the changing nature of competition

Happy Halloween!!

This is the continuation of my post from last Friday.

A generation ago, establishing a competitive edge in a business was about having plant and equipment, operating that physical capital efficiently and, for consumer-facing firms, advertising to create and maintain a brand image.

First mover advantage was often key, since it might allow the initial entrant to achieve economies of scale (lower unit costs) in manufacturing or marketing that would discourage potential rivals  by making their path to profits prohibitively long and expensive.

The Internet, and the rise of China as a low-cost contract manufacturing hub, changed all that.  Supply chain management software did allow vertically integrated companies to coordinate actions much more efficiently.  But it also gave smaller, more focused firms the power to create virtual integration using third-party supply chain partners.


Today’s competition, particularly in the consumer arena, is as much about services as physical products.  The development of internet-based social media has made it much easier for a fledgling niche product to find a voice without spending heavily on traditional advertising.

Knowledge and relationships have replaced plant and cumulative advertising expense as “moats” that protect a firm from competition.


These developments present two problems for stock market investors:

–the first one is straightforward.  Comparing a stock price with the per share value of tangible balance sheet assets (Benjamin Graham) may no longer provide relevant buy/sell signals.  Nor will supplementing this analysis by including intangibles (Warren Buffett), using, say, the sum of the past ten years’ advertising expense.

A very successful value investor friend of mine used to say that there are no bad businesses, there are only bad managements   …and bad managements will invariably be replaced.  In an overly simple form, he thought that so long as he could see large and growing revenue, everything else would take care of itself.  Broken companies were actually better investments, since their stock prices would leap as new managements created turnarounds.

As I see it, in today’s world this traditional approach to valuation is less and less effective–because assets no longer have the enduring worth they formerly did.

–first mover advantage is probably more important today than in the past.  But while network effects are readily apparent, a company’s development stage, where the network is growing but the source of eventual profits is unclear, can be very long.  And it may be difficult in the early days to separate a Fecebook from a Twitter.


So while we can all dream of finding a profit-spinning machine that has high turnover and negative working capital, today’s versions are inherently more vulnerable than those of a generation ago.  They may also come to market in their infancy, when what kind of adults they’ll tun into is harder to imagine or predict.


are high margins better than low ones?

This post is indirectly about Amazon’s retailing business, although it has much wider implications.

My answer:  not necessarily.  It depends on what kind of company we’re talking about.  Note, also, that this is a topic that’s badly misunderstood, particularly in the financial press, which clings to the simple assumption that high margins, of themselves, are better than low ones.


The apparent virtue of having high margins is clear.  Companies that have, for instance, essential intellectual property protected by high patent/copyright/manufacturing-knowhow walls, can achieve selling prices that are much greater function of the usefulness of their products/services to customers than of their production costs (this latter is the functional definition of a commodity company).  Software firms can easily achieve 50%–or maybe 80% or 90%–operating margins for their wares.


Most distribution companies–both wholesale and retail–don’t work this way, however.  They thrive through low margins, high inventory turnover and careful working capital management to achieve superior financial results.  In fact, for these companies high margins are a threat, not a boon.  Why?    …because high margins attract competition.

the low-margin model

Here’s a (highly simplified) account of how the low-margin model works:

the simplest case

A warehouse holds inventory of $1 million.  It constantly replenishes its stocks, and pays cash immediately for new supplies, so that it always has $1 million invested.  It marks items up by 5% over its costs.

Let’s say the company generates an average of $525,000 in sales per month.  That means it turns over about half its inventory (a turnover ratio of 6x/year) each month, earning operating income of $25,000.  $25,000 x 12 = $300,000 in operating profit per year.  Applying a 1/3 income tax rate, it produces $200,000 in net income.  That’s a 20% return on invested capital. Not bad.

a more favorable one

Let’s now imagine that the company can turn its inventory once a month (turnover ratio = 12).  This means it earns operating income of $50,000/month, or $600,000 per year. This translates into $400,000 in net income. That’s a 40% return on capital.


Let’s say the company turns inventory once a month but is large enough or important enough to suppliers that they no longer ask for payment on delivery.  Instead, they are willing to wait for 30-45 days.

Now the company has zero/negative working capital, i.e., no capital invested in inventory.  It’s return on investment is now infinite.


Yes, this third case is probably too good to be true.  But it illustrates the enormous, badly-understood, power of high inventory-turnover companies.


