invading the Ukraine

All I know is random facts about Russia and Ukraine–so basically nothing of much value. Therefore, as an investor my main goal should be not to let my ignorance persuade me to do some stupid Ukraine-related thing to my portfolio that will lead to losses.

What do I know? …or, better, what do I think I know about the situation?

Russia is run by former KGB people who seized control after the 1991 collapse of the former Soviet Union and its dissolution into 15 different states. It retains nuclear weapons and a very large army.

The country is an economic mess. It’s Third World-ish, with a large land mass, an aging and relatively static population of about 145 million (less than half as many people as the US) and an overall economy about the size of Pennsylvania’s + Ohio’s. Oil and gas production are its principal industry, at about a third of its GDP; hydrocarbon exports generate about 2/3 of its hard currency.

Oil and gas are the main economic issue here. Russia, the US and Saudi Arabia each produce about 10% of the 100 million or so barrels of petroleum the world uses each day. Because there are no easy substitutes for oil, even tiny changes in supply or demand can cause dramatic changes in price. This gives Russia and Saudi Arabia tremendous economic power. The US would have the same, were we not also the world’s most profligate consumer of oil, with our 4% of the globe’s population using close to 20% of the world’s oil output.

Russia also supplies the energy-deficient EU with enormous amounts of natural gas by pipeline. This last is the area that stands to be most affected by a potential boycott of Russian energy exports that would likely result from an invasion of Ukraine.

Why would Russia invade Ukraine? I have no idea. Success, which seems highly likely, would increase Russia’s population by about 30%, giving it greater economic heft. There may be internal political reasons, as well.

If this happens, presumably NATO nations would boycott Russian oil and gas exports. Past oil boycotts have not really restricted the flow of oil that much. Barrels get relabeled and sold to less fastidious parties. In this case, maybe China and India. Presumably, other oil-producing nations would be happy to increase their output to replace lost Russian barrels. The oil price would likely rise despite this, however. Of course, oil stocks are already rising in anticipation–even though we are now entering the seasonally weakest part of the year for demand.

For natural gas, on the other hand, a boycott would likely be highly effective. In this case, the target would be exports to the EU, the area most worried about Russian aggression., as well as the region least able to replace lost supplies.

In addition, the US/EU appear to be threatening to exclude Russia from the world banking system and to scrutinize more closely dubious international business dealings of Putin’s prominent domestic supporters.

my guess about the stock market:

if Russia invades,

–energy prices will rise and stocks will continue to do well. At some point, however, investors will begin to realize that higher prices will accelerate the trend toward electric vehicles. The big question is how quickly–although arguably the worst possible thing NATO can do to Russia is to accelerate this process. Although energy earnings will continue to rise, the multiple applied to them will begin to shrink.

–ex oil, the rest of the world other than perhaps eastern Europe, will probably not experience significant negative long-term economic effects because of Russian aggression. If so, the prospects for future profits will be more or less unaffected

–the shock/surprise of military action in Europe would likely have a greater negative effect on US-traded stocks than, say, conflict between India and China, or Pakistan and Afganistan. If the past is any indicator, a selloff triggered by an invasion would be at least partly the occasion to do selling that basically has nothing to do with the military action. Such downward movements have also tended to be short-lived. At times, like when the US invaded Iraq, the markets go up as fighting begins (not this time, though, I think).

what I’ve been doing

I’ve combed though my portfolio and raised about 10% cash on the idea that if an invasion happens (I can’t help thinking that it will end up being bad for Russia, so I don’t get why Putin is doing this) markets will be depressed for a short while and I can put the money back to work. The stocks I got rid of were mostly things like TGT, which has had a great run, and mistakes that somehow managed to hide themselves when I’ve looked down my list of holdings (my experience in supervising other portfolio managers is that everybody had detritus like this).

the 10-year Treasury yield rises above 2%

This comes in response to yesterday’s government report on domestic inflation, which came in somewhat higher than expected at 7%+. That’s a startlingly high number, expected or not. The bond market response during the trading day was, to my mind, heartening. The yield on the 10-year rose by 9 basis points, from 1.94% to 2.03%–above the psychologically important 2% level. I interpret this as meaning the bond market is finally getting on with the important business of getting rates into the 2.5% or so range needed to deal with the threat of continuing high rates of price increases. Once we get there, the stock market can get on with the task of going up.

I happened to be eating breakfast and watching the crawl on CNBC when the inflation number came in. There were three cast members commentating–the old curmudgeon, the pugnacious guy from the other side of the tracks who knows almost nothing but rants about everything anyway, and the regular-old reporter who actually knows stuff but the others make fun of because of that. It could have been a bad Shakespeare play, except no audience throwing vegetables. The three were joined by professional investor Jim Paulsen, who is quite good.

