building a new company HQ–a sign of trouble ahead?

This is a long-standing Wall Street belief.  The basic idea is that as companies expand and mature, their leadership gradually turns from entrepreneurs into bureaucrats.  The ultimate warning bell that rough waters are ahead for corporate profits is the announcement that a firm will spend huge amounts of money on a grandiose new corporate headquarters.

An odd article in the Wall Street Journal reminded me of this a couple of days ago.  The company coming into question in it is Amazon, which has just initiated a search for the site of a second corporate HQ.

What’s odd:

–why no comment on Apple’s new over-the-top $5 billion HQ building?

–the headquarters idea was followed by a discussion of research results from a finance professor from Dartmouth, Kenneth French, which show that publicly traded firms with the highest levels of capital spending tend to have underperforming stocks.

I’ve looked on the internet for Prof. French’s work, much of which has been done in collaboration with Eugene Fama.  I couldn’t find the paper in question, although I did come across an interesting, and humorous, one that argues the lack of predictive value of the capital asset pricing model (CAPM)–despite it’s being the staple of the finance theory taught to MBAs.  (The business school idea is apparently that reality is too complicated for non-PhD students to understand so let’s teach them something that’s simple, even though it’s wrong.)

my thoughts

–money for creating/customizing computer software, which is one of the largest uses of corporate funds in the US, is typically written off as an expense.  From a financial accounting point of view, it doesn’t show up as capital spending.

–same thing with brand creation through advertising and public relations.  I’m not sure how Prof. French deals with this issue.

Over the past quarter-century, there’s been a tendency for companies to decrease their capital intensity.  In the semiconductor industry, this was the child of necessity, since each generation of fabs seems to be hugely more expensive than its predecessor.  Hence the rise of third-party fabs like TSMC.

For hotel companies, it has been a deliberate choice to divest their physical locations, while taking back management contracts.  For light manufacturing, it has been outsourcing to the developing world, but retaining marketing and distribution.

 

What’s left as capital-intensive, then?  Mining, oil and gas, ship transport, autos, steel, cement, public utilities…  Not exactly the cream of the capital appreciation crop.

 

At the very beginning of my investment career, the common belief was that high minimum effective plant size and correspondingly large spending requirements formed an anti-competitive “moat” for the industries in question.  But technological change, from the 1970s steel mini-mill that cost a tenth the price of a blast furnace onward, has shown capital spending to be more Maginot Line than effective defense.

So it may well be that the underperformance pointed to by Prof. French has less to do with profligate management, as the WSJ suggests, than simply the nature of today’s capital-intensive businesses–namely, the ones that have no other option.

 

 

 

 

 

 

the amazing shrinking dollar

So far this year, the US$ has fallen by about 14% against the €, and around 8% against the ¥ and £.

A substantial portion of this movement is giveback of the sharp dollar appreciation which happened last year after the surprise election of Donald Trump as president.  That was sparked by belief that a non-establishment chief executive would be able to get things done in Washington.  Reform of the income tax system and repair of aging infrastructure were supposed to be high on the agenda, with the resulting fiscal stimulus allowing the Fed to raise interest rates much more aggressively than the consensus had imagined.  Hence, continuing dollar strength on a booming economy and increasing interest rate differentials.

To date, none of that has happened.   So it makes sense that currency traders would begin to reverse their bets on.  However, last year’s move up in the dollar has been more than completely erased and the clear consensus is now on continuing dollar weakness.

 

Dollar weakness has caused stock market investors to shift their portfolios away from domestic-oriented firms toward multinationals and exporters.  This is the standard tactic.  It also makes sense:  a firm with costs in dollars and revenues in euros is in an ideal position at present.

It’s interesting to note, though, that over the weekend China lifted some restrictions imposed last year that limited the ability of its citizens to sell renminbi to buy dollars.

To my mind, this is the first sign that dollar weakness may have gone too far.

It’s too soon, in my view, to react to this possibility.  In particular, the appointment of a new head of the Federal Reserve could play a key role in the currency’s future path, given persistent Republican calls to curtail its independence.  Gary Cohn, the establishment choice, is rumored to have fallen out of favor with Mr. Trump after protesting the latter’s support of neo-Nazis in Charlottesville.

Still, it’s not too early to plot out a potential strategy to benefit from a dollar reversal.

 

 

why September is usually a bad month for US stocks

It has to do with taxes on mutual funds and ETFs, whose tax years normally end in October.

That wasn’t always true.  Up until the late 1980s, the tax year for mutual funds typically ended on December 31st.  That, however, gave the funds no time to close their books and send out the required taxable distributions (basically, all of the income plus realized gains) to shareholders before the end of the calendar year.  Often, preliminary distributions were made in December and supplementary ones in January.  This was expensive   …and the late distributions meant that part of the money owed to the IRS was pushed into the next tax year.

So the rules were changed in the Eighties.  Mutual funds were strongly encouraged to end their tax years in October, and virtually every existing fund made the change.  New ones followed suit.  That gave funds two months to get their accounts in order and send out distributions to shareholders before their customers’ tax year ends.

getting ready to distribute

How do funds–and now ETFs–prepare for yearend distributions?

