Boeing

BA has lost about a quarter of its value since fatal accidents caused its newest 737 model civilain aircraft to be pulled off the market.  Stories are starting to circulate (that I’m hearing them suggests “starting” may not be the best word) that the Sage of Omaha is beginning to buy Boeing (BA) stock.   The rationale?   …a value investor‘s belief that the company’s woes are temporary and that all the probable bad news is already discounted in the stock price.  Buffett has positions in several airline companies and in at least one supplier to BA, so he arguably would have better insight than most into the BA situation.

initial thoughts

How plausible is this?  Is the rumor based on fact or simply launched by a third party with an agenda?  …if the former, is this a repeat of Buffett’s foray into IBM, another questionable trip down memory lane?  what’s BA’s price to book, price to cash flow?  I don’t know.

I’ve never owned BA during 25+ years managing other people’s money.  I’ve never felt a compulsion to investigate it, either, even though I worked for a long time in value-oriented shops where BA was often a topic of discussion.  But I was curious about what interest in BA might not only say about the company but also about the temperature of the market.  So I took a quick look.

I went to the Fidelity research area to get some relevant ratios, in this case the P/CF and P/B.  I found:  $185 billion market cap, P/B of negative $7+ or so a share and P/CF of 30x–not what I would have called a “value” buy.  I decided to take another step and look at BA’s September quarter 10-Q  on the SEC Edgar site.

the latest 10-Q (9/19)

random-ish figures:

–BA has total assets of $133 billion.  Of that $13 billion is plant and equipment, $12 billion is goodwill and other intangible assets and $75 billion is customer financing.  So this is not a plant and equipment story.  It’s about intangible assets, craft skill/ proprietary company know how, being a national champion.

–Book value is negative.  How so?  The most important reason is that over the years BA has spent over $50 billion buying back its own stock, including $1 billion+ during the first nine months of 2019.  Accountants deduct that expenditure from net worth.  Another $15 billion gets subtracted though”comprehensive loss” related to pension plans.  Ex those items, book value would be about $65 billion, meaning the stock is trading at about 3x adjusted book.  Again, not an obvious value story.

–Cash flow, which was about $12 billion during the first three quarters of 2018 is slightly negative for the comparable period of 2019.

my take

The idea behind the typical value stock is that the company has assets that have lost value for now because of economic circumstances or lack of skill of current management.  Once economic conditions improve and/or management is replaced by more competent executives, their value will shine through again.  That’s because the assets haven’t been destroyed, they’ve just been misused.

I don’t think that’s the case here.  The assets in question are intangible.  The strongest, I think, is that BA is one of only two global large commercial aircraft manufacturers–and the only one in the US.  As for the rest, if press reports are correct, BA tried to solve a hardware problem (very heavy engines) with software, a dubious proposition at any time, according to my coder son-in-law.  Worse than that, BA may have been less than forthcoming with regulators about potential risks with this solution.  As for myself, I’d go to considerable pains to avoid flying on a 737 MAX, given that the penalty for a mistake is so high.

So I don’t get bullishness about BA for two reasons:  I think intangibles like craft skill and industrial software can melt away in short order in the way, say, a chemical processing plant can’t.  Also, given what I think is the severity of BA’s problems, I don’t think a loss of a quarter of the company’s stock market value is an overreaction.  If anything, I think it’s an underreaction.

 

 

 

 

 

 

 

 

 

 

a PS to today’s post

The Russell 2000, which is composed of medium-sized US-based firms serving mostly US customers is up by 4.5% over the past two years.  This compares with +16.5% for the S&P 500 and +25.5% for the NASDAQ, which are far more globally oriented.  (These are capital changes figures, which I plucked off Yahoo Finance.)

The latter two are 3.7x and 5.7x the return on the Russell 2000.  Attention grabbing, yes, but not the right way to sum up the situation.  More important is that these ratios happen because ex dividends the Russell has returned pretty close to zero.

starting out in 2020

The S&P 500 is trading at about 25x current earnings, with 10% eps growth in prospect, implying the market is trading at around 22.7x forward earnings.  During my working career, which covers 40+ years, high multiple/lower growth has virtually always been an unfavorable combination for market bulls.

