higher level of risk than simply owning a garden-variety publicly traded stock or fund.  I question whether the returns are high enough to justify making this extra effort and exposing my portfolio to the extra level of risk.

 

 

surviving the next twelve months (iv)

June 12, 2015 By in bond market, Constructing a Portfolio, Portfolio management, securities markets, stock market, Strategy Tags: , , , , , , , , Leave a comment

what makes me optimistic

I’m a growth stock investor.  So I’m optimistic by nature.

More to the point, the two worries about thinking stocks will go sideways to up as the Fed normalizes interest rates are that:

–recovery in the US may continue to be sub-par..  

If so, the normalization process is going to take a looong time, since the Fed’s goal is to raise interest rates at a slow enough pace that the economy in unaffected.  Yes, the Fed may make a mistake, but the error it typically makes is to wait too long to raise rates, not to raise them too fast.

In addition, there’s serious discussion in economic circles that maybe the way we have measured economic progress in the US in the post-WWII era has passed its “use by” date and isn’t capturing what’s going on in an Internet-centric world.  After all, it took many years for government data to acknowledge that personal computers enhanced productivity and increased consumers’ well-being.  We’re now in the midst of a much greater period of change–the baton-passing from Baby Boomers to Millennials and the demise of the post-WWII corporation designed on the model of the 1940s Army.

Maybe the economy is a lot hardier than we now think.  If so, the strength of earnings growth may not be the issue the market perceives it to be.

–the rest of the world is a mess…

therefore the 50% of S&P 500 earnings that comes from abroad will  be a source of disappointment.

As far as commodity-based emerging economies are concerned, “mess” is probably an apt characterization.  But they’re (thankfully) only a tiny portion of the foreign 50% of S&P earnings.  The key areas for the index are Europe and Asia, especially China.

As far as Europe goes, there’s evidence that the worse of the recession is behind it.  The euro may have bottomed against the dollar, as well.  The EU is still struggling with the problem of Greece.  But that’s not because Greece is a key economic driver for the EU (quite the opposite), but because Brussels fears that allowing/forcing one member to leave the union will set a precedent, and encourage separatist political parties elsewhere.

I have no idea whether Greece goes or stays.  But I think that the negative economic consequences for Greece–Cuba is the only analogue I can come up with, and it’s not a very good one (Argentina?)–of leaving the EU will be so devastating for the country that Grexit itself will silence separatists.

There are also the first signs of economic stabilization in China.

So maybe the half of S&P earnings that come from abroad also won’t be as bad as the market now thinks.

an active strategy

areas to avoid–stocks whose main attraction is their dividend

areas to emphasize–Internet economy, firms catering to Millennials

 

 

surviving the next twelve months (iii)

June 11, 2015 By in bond market, junk bonds, Portfolio management, securities markets, stock market, Strategy Tags: , , , , , , , Leave a comment

In the past in the US when the Fed has raised interest rates from recession-emergency lows, bonds have gone down and stocks have gone sideways to up.

Will this time be an exception?   …another way of saying, Will stocks go down this time around?

The generally accepted explanation of the divergence between stocks and bonds while the Fed is normalizing interest rates after a downturn is that the negative effect of higher rates is offset, in the case of stocks, by the positive effect of strong earnings growth.  Bonds–other than junk bonds, or municipal bonds–don’t have this offsetting factor.  So for Treasuries the news is all bad.

(There are at least two reasons why interest rates matter for stocks:

–broadly speaking, people (me being a possible exception) don’t actually want to own stocks.  What they want is to own liquid long-term investments so they can fund their retirements and send their kids to college.  Those can be either stocks or bonds.  A decline in the price of bonds makes them more attractive, taking some of the shine off stocks.

–in broad conceptual terms, the worth of a company should be related to the value in today’s dollars of its future earnings.  To the extent that investors use today’s interest rates to discount future earnings back to the present, rising rates will result in lower present values.)

 

I remain squarely in the “sideways to up” camp, but I can see, and am monitoring, two possible worries that may weaken the case for s-t-u:

–in what has been to date a sub-par rebound from recession, earnings growth may not be as strong as in prior recoveries, and

–the S&P 500 is a global index, about half of whose earnings come from abroad.  Even if US-sourced earnings are great, the same may not be true for foreign-sourced.  In particular, an increase in the value of the dollar vs. the euro caused by increasing interest rate differentials (the worry of the IMF and World Bank) could mean a lower dollar value for EU-sourced earnings (which make up about a quarter of the S&P 500 total).

More tomorrow.

 

surviving the next twelve months (ii)

June 10, 2015 By in bond market, Constructing a Portfolio, currency markets, Current Market Thoughts, growth vs value, stock market, Strategy Tags: , , , , , , , Leave a comment

two types of tightening

The Fed raises rates in two different situations:

1  to slow down an overheating economy.  This is not where we are now.  In the overheating situation, the economy is expanding at an above-trend rate.  Inflation is accelerating.  Wages are rising rapidly.  The stock market is frothy.  The long bond is trading at inflation +2% – +3% (meaning a nominal yield of 4% – 5%, in a 2% inflation scenario).

As the Fed ups short-term rates, what  follows is a garden-variety recession/bear market.  Bonds go down.  Stocks go down.  The damage to stocks is worse than the damage to bonds–often by a lot.

Again, this is not the situation we’re in now.

2)  to restore money policy to normal after a period of extreme easing aimed at ending a recession or combating a severe economic shock.  That’s where we are now.

 

In situations like this, bonds go down but stocks go sideways to up.  There’s no theoretical reason I can see for the latter behavior.  It happens, I think, because, unlike the overheating situation,  the Fed doesn’t intend to bring growth down dramatically.  It just wants to wean the economy off a sugar high of very easy credit.

Two things make todaydifferent from past rate normalization periods, however:  the amount of easing has been very large and of unusually long duration; and dysfunction in the legislative and executive branches in Washington has meant fiscal policy has failed to do its part come to the country’s support, other than in the earliest days of the financial crisis.

Some argue that beause of this, today’s situation may be different enough that the past won’t be a sure guide.  I’m going with history.  But I take th point that we can’t just be on cruise control.

two different portfolio responses

The two types of tightening call for different stock portfolio construction, in my view.

In today’s world:

–bond-like stocks will probably not do well.  Years of ultra-low interest rates have forced Baby  Boomers to search for income in the stock market.  As rates rise, and bonds become increasingly attractive, some Baby Boom money will return to bonds.  At first, the reverse flow may only be new money.  At some point, however, Boomers may begin to liquidate their income stocks.

–rising rates may make the dollar spike.  In fact, the IMF recently expressed this fear in an emphatic plea to the Fed to postpone the start of the rate normalization process into 2016.  It’s not clear to me that the dollar will appreciate much further, however.  But if it does, stocks with foreign exposure will become less attractive, since the dollar value of their foreign earning power declines.  On the other hand, foreign companies with large US exposure become more attractive, both to local investors and to you and me.

–companies with their own special growth story become more attractive than those that are mostly dependent on the general business cycle for their oomph.  Cloud computing and Millennial favorites should be relatively fertile fields.  Arguably, the market’s preference for growth stocks over value has been in place for some time.  But the preference for the former should intensify.

 

More tomorrow.