A post on potential troubles in paradise on Tuesday.



3Q2016 earnings for Tesla (TSLA): still a “dream” stock

TSLA reported 3Q16 results yesterday after the New York close. The numbers were better than admittedly modest expectations:  the company sold a record number of cars: it had profits; cash flow was strongly positive–although flattered by better management of working capital and sale of pollution tax credits.  Still, a plus.  And the stock is up by about 4% in pre-market trading as I’m writing this.  (I should mention that other members of my family and I hold small positions in TSLA.)

The fact that a $30+ billion market cap company earned $22 million in a quarter would scarcely be considered good news under most circumstances.  Annualizing and rounding up to $100 million for a full year would imply a PE of 300x for  the company’s stock!  However, TSLA is still to a considerable degree a “dream” or “concept” stock.


The prototypcial “dream” stock is a firm that starts up with the intention of prospecting for gold.  It makes what it thinks/says is a significant strike.  While the company creates the mine and associated processing facilities, speculation about the quality and extent of the orebody runs rampant.  After all, there’s no factual information to contradict any rumors that may float about.

Then the mine opens.  There are now facts available about ore quality and mining costs.  So there’s no more dream–only brass-tacks reality.  The stock typically peaks the day the mine opens.

TSLA’s case is an unusual one.  Auto production has been under way for some time.  Yet the stock hasn’t reverted to trading on actual results.  To some degree the dream has been dented–I find it hard to imagine TSLA could repeat today its 2014 convertible bond offering, whose conversion price was set at $350.  But Elon Musk has expanded and reset his aspirations for TSLA  often enough during its short life as a public company that at least some version of the dream remains alive.  Unless/until TSLA disappoints severely in its results, I’d think the stock will continue to trade without a strong connection to earnings for some time to come.




seeking outperforming funds

Earlier this morning I ws reading a Wall Street Journal article on the Janus fund group.  What  especially caught my eye was the part on the performance of Janus bond funds.

Over the past one and three years, only 9% and 15% of Janus bond fund assets ranked in the top half of their Morningstar categories.  The corresponding figures from twelve months ago are 75% and 100%.

This home-run-or-strikeout approach to fund management is what I saw when I was competing against Janus equity products ten or twenty years ago.  The idea, which I think is never successful over long periods, is to run portfolios that are built for large deviations from their benchmark indices, in the hope of achieving eye-popping relative returns that will result in large asset inflows.

One problem with this approach is that it’s extremely hard to be very right in a big way on a consistent basis. A second is that, while the freedom to make big bets may be emotionally satisfying for portfolio managers, clients don’t necessarily want the resulting large relative ups and downs.  As one of my former bosses (often, as it turns out) put it, “The pain of underperformance lasts long after the warm glow of outperformance has disappeared.”

That is also, in a nutshell, the basic appeal of index funds:  while there are no sugar highs, there are no heart-attack lows that force the holder to periodically evaluate whether the fund manager knows what he’s doing.   Since there’s really no easy way of knowing, staying with an underperforming fund requires a leap of faith most investors are leery of making.  Better to avoid being put in this position in the first place.


This is probably also the gound-level reason Janus is selling itself to Henderson.  It will be interesting to see whether Janus changes its stripes under new ownership.  By the way, achieving such a cultural change is easier than one might think–just change the bonus structure to strongly emphasize batting average and defense instead of Dave Kingman-like power.

stocks vs. cash

At present, cash yields zero.  Investors who hold cash receive safeguarding of their deposits but no financial return.

Stocks carry no guarantees against loss.  At present, the S&P 500 yields about 2%.  One might reasonably estimate that yearly capital gains will average, say, 6% over longer periods of time.

A guaranteed zero vs. a possible +8% per year.  To my mind, not exactly a compelling case for cash.

In theory, and in practice during the 1970s- 1980s, investors have shifted large amounts of money from stocks to cash when the returns on cash have been high enough.

Hence, the thought-experiment question:  how high would short-term interest rates have to be to trigger serious reallocation away from stocks in favor of cash?

My answer:  I don’t know for sure.

In my experience, during periods of much higher interest rates than are the norm today, when short rates would get above half of the expected return (of about +10% per year) on stocks, then money would begin to shift away from equities.  That flow would accelerate–causing stocks to begin to stall–if short rates got to 60% of the expected return on stocks.


My conclusion is that short rates would have to get well above 3% in today’s world before reallocation becomes a worry.