Could the growth figure be too low, on the idea that forecasters give themselves some wiggle room at the beginning of the year?

For the 50% or so of earnings that come from the US, probably not.  This is partly due to the sheer length of the expansion since the recession of 2008-09 (pent up demand from the bad years has been satisfied, even in left-behind areas of the country–look at Walmart and dollar store sales).  It’s also a function of shoot-yourself-in-the-foot Washington policies the have ended up retarding growth–tariff wars, suppression of labor force expansion, tax cuts for those least likely to consume, no infrastructure spending, no concern about education…  So I find it hard to imagine positive surprises for most US-focused firms.

Prospects are probably better for the non-US half.  How so?  In the EU early signs are emerging that structural change is occurring, forced by a long period of stagnation.  The region is also several years behind the US in recovering from the recession, so one would expect that the same uptick for ordinary citizens we’ve recently seen in the US.  Firms seeking to relocate from the US and the UK are another possible plus.  In addition, Mr. Trump’s life-long addiction to risky, superficially attractive but ultimately destructive, ventures (think:  Atlantic City casinos) may finally achieve the weaker dollar he desires–implying the domestic currency value of foreign earnings may turn out to be higher than the consensus expects.

 

The biggest saving grace for stocks may be the relative unattractiveness of fixed income, the main investment alternative.  The 10-year Treasury is yielding 1.81% as I’m writing this  That’s 10 basis points below the dividend yield on the S&P 500, which sports an earnings yield (1/PE) of 4.  I say “may” because, other than Japan, the world has little practical experience with the behavior of stocks while interest rates are ultra-low.  In Japan, where rates have flirted with zero for several decades, PE ratios have declined from an initial 50 or so into the low 20s. Yes, Japan is also the prime example of the economic destructiveness of anti-immigration, anti-trade, defend-the-status-quo policies Washington is now espousing. On the other hand, it’s still a samurai-mentality (yearning for the pre-Black Ship past) culture, the population is much older than in the US and the national government is a voracious buyer of equities.   So there are big differences.  Still, ithe analogy with Japan holds–that is, if the differences don’t matter so much in the short term–then PEs here would be bouncing along the bottom and should be stable unless the Fed Funds rate begins to rise.

That’s my best guess.

 

The consensus was of viewing last year for the S&P is that all the running was in American tech industries.   Another way of looking at the results is that the big winners were multinational firms traded in the US but with worldwide markets and very small domestic manufacturing and distribution footprints.   They are secular change beneficiaries located in a country whose national government is now adamantly opposing that change.  In other words, the winners were bets on the company but against the country.  Look at, for example,  AMZN (+15%) vs. MSFT (+60%) over the past year.

The biggest issue I see with the 2019 winners is that on a PE to growth basis they seem expensive to me.  Some, especially newer, smaller firms seem wildly so.  But I don’t see the situation changing until rates begin to rise.

 

Having said that, low rates are an antidote to government dysfunction, so I don’t see them going up any time soon.  So my practical bottom line ends up being one of the gallows humor conclusions that Wall Streeters seem to love:  the more unhinged Mr. Trump talks and acts–the threat of bombing Iranian cultural sites, which other governments have politely pointed out would be a war crime, is a good example–the better the tech sector will do.  As a citizen, I hope for a (new testament) road-to-Damascus event for him; as an investor, I know that would be a sell signal.

 

 

 

 

 

 

 

 

today’s discounting mechanism

discounting

Discounting is Wall Street jargon for new information being factored into stock prices.

Discounting isn’t a single thing.  In the 1920s, for instance, company managements issued unreliable financial statements while happily passing along inside information to their bankers.  Ordinary investors fended for themselves with the only tool they had back then–watching prices and stock charts.

