Cathie Wood and the “Buffett indicator”

One of the fundamental forces portfolio investors should be aware of is the tug of war between concept and valuation. Put a different way, between what growth prospects are for a company and the price we have to pay to own a piece of those prospects in the current market.

This question is important because loong history says that prices are determined as much by the hopes and fears of investors as by the objective characteristics of the company profits/profit growth we’re ultimately buying and selling. These emotions, which often feed on themselves, can vary from euphoria to depression.

To my mind, it’s like being in a sailboat sailing across the Atlantic (the fact that I don’t know anything about sailing doesn’t bother me, or matter here). Weather conditions–sunny skies or hurricane–can make a big difference in how you set your sails.

Warren Buffett recently observed that the ratio of the market cap of the S&P 500 to the current level of US GDP is unusually high–higher in fact than at the peak of the internet bubble of 1999-2000. I interpret this as saying that a gigantic storm is on the horizon. It’s just a question of when and how hard it hits.

According to news reports I’ve read (my quick search hasn’t unearthed a transcript) right after this Elon Musk asked Cathie Wood, owner of ARKInvest, what she thought. Her reply was that GDP underestimates US economic growth and, implicitly, that Buffett doesn’t get this. There’s a certain irony here since Buffett’s claim to a place in the American investor Hall of Fame is his understanding, way ahead of everyone else, that conventional accounting statements understate the value of companies with intangible assets like brand names and superior distribution networks.

As far as I can tell, the link between the market cap/GDP ratio and Buffett comes from a 1999 speech in which he describes it as a powerful indicator.

I encountered the idea for the first time–no Buffett name attached to it–in the mid 1980s, as investors and academics tried to come to grips with the apparent overvaluation of the Tokyo stock market. As an explanation, market cap/GDP only worked if you pretended that Europe didn’t exist. Yes, the Japanese market was trading at~2x GDP while the US traded at, say, .8x–these figures are at least directionally correct. That reinforced the idea, which led to terrible investment decisions for a half-decade, that Japan was expensive while the US was cheap. But during the same period, the German stock market was trading at 0.2X GDP, and going nowhere, despite strong GDP growth. The UK market, on the other hand, had a market cap well in excess of all of Continental Europe combined, even though its economy represented barely a fifth of the EU total. So even in the same economic bloc, UK stocks were crazy expensive while their German counterparts were dirt cheap.

Although the industry studiously ignored EU counterexamples to the simple market cap/GDP theory, it seems to me that both the UK and Germany were particularly instructive. In the case of London, most of the market cap represented foreign profits that derived from the UK’s former colonial empire. In Germany, it was (and remains) a question of investor preference: companies preferred to remain private and get the capital they needed from banks; investors had (have) a much greater desire for fixed income than stocks.

Back to the here and now.

At least half the revenues of the S&P 500 come from abroad. I think a much greater percentage of the revenue growth of the S&P comes from its non-domestic exposure. I suspect the foreign percentages for the NASDAQ are considerably higher still. So, in my view, what was a somewhat useful simplification 35 years ago probably doesn’t have much relevance today. That doesn’t mean stocks are cheap or that a storm isn’t on the way, just that market cap/GDP isn’t a great indicator.

What little I get from Cathie Wood’s response is that she seems to believe that the souls of mature iconic American companies are being eaten by insiders’ financial engineering that prioritizes current profits over future growth. Arguably, this will be exposed during the next economic downturn and that, therefore, such firms will not have the defensive characteristics that their size and (lower) PEs might suggest. Think: Intel.

semiconductor wars (ii)

If there has been a strategy to the Trump administration’s actions on semiconductors, it has been to try to lessen China’s dominance in advanced communication technology by denying China’s national champions access to state-of-the-art semiconductors that are either: manufactured in the US or that contain US intellectual property or that are manufactured by machines that use US intellectual property.

At the same time, however, Trump has substantially weakened the domestic technology industry by denying skilled industry workers entry to the US, based on his white racist ideology. He has also undermined the finances of domestic research universities by encouraging violence against Asian students, thereby discouraging them from coming to the US and enrolling. My point is that there seems to have been no long-term strategy to strengthen US tech and to close the 5G gap with China (in fact, quite the opposite), but rather only the simple-minded notion of doing near-term harm to firms like Huawei.