Although it doesn’t make much economic sense, shareholders like to receive distributions.  They appear to view them as like dividends on stocks, a sign of good management.  They don’t, on the other hand, like distributions that are eitherminiscule or are larger than, say, 5% of the assets.

When September rolls around, management firms begin to look closely at the level of net gains/losses realized so far in the year (the best firms monitor this all the time).  In my experience, the early September figure is rarely at the desired target of 3% or so.  If the number is too high, funds will scour the portfolio to find stocks with losses to sell.  If the number is too low, funds will look for stocks with large gains that can be realized.

In either case, this means selling.

Some years, the selling begins right after Labor Day.  In others, it’s the middle of the month.  The one constant, however, is that the selling dries up in mid-October.  That’s because the funds’ accountants will ask that, if possible,  managers not trade in the last week or so of the year.  They point out that their job is simpler–and their fees smaller–if they do not have to carry unsettled trades into the new tax year.  Although the manager’s job is to make money for clients, not make the accountants happy, my experience is that there’s at least some institutional pressure to abide by their wishes.

Most often, the September-October selling pressure sets the market up for a bounceback rally in November-December.

 

 

 

auto companies and their financing affiliates

Last Friday the Wall Street Journal reported that Ford is going to use new measures of creditworthiness beyond FICO scores that will allow it to approve loans to borrowers now considered too risky to provide financing to.

 

One of the reasons I’ve rarely owned auto company stocks is not just that they’re highly cyclical.  I (hope I) can deal with that.  Rather, it’s it seems to me that, invariably, as the car-buying cycle matures, operating and sales executive put pressure on the captive lending arm of the company to make riskier and riskier loans.

This happens it two ways:  more liberal lending policies; and increasingly optimistic assessments of the resale value of leased cars (called residual value) when they are returned at the end of the lease.

The poster child for this type of behavior is Mitsubishi Motors, which tried years ago to jumpstart US sales through a “triple-zero” sales campaign.  It offered loans with no down payment, 0% interest and no payments for the first year.  The campaign produced an unwanted fourth zero when virtually no one made loan payments when required–and the firm only avoided bankruptcy through a Japanese style rescue by the less-than-pleased other members of the Mitsubishi industrial group.

 

Generally speaking, the PE multiple for companies whose earnings are very cyclical tends to contract as the cycle nears its peak.  For auto firms, and other companies with similar in-house financing operations, this contraction is especially severe because investors fear that too-generous financing may boost sales today but be offset by big writeoffs in a year or two.  Because of this, investors are not willing to pay for what they regard–historically, correctly–as artificially inflated results.

Maybe Ford will be different this time, but my guess is that investors will at least initially regard results with skepticism.

 

 

Jeep as a Chinese brand

A mainland Chinese company, Great Wall Motor of China, has recently expressed interest in acquiring either the Jeep brand + manufacturing operations or all of Fiat/Chrysler.

The press has since been filled with commentary whose thrust is that Washington will oppose either sale proposition.

Several things strike me as odd about this:

–brands like Volvo and Jaguar have looked a lot more interesting recently since coming into Asian hands, so that shouldn’t be an issue (although this is likely the crux of the matter)

Jeep is now part of an Italian company   …which bought it from a German firm that was slowly sinking under the weight of a senescent Chrysler   …which had been foundering despite a government bailout in the 1970s and a huge injection of badly needed engineering talent under Daimler.  So a firmer economic footing for the whole Chrysler enterprise is unlikely to come without outside-the-box thinking.  Also, it’s hard to make a logical argument that foreign ownership for any part of Chrysler is a problem

–if the Great Wall Motor interest is real, it suggests the company has access to foreign exchange at a time when Beijing is cracking down on reckless foreign m&a by domestic corporations.  That likely means that Great Wall has enough influence in China to be able to expand the Jeep brand’s reach quickly

–I haven’t heard a lot of posturing from Washington.  Either I’m really out of touch on this one, or the anti-Great Wall sentiment is mostly in the minds of reporters.

the Wall Street Journal’s new direction

The Wall Street Journal recently announced a reorganization intended to narrow its focus back toward politics and business, as well as to shift its orientation from print  to online.

As far as the stock market is concerned, the WSJ now seems to be trying to provide less news and more analysis.

But I’m finding the new analysis tack to be quite odd.  For example:

–two days ago, an article pointed out that shoppers are frequenting low-price retailers.  Yes, that’s true, but there was no acknowledgement that this trend has been going on for ten years

–yesterday’s paper pointed out that companies are preparing for higher short-term interest rates by tightening up their working capital management.  Potentially very interesting.  Unfortunately, the authors didn’t have much of a grasp of what working capital is, so the article’s usefulness was limited

–a third article, this one also from yesterday, contrasted the performance of value-oriented ETFs and their growth counterparts.  It also would have been a lot better if the author had a basic idea of what growth investing is   …and had refrained from using the disparaging term “momentum” for growth.

 

What could be going on?

–maybe it’s just August

–it could be a change in editors or in reporters

–it might also be sources.  To the degree that the Journal