When I entered the stock market in late 1978 there were already laws requiring publicly traded companies to file detailed financial statements with the SEC.  From the early 1970s cadres of well-paid analysts poring over them and creating the microeconomics of firm and industry behavior.  Yes, there were still throwbacks who expected analysts to be part of their public relations efforts…and there was pressure on analysts who worked for brokerage houses to make their ideas known to the proprietary trading  desk before anyone else.  Still, the playing field was a lot more level.  There were significant rewards for original research conclusions, particularly with traditional growth companies, where the game was, and still is, finding situation where the consensus was too pessimistic about the rate of profit growth and/or the length of time unusually high earnings gains could be sustained.  Typically, stocks would start to rise a year or more in advance of confirming earnings.  In over-bullish markets investors might discount as much a three years into the future; in the depths of bear markets investors would stick to actual earnings and not discount the future at all.

In the 1990s this dynamic began to change, as investment managers began to lay off their in-house analysts on the idea that relying on brokerage research was a lot cheaper and a lot less effort.  In 2000, the SEC passed Regulation FD, which required publicly-traded companies not to make selective disclosure of corporate information (the presumed recipients were investment bankers and institutional shareholders).  Replying to an analyst’s novel question or inadvertently revealing information through body language became worrisome enough that companies either stopped having meetings or developed canned presentations and pretended they were news.  In the wake of the financial crisis, brokers laid off virtually all their experienced analysts.  Since academics are totally clueless about finance, this left no place for newcomers to learn how to do traditional analysis.

Enter AI–whose specialty is reacting to newly released information with lightning speed rather than anticipation of yet-to-be-announced developments.

What is a fundamental analyst to do?

Strategically, fundamentals-based investing remains the same, I think–figuring out potentially market-moving information before the average market participant does.  Today’s tactics are different, though.  Fifteen years ago, the best strategy would have been to amass a large position in a given stock and wait for the market to work out what you already knew.  Price action would tell you when/if that was happening.  There would likely be bumps in the road, but these would offer opportunities to add.

I think the better course of action now is to start with a smaller position and use AI-induced volatility to add and subtract.

 

 

 

 

 

thinking about 2020

where we are

The S&P 500 is trading at around 25x current earnings, up from a PE of 20x a year ago.  Multiple expansion, not earnings growth, is the key factor behind the S&P rise last year.In fact, earnings per share growth, now at about +10%/year, has been decelerating since the one-time boost from the domestic corporate income tax cut cycled through income statements in 2018.  Typically earnings deceleration is a red flag.  Not so in 2019.

EPS growth in 2020 will probably be around +10% again.

About half the earnings of the S&P come from the US, a quarter from Europe and the rest from emerging economies.  The US will likely be the weakest of the three areas this year, as ongoing tariff wars take a further toll on agriculture and manufacturing, as population growth continues to wane given the administration’s hostility toward foreigners, and as multinationals continue to shift operations elsewhere to escape these policies.  On the other hand, Europe ex the UK should perk up a bit, emerging markets arguably can’t get much worse, and multinationals will likely invest more abroad.

 

interest rates:  the biggest question 

What motivated investors to bid up the S&P by 30% last year despite pedestrian eps growth and Washington dysfunction?

Investors don’t buy stocks in a vacuum.  We’re constantly comparing stocks with bonds and cash as alternative liquid investments.  And in 2019 bonds and cash were distinctly unattractive.   The yield on cash is close to zero here (elsewhere in the world bank depositors have been charged for holding cash).  The 10-year Treasury started 2019 yielding 2.66%.  The yield dipped to 1.52% during the summer and has risen to 1.92% now.  In contrast, the earnings yield (1/PE, the academic point of comparison of stocks vs. bonds)) on the S&P was 5% last January and is 4% now.

The dividend yield on the S&P is now about 1.9%.  That’s higher than the 10-year yield, a situation that has occurred in our lifetimes only after a bear market has crushed stock valuations.  In my working career, this has happened mostly outside the US and has always been a clear buy signal for stocks.  Not now, though–in my view–unless we’re willing to believe that the current situation is permanent.

The situation is even stranger outside the US, where the yield on many government bonds is actually negative.

In short, wild distortions in sovereign bond markets, a product of unconventional central bank measures aimed at rescuing the world economy after the 2008-09 collapse, have migrated into stocks.

How long will this situation last and how will it unwind?

 

more on Monday