TSMC has already agreed to send lagging-edge machinery to a new foundry it intends to construct in Arizona and Intel has promised two more. Samsung is also planning to open a combination fab (for itself)/foundry in Texas. Plans for both are under threat, though, by current Trump-inspired legislative proposals in AZ and TX to suppress voting in Democratic areas of those states. Intel and AZ faced a similar situation in 2014, with large companies threatening to leave the state after the legislature passed a bill permitting merchants to refuse to serve LGBTQ customers. Under immense pressure from businesses, which the legislature shrugged off, the governor vetoed it.

How events will play out over the next ten years is hard to say. As an investor, however, one thing that interests is the idea that the semiconductor manufacturing industry has been made substantially less efficient today than it was even a year ago. China must take much more seriously than the lip service it has given to date to the need to develop its own chip manufacturing capabilities. Non-China firms that want to sell to China must now have both their research and the fabs they access located outside the US. The US, in turn, is suddenly aware of how dependent it is on TSMC and demanding to have state-of-the-art manufacturing facilities located domestically.

To me, this implies there’s going to be very strong demand, likely for years, for new semiconductor manufacturing equipment to fill fabs that will be built in both China and the US. Yes, there’ll be excess capacity, and yes the plants won’t be humming along at profit optimizing speed. But that will be a secondary concern, I think. The primary objective will be for plants to be either under control of the China camp or the US–because neither camp is likely to make its most advanced chips available to the other side.

What happens to TSMC, the world’s undisputed technology leader, is unclear, although recent reports say that, given Biden administration incentives, it is planning on opening as many as six new fabs in AZ.

This has never been my favorite area of tech and, I think, has typically not had the zip of the chip companies themselves. But I think circumstances have changed. I’ve been learning on the fly and already have established positions in AMAT, ASML and LRCX. These aren’t recommendations, just disclosure that I have an interest in this area.

semiconductor wars

About 25 years ago, the semiconductor business began an evolutionary change, one that encouraged separation of semiconductor design from semiconductor manufacturing.

Four reasons for this:

cost. As semiconductor designs became more complex, the cost of a semiconductor fabrication plant (fab) began to breach the $1 billion level. This became a substantial barrier to entry, not only because of the capital needed for construction but also because its efficient operation required it spew out $3 – $4 billion of annual output. What startup had that kind of money or that kind of sales.

sharing not a thing. No one wants to share manufacturing space with a rival who operates a fab, for fear its designs will be pirated. At the very least, the subcontractor is supporting a rival’s operations. Apple’s withdrawal from Samsung’s fabs is a prominent example.

work in a bureaucracy? There’s a tendency for companies to lose their entrepreneurial spirit as they get larger and begin to be controlled by professional managers who don’t have product knowledge. Think: GM, Intel, Microsoft under Ballmer, Disney under Eisner. (An aside: I find that how well I’m treated when I call a company, say I’m a shareholder (i.e., a part owner) and ask for information is a good indicator. The bad ones tend to support only brokerage analysts, who then try to sell info about “our” companies to you and me.)

In any event, entrepreneurs tend to have little interest in office politics.

alternative solutions. One is the emergence of trusted third-party fab companies, called foundries, the best of which is Taiwan Semiconductor Manufacturing Company (TSMC). A second is the development of Arm Holdings, a UK-based company now owned by Softbank (but, assuming regulatory approval, being sold to Nvidia), which provides extensive software templates for use in semiconductor design.

The prime example today of the older integrated model is Intel (INTC). It remains wedded to an architecture introduced in 1978. Formerly the world leader, it has recently been passed in fab capability by TSMC and in chip performance by smaller rival Advanced Micro Devices (AMD), a TSMC and ARM customer.

INTC’s simpler chips for server farms are now also being supplanted by proprietary designs (ARM + TSMC) by Google, Microsoft and Apple.

where we stand today

To summarize, the most advanced semiconductor chips are being designed by US firms, using UK-based ARM architecture and manufactured by TSMC in Taiwan.

A state-of-the-art fab now costs well over $10 billion. One can be built just about anywhere there’s land, skilled workers, reliable electricity and water. As a practical matter, the decision about location comes down to tax breaks.