The “drama” consisted in the reporter trying to explain to the ranter (who was pretending to be an expert on fixed income) about how the Fed gets interest rates to rise. This is something economist Ed Yardeni made explicit in the 1980s, when he coin the term bond vigilantes. The process: the Fed announces its intention to tighten. It waits for bond market participants to boost rates in actual trading. The Fed then confirms the move–and signals verbally any need for more–with a corresponding move in the Fed Funds rate.

Paulsen reinforced the reporter’s analysis, adding that in his view today’s high level of inflation is a result of supply shortages. These are taking much longer than initially expected to be put behind us but, if I understand him correctly, he thinks they’ll be gone by late in the year. In other words, there’s a risk to having rates go up too fast.

This morning I heard a radio commentator say he went into a store to buy an everyday item, saw the price was higher than he expected and left without buying. I found myself doing the same thing a couple of days ago. In a truly inflationary environment, we would have each bought 3x what we needed and hoarded the rest, on the idea that prices could only go up. This is the strongest evidence I can think of that we’re not in a late-1970s, inflation-spiral environment.

another random-ish thing

I read yesterday about an AI-driven US stock investment strategy, operating with real money and trading real stocks, that has been underperforming its benchmark by almost a percentage point a week. In a sense, this is hilarious. Assuming they didn’t own the investment firm, a human wouldn’t have lasted this long. Presumably the AI is acting on information in the financial press and on price/volume and other technical indicators from daily trading and not simply banking on being able to trade faster than fellow computers. Why don’t I find this lack of success surprising?

where undervaluation is today

I’ve been meaning to write this for a week or so but haven’t been able to figure out a coherent way to begin. Here’s what I’ve got:

–this started with Robinhood (HOOD). I’m not a fan of company management. What I get from them is that they want to grab me, turn me upside down, shake all my money out of my pockets and then toss me aside. It’s never a good thing, in my experience, if the other side believes this is the necessary condition for its prosperity, rather than thinking we should all get rich together. On the other hand, I’m not the target customer.

The company went public last year at $38 and quickly rose to an intraday high of about $85. It’s been all downhill from there.

It hit an intraday low about a week ago at just under $10. At about the same time, I hear the chairman of Interactive Brokers (IBKR) comment admiringly that HOOD has a unique hold on younger investors and that it makes 50% more on customer assets than IBKR does.

And I looked at the company financials. At last report, HOOD had net working capital of about $8 a share. This means if it simply stopped doing any business and would itself down, in short order there would be a shell with $8 a share in cash in it. Although the corporate history is very short, my guess is that HOOD is adding $1+ to that each quarter.

So I could buy for $2 a share the same business and brand name that (admittedly, only for a nanosecond) went for $70+, ex net working capital, a year ago! So I bought some at about $11 and have continued to add. The business is going for $6.50 as I’m writing this.

In my view, this is a classic value stock. Lots of warts, but loads of potential.

–I think HOOD isn’t an isolated story. To my mind there’s been relentless, not particularly well-informed, selling of a whole class of relatively early-stage tech-ish stocks for months. The general conceptual idea, if there is one other than maybe that the ARK funds own them, seems to be that the companies in question aren’t showing GAAP profits. It isn’t just SPACs, which would be my simple screen if I were being forced to do across-the-board shorting. The argument is presumably that if you can fog a mirror, you can show GAAP profits, therefore..

–if you flip past the income statement, though, and look at the flow of funds statement, you may notice three things that to my mind make a loss-making company worth a second look: positive cash flow from operations; non-cash employee expense (non-cash = stock options/grants, which may be unusually large in the first year public); and large spending on software infrastructure. Arguably, at least some–maybe most, depending on the company–of this spending is more akin to factories and the machinery in them than to office supplies. But, because of abuses a generation ago, GAAP rules say this spending must be expensed as incurred rather than put on the balance sheet and written off little by little as sales occur.

Of course, there’s also the balance sheet itself, where there may substantial value in cash or cash-like holdings.

–Barton Biggs of Morgan Stanley popularized the term “dead cat bounce” a long time ago, writing that if you toss even a dead cat off the top of an office building, it will bounce when it hits the ground (my guess is this isn’t true). This was his way of saying that it’s dangerous to read anything into the kind of upward move we’ve had in tech-ish stocks since January 24th. This second is right, I think. But odd as it sounds, I think there’s much more value in “dead cat” tech than the consensus realizes.

interest rates and the stock market

The iron law of microeconomics, as the business school professor I learned micro theory from used to revel in saying, is: what determines price is the availability of substitutes. As regular readers may not, I like writing this as well.

