I turned on Bloomberg radio on my way to the dentist yesterday (the pandemic has apparently been good for my teeth, as it turns out). A guest was about to talk about a survey he’d done to find companies who had enhanced their brand value during covid vs. those that lost luster. The Bloomberg reporter began his introduction by declaring that he, the reporter, being a seasoned veteran of Wall Street, was well aware that brands had little role in investment evaluation.

This is where the laughing/crying comes in. How could any financial markets reporter, let alone a financial markets “veteran,” not have a clue about Warren Buffett, the most highly publicized US investor of the past half century? Buffett’s main claim to fame is his understanding, cutting edge in the 1960s-70s, of the immense value of intangible assets like brand names and distribution networks to corporate profitability.

After my surprise at how low the knowledge bar is at Bloomberg for reporters to get air time wore off, I returned to my usual thought on the current financial press information desert–that this low bar means it’s easier for us as individual investors to gather insights that are not yet in the consensus (and therefore not likely to be already incorporated in a stock’s current price).

An aside on advertising: suppose we wanted to launch a new soft drink, call it XXXX, to compete with Coca Cola (KO) worldwide. Let’s assume, as a first (too simple, but still useful) guess, that we’d need to at least match Coke’s ad spending for, say, five years to build up consumer awareness of XXXX to the level that a soda drinker might think of it as a possible alternative. The actual KO ad spend for the past five years is $20 billion. Buying the Coca Cola name for $20 billion, rather than taking the risk of building from scratch, would probably be a bargain. Therefore, I conclude, the Coca Cola brand is worth at least $20 billion.

What Buffett realized earlier than everyone else is that although this cumulative ad spending is a big plus, it’s not visible in the primary financial statements. It doesn’t appear at all on the KO balance sheet. It’s only in the income statement as a minus, as a reduction of income.

KMB reported earnings late last week. I’m not really that interested in the company, other than as an indicator of market sentiment, since KMB seems to me to be a quintessential stay-at-home stock in a very mature industry. I was particularly struck, though, by the Wall Street Journal article I read that outlined the results and management comments.

What I thought was important (the whole story is a little more complicated):

–US consumers buy about $9 billion worth of KMB toilet paper in a typical year. Sales growth is likely a function of population growth, implying that revenues only increase at a glacial pace. In 2020, however, sales jumped by a third to about $12 billion, despite a falloff in business to away-from-home customers. Quantitative evidence, in other words, of what everybody sort-of knew–major-league hoarding during the early days of the pandemic. We began to realize equally that shortage days are behind us when store shelves began to be full and remain full of hand sanitizer and paper towels and toilet paper before last Christmas.

–KMB management expressed surprise that sales fell below typical-year levels in 1Q21. I wonder why they didn’t consider that customers with four months extra worth of toilet paper on hand (which could be 3x the normal amount, although I’m just making that figure up), and ample supplies in the stores, wouldn’t cut back on buying

–the stock fell 5% on the earnings report. Again, how could the market not have anticipated this sales and profit weakness, despite company guidance?

But then I thought, maybe it did.

So I went back to look at KMB’s relative performance over several periods in the recent past. Here are the results:

1/1/20 – 3/18/20 the downward slide

KMB -8%

ARKW -19% ARK internet

ARKK -20% ARK innovation

NASDAQ -20%

S&P 500 -25%

AAL -64% American Airlines

DIN -78% Dine Brands ( = Appleby’s + IHOP)

3/18/20 – 9/26/20 sharp bounceback

ARKK +140%

ARKW +132%

DIN +87%

NASDAQ +52%

S&P 500 +32%

KMB +2%

AAL -18%

9/26/20 – 3/31/21 market rotates

AAL +94%

DIN +65%

ARKW +42%

ARKK +33%

NASDAQ +24%

S&P 500 +21%

KMB -6%

past month (if I had to name this, I’d say awaiting more input)

NASDAQ +8%

ARKK +8%

ARKW +7%

S&P 500 +7%

DIN +3%

KMB -3% (-5% since posting 1Q21 results)

AAL -7%.

As I read the four periods, during the earliest, the slide into pandemic, KMB outperformed substantially. Domestic reopening stocks–restaurants and airlines–were crushed.