Oddly, but on reflection maybe not so (think: Trump Steaks, or his Atlantic City casinos), the Trump administration announced its policy of denying Chinese companies access to US designs, despite there not being a cutting-edge fab located in the US. That has belatedly become a priority. TSMC has agreed to build an older-generation fab in Arizona, Samsung a big fab in Texas. We’ve since seen, however, how unreliable the power grid is in Texas. Probably more important, pending voter suppression legislation in both states threatens the viability of these projects.

Investment implications tomorrow.

Archegos vs. Long Term Capital Management (LTCM)

When I was thinking about leaving my job as a conventional global equities portfolio manager, I briefly considered setting up a hedge fund. I changed my mind pretty quickly, however, when I spoke with the investment bank I was considering to be my prime broker. The conversation was an eye-opener. It was clear from the outset that the broker had no interest in me or the product I would create. Its support in raising assets would be completely a function of the amount of financial leverage I would be willing to take on–the higher the better.

This mindset, more than anything else, explains for me the demise of Archegos, the hedge fund that collapsed last week. If press reports are accurate, the founder, Bill Hwang, had assets of about $10 billion (initially, at least) in his hedge fund. He had assembled a group of primer brokers, all large global banks, none of whom seemingly knew about any of the others. Hwang apparently called them together last week, after he was unable to meet calls for more collateral, to work out an orderly liquidation of Archegos’s holdings. The banks learned not only that their Hwang relationship wasn’t exclusive, but, more worrying, that they had collectively lent him somewhere between $50 billion and $100 billion to buy stocks like ViacomCBS and Discovery.

It sounds like the lenders fell into two camps. US-based firms wanted to liquidate immediately and non-US firms, in their vintage fashion, wanted the group to bury the losses in some dusty corner of their balance sheets and hope for the best. As soon as the meeting broke up, the Americans appear to have begun to line up buyers for the Hwang holdings, with the idea of cutting their losses as quickly as possible.

Perhaps the two most notable aspects of this situation are: that Hwang was able to borrow so much, despite a 2011 conviction for insider trading; and that foreign banks were so slow to act once they learned how fragile the Hwang situation was, allowing competitors to exit their positions first (meaning, at higher prices).

What ties Archegos and LTCM together is an enormous amount of leverage. Otherwise, they couldn’t have been more different. LTCM was founded by John Meriwether, former head of bond trading at Salomon Brothers, the powerful bond house in 1994. LTCM also had on its board two famous finance professors as front men. Its main trading strategy was a relatively pedestrian arbitrage in the Treasury bond market, which others on Wall Street at the time made fun of as something any commercial bank did in the normal course of business. LTCMs twist was to do this on a very large scale, to use sophisticated mathematical models and to apply large amounts of financial leverage.

A simple version of the strategy: A quirk of the Treasury bond market is that the issues that are components of bond derivatives (these bonds are “on the run”) tend to be highly liquid and to trade at somewhat higher prices than virtually identical issues that are not components (“off the run”) but can be highly illiquid. As they near maturity, the prices of on the run and off the run converge, since the Treasury will redeem both for $1000. What LTCM did was capture this price spread: short on-the- run issues, use the money to buy similar off-the-run issues and wait for price convergence.

Unfortunately for LTCM and its backers, after three years of success, the world economic situation changed. First came the 1997-98 Asian financial crisis, followed by the 1998 collapse of the Russian ruble and that country’s default on its foreign debt. This generated an enormous flight to safety by global investors, which pushed up the prices of on-the-run bonds. Off-the-run bonds didn’t follow because they were too difficult to buy.

The LTCM operation was large enough that a forced liquidation in a fearful time would have the potential to destabilize even the US government bond market. This worry compelled the Federal Reserve to orchestrate a rescue by a consortium of 14 banks that had been prime brokers to LTCM.

The similarities between the two cases are that both involved large amounts of money, a lot of financial leverage and ultimate failure. The differences, however, are a lot more important, I think. In the Hwang case, one individual with a sketchy past persuaded a number of banks to lend him a surprisingly large amount of money. When his firm failed, he did damage to his lenders, but it looks as if his holdings were unwound in a matter of weeks.

In the LTCM case, in contrast, the firm was chock full of bond market stars. The strategy was clear and the prime brokers appear to have known about each other, if not about the amounts lent. LTCM’s failure, however, was a much more serious affair. It threatened the stability of the US government bond market. Unwinding took the better part of two years.