Its relevance for me in today’s stock market world–it raises the question of at what yield do Treasuries become a reasonable enough substitute for stocks that investors begin to change their portfolios by selling stocks to buy bonds.

The yield on 10-year Treasuries is 1.96%. On the 30-year, it’s 2.25%. The dividend yield on the S&P 500 is now about 1.35%. Taking the 10-year, I would probably pick up 60bp in yield over the next year by switching money from an S&P index fund into bonds.

On the other hand, the long-term yearly return from holding stocks is something like 300-400bp higher than from holding bonds. And the Fed is closer to the beginning than the end of the process of raising interest rates back up from their emergency pandemic lows. While this is going on, the price of already-issued bonds is more likely to fall than rise.

Nevertheless, even though today is probably not the time to do so, I think it’s an important question. At what yield would stock market investors like you and me begin to allocate money away from stocks and into bonds?

I’ve only rarely held bonds, so I’m not going to be in the vanguard of the movement. Still, if the10-year were to yield, say, 4%, I’d have no qualms about switching some of my less favorite stocks into bonds.

What about at 3%? For me, no. Maybe I’d look at the 30-year, though, to see if there would be enough yield pickup to influence my decision.

Why is this important to think about?

Rising interest rates can influence stocks in two ways:

–higher rates means higher interest expense for companies with large amounts of bank debt …which means earnings lower than they otherwise would be. I haven’t looked at any depth, and there must be some companies that would be negatively affected this way, but there’s been such immense issuance of corporate debt at lower interest rates that I can’t imagine that higher interest expense is an existential issue for the S&P. And, conceptually at least, this possible negative should me more than offset by gains in the value of corporate long-term debt issued over the past few years.

–at some point, rates can reach a high enough level that new money goes into bonds instead of stocks, and maybe old money leaves stocks for fixed income. I think this potential effect is the much greater threat to today’s stock values than simply rising rates.

more tomorrow

Peleton (PTON) and today’s stock market

This is a stock that I think embodies a number of important issues investors have to deal with in today’s US stock market.

PTON went public at $29 a share in September 2019. It had a follow-on offering in November of last year at $46 a share. In between those two dates, it had peaked at an intraday high of $171 in early 2021, as the stay-at-home market frenzy was at its strongest.

It has been all downhill since then. PTON closed at $24.60 last Friday.

Using the principles that Benjamin Graham, the father of “value” investing, articulated during the 1930s, PTON is still substantially overvalued. How so? Its earnings and cash flow are both negative; shareholders’ equity (also called book value) is a bit under $15 a share.

Nevertheless, the stock is up by about a third in premarket trading today, on reports that both Nike and Amazon are interested in buying the company.

What’s going on?

–PTON’s value, as I see it, is mostly in an intangible asset, its brand name. The main way the brand appears in financial statements is either as R&D or marketing. Both items are expenses, that is, reductions of income. So, arguably, the stronger the brand, the lower the current income.

A half-century ago, Warren Buffett pointed out this defect in a simple-minded earnings/cash flow approach to valuation. Suppose, for example, you wanted to create a brand name equivalent to PTON’s. It could easily take years, would probably cost a ton of money, and you might not be successful. Most likely, it would be much cheaper to buy the company. But you’d never see any of this from examining the company’s annual report. (You could add up a company’s actual advertising expenditures over the past, say, decade. For most consumer firms, this is a staggeringly high sum.)

Software companies have the same kind of accounting-rule bar to putting software development costs on the balance sheet. That’s because of technology accounting scandals from the 1970s.

–PTON management doesn’t get many All-Star votes. There’s already one activist shareholder clamoring for current management to be replaced. Myself, I thought the company’s response to young children being injured by the company’s treadmills was incomprehensibly wrong-headed.

–forced change of control may be impossible. As is common in today’s world, the PTON chairman owns a special class of shares that have extra voting rights. In this case, it’s 20x the voting power of ordinary shares. So he retains voting control despite owning only about 10% of the outstanding stock. This isn’t a trivial thing. A key reason activist value-oriented investors have been so unsuccessful over the years in places like Japan or the EU is that in both areas there’s been no way to take control out of the hands of incompetent incumbents.

I think the PTON case is particularly interesting. My hunch is that if we look closely enough the real “value” stocks today include a good number of still-unprofitable newer tech companies, some of which came close to trading for the value of their net working capital at the recent market lows. PTON developments might be the catalyst needed for investors to do some shopping in this bargain basement.