During the initial bounce back, the ARK funds soared. They were in the ideal position, full of secular growth stocks with the smallest possible exposure to the medical disaster and the ever more explicit white racism emanating from the administration in Washington. DIN rebounded, although the low starting point makes its relative performance a bit deceptive. At the the end of the period it was still 60% below its 2019 close. KMB tread water. AAL continued to decline, on worries about its ability to survive.

From late September until the end of March, roles were reversed to a great extent. AAL and DIN shot through the roof. The ARK funds outperformed a bit, based mostly on their performance through their January creating. In contrast, KMB sagged in a serious way–indicating to me that the market of six months ago was already beginning to heavily discount stocks that could be hurt by reopening, i.e. “pure” stay at home beneficiaries.

During the past month, the market seems to have stabilized. While I think it’s too soon to argue that the worst is over for the ARK funds, they have at least been able to more or less keep pace with NASDAQ. DIN has lost some of its steam, although after a fabulous run. AAL seems to me the easiest to interpret. It’s in the worst shape of the major domestic airlines. For an investor, this means it’s the most highly leveraged to both good and bad news. My sense is that for travel/vacation stocks like AAL, the market is beginning to move away from the general concept of recovery to a closer examination of how recovery will actually work out–to look for the warts, as it were. And in the case of airlines there are plenty of them, I think. My guess about KMB is that as a stock it has already entered a more advanced phase of recovery assessment, one where reported earnings will count for a lot more than the promise of a future rebound. Sooner or later, the rest of the market will come under the same kind of scrutiny. The safer course for us is always to prepare for “sooner,” even though my sense is that with KMB we’re seeing port-pandemic earnings performance of a type we won’t get for much of the rest of the market for another three to six months.

In layman’s terms, which is as deep as I go, a carried interest is a share in the profits of a partnership that the general, or managing, partner receives without having to pay any of the costs involved in earning those profits. The GP’s notional share of expenses is “carried” by the limited partners.

In an oil and gas partnership, for example, the managing partner may receive 20% of the revenue from producing wells without having to pay a penny of the land acquisition, exploration and drilling costs. The GP justifies this special treatment because of his entrepreneurial flair, deal-making ability and specialized knowledge of the oil and gas industry. My experience in the oil and gas world has been that these are sweet deals for the GP but not so much for anyone else.

One of the rough equivalents of this structure in today’s world is the SPAC.

Another is the private equity or hedge fund partnership, where the private equity fund/hedge fund acts as GP for, say, an equity portfolio managed for pension fund clients. The bulk of the GP’s compensation in these partnerships is the 20% or so carried interest in the partnerships’ profits it receives and redistributes to the GP’s employees, i.e., the portfolio managers.

The twist in the private equity/hedge fund cases is that profits from holdings retained in the partnership for three years before sale are classified as long-term capital gains for income tax purposes. In contrast to the case of a mutual fund/ETF that liquidates holdings to pay its investment managers, who are taxed at ordinary income rates for the money they receive, identical payments to a hedge fund manager (who would be crazy not to sell holdings older than three years) are taxed as capital gains. The Congressional Research Service estimates the loss to the Treasury from this loophole at $1.2 billion a year.

As part of his “Drain the Swamp” campaign, Trump pledged to eliminate special interest tax breaks like carried interest or the special deals given to natural resource companies. None of that happened in the 2018 tax bill, which lowered taxes for the wealthy instead.

My take on the Biden proposal is that the the control of Congress by recipients of the carried interest tax break is so strong there’s no chance that Congress will eliminate it. Therefore, the only way to close the loophole is to raise the capital gains rate for the wealthy.

It seems to me that there’s enough fiscal and monetary stimulus in the air to trigger a substantial economic upsurge as/when reopening occurs. There’s also presumably a lot of pent-up demand in the US from stay-at-home families who have been saving simply because they have either not been able, or not been willing, to leave their dwellings to do in-person transactions–like shopping, dining, exercise, entertainment.

The first-order questions about recovery revolve around its timing (when does it start, how long does it last) and strength. My initial thoughts: it’s already underway, and we don’t have to worry about duration just yet. More important from a stock market point of view, I think,, we should try to figure out, if we can, what aspects of adaptation to lockdown will endure (home delivery of groceries?) and what aspects of pre-pandemic life are going to come back in surprisingly weak fashion (urban high-rise office space?, business travel?, international vacation travel?).