If so, a rising Fed Funds rate is something to keep an eye on but not a serious current threat to stocks, in my view.

demographics and interest rates

In an op-ed column in Financial Times yesterday, Gavyn Davies wrote about the effect of demographics on interest rates.  His conclusion seems to be that demographics–not cyclical factors–may be the entire story behind why interest rates can remain so low without sparking an increase in business investment.

The demographic argument has three aspects:

–the slowdown in growth of the working population means that companies need to spend less on productivity-enhancing machinery.  This means lower issuance (supply) of corporate debt finance, therefore less upward pressure on rates.  I’m not sure I buy this, but one might equally argue that the price of tech machinery always falls and arrive in a way I find more plausible at the same conclusion

–life expectancy is increasing.  Therefore workers have to save more to support themselves after they retire, thus increasing demand for bonds

–a large proportion of the population is working, meaning the number of savers is high  …and workers save more than non-workers.  This percentage will gradually decrease as the Baby Boom retires.  But for now the population is in prime saving mode.  This, again, means high demand for bonds.

According to a Federal Reserve research paper Davies cites, demographics explains basically all the downward pressure on rates since 1980.

My reaction?

I think that we’re now truly at a point of inflection with interest rates.  I’m torn between two lines of reasoning in support of that conclusion, however.

The demographic argument is effectively that the current regime of extraordinary efforts to keep interest rates low is doing more harm than good.  It hurts savers, compelling them to accept lower returns for their savings than they would get otherwise, while having no positive effect on corporate borrowers.  If anything, the current stance of world monetary authorities mere fuels speculative financial markets activity.  Therefore, extraordinary money stimulus should be removed.

On the other hand, as they say, the market doesn’t bottom until the last bull capitulates.  In the current situation, this translates into:  the economy doesn’t begin to grow more vigorously until the last growth advocate begins to despair that the turn will never come.   That demographic explanation, i.e. abandoning the conventional business-cycle view, can be seen as evidence of that despair.


I don’t expect that rates will rise quickly or that they’ll rise very much–another aspect of the demographic argument that the conventional view of the “normal” level of rates has them pegged much too high.

Initiating the process in a systematic way will, however, gradually dispel the anticipatory anxiety about rate rises currently in financial markets.  That should, if nothing else, make for smoother sailing.




1Qfiscal17 earnings for Microsoft(MSFT)

MSFT reported a strong 1Q17 after the close last night.

Revenue was up +3% (non-GAAP) year on year.  Operating income was flat, on the same basis, and net up +6%.  EPS was up by +9%, at $.76, exceeding the high end of the expectations of the thirty-odd professional sell side analysts who follow the company.

Growth businesses, like the cloud or the Surface line of laptop/tablet hybrids, were up strongly.  Legacy businesses held their own.  Guidance is for a flattish 2Q17.


In many ways, the MSFT report is similar to the Intel (INTC) results from the night before.  Guidance for both companies appeared roughly the same, as well–more or less flat quarter on quarter performance, during a period that’s typically seasonally strong.

The reaction in the press and in the stock price for MSFT, however, was strongly positive.  The stock was up by 4%+ when the results were made public   …and by more than that after the conference call.  As I’m writing this on Friday afternoon, MSFT is holding onto almost all of its after-hours gain during a down day on Wall Street.

INTC, in contrast, fell at all three waypoints–announcement, conference call, next-day trading.


Part of the contrast in stock performance has to do with the differing nature of the two companies’ businesses, hardware vs. software.  Part is a function of the greater speed at which MSFT has been able to demonstrate that it is turning itself around.


On the other hand, I find it noteworthy that there should be a 10% relative performance difference in two days between the two behemoths who were once the constituents of the former Wintel alliance–and on bottom lines that, if we removed the company names, don’t look all that different.

The rest, of course, must represent two different sets of expectations.  I hold both stocks, which I’ve been studying for over a quarter century (and which I find a little scary).  My expectations aren’t that different.

I’m not simply grousing about being wrong aobut INTC.  I think of investing in the stock market as somewhat like playing a game whose rules each player has to figure out as play progresses.  I’ve often likened the difference between investing in, say, the UK or Japan vs. the US as like that between playing checkers or Sorry and playing chess.

I have a hunch that in reports like these we’re seeing evidence of a change in how the stock market game will be played in the US in the future.  If so, it will be important to catch on to the new state of things as soon as possible.