There’s also the possible complication, which I’m choosing to ignore for the moment, of the number of people in the US who may refuse to be vaccinated, for whatever reason, and the economic and health threat they may pose. A much wider issue is the lack of vaccination so far in poorer parts of the world, leaving them open as potential breeding grounds for of new, vaccine-resistant, variants of covid. Again, I think these are not here-and-now issues for financial markets.

There’s an issue, as well, with pandemic-beneficiary stocks, like makers of building materials, gym equipment, comfort food, masks and hand sanitizer…, whose earnings may well weaken as shortages abate. For me, these are easier to come to grips with, so identifying–and avoiding–“pure” pandemic stocks is a priority.

A second, not so widely noticed, I think, set of influences on the economy comes from the change in administrations in Washington. It’s not clear how deeply Trump’s white racism and encouragement of violent race extremists has hurt the ability of domestic universities and businesses to recruit competent foreigners. His refusal to supply US-made products, from agriculture to tech, to China, however, is having an effect. The most straightforward investment idea is that the present multinational supply chain for computer chips is broken and will be replaced as quickly as possible with competing China-centric and US-centric supply chains. This means sustained high demand for semiconductor production equipment from both camps. A less clear, but still possibly important, result is the not only his tariff-induced loss of the soybean trade to Brazil but the rainforest destruction this has induced.

more tomorrow

More a side note than anything else, the top countries by percent of population having received at least one vaccine dose are:

Israel 60%+

UK 50%-

Chile 40%+

US 40%

Canada ~25%

EU 20%-

Mexico 10%-

the world in total ~5%.

Two implications:

–there’s probably a lot of substance to anecdotal reports that reopening in the US is happening sooner and at a faster pace than the consensus expects, and

–the still vast pool of unvaccinated people around the world suggests that the threat of new variants is not going to go away any time soon. This may simply mean annual booster shots will be needed for a long time, or it could be something more dangerous. In either case, my guess is that this will not be a front-of-mind issue for the US stock market for a long while. Still, I have to remember this as an assumption in formulating a market strategy.

setting expectations

One of my earliest stock market mentors, Denis, a very careful investor, told me he thought a careful analyst of companies, putting in a reasonable amount of effort studying a small number of companies, could achieve a 20% return most years in the stock market. Stress careful and effort and I think this is a reasonable expectation. Can I do this? Not every year. I’m not very good at detecting market tops, so I end up with higher highs and lower lows.

If we look over long periods of time and in stock markets around the world, indices seem to average gains of inflation + 6 percentage points a year. Gains aren’t steady, though. A typical pattern by year might be +10%, +10%, +10%, -12%, the last being a recession–which sets the stage for the pattern to repeat.

My point: 2020 was an extremely unusual year that we shouldn’t generalize from. The salient question from 2020 for us today is how we deal with the unwinding of the extraordinary measures (e.g., near-zero interest rates) needed to deal with the pandemic and the retrograde social/economic policies of the Trump administration causing firms to prepare to leave the country. Bad for the US but extraordinary for the stock market, especially stay at home and capital flight stocks.

Take the extreme example of the ARK funds. The flagship, AARK, was up by about 160% in 2020. Breakeven would, to my mind, be a laudable result for 2021. I’m sure the managers intend to do better, maybe much better, but really…

themes?

end to lockdown

The typical stock market pattern during a business cycle shift from recession to expansion is for the most highly cyclical stocks–mining, farming, construction, autos, hotels, airlines–to move, as a group and very early in recovery, purely on the idea or concept of recovery itself. They then tend to move sideways until the actual recovery begins. Then the group gets sorted out, moving up/down depending on their actual experience.

I think we’ve entered the second phase. The biggest question marks that are arising have to do with travel stocks, i.e., airlines, cruise ships and hotels. How much and how quickly is business travel–repeat customers who pay full price for deluxe treatment–going to recover? What about affluent senior citizens going on international cruise vacations?

What makes this a key issue is that travel industry firms tend to have a high degree of operating leverage, that is, they may need 60%/70% of their seats/cabins/rooms filled in order to break even. United Airlines (UAL) went from $25 to $60 on the concept of an eventual return to the friendly skies. Only recently, however, has the market’s attention turned to the thorny issue of how to achieve, say, 80% occupancy while maintaining social distancing.

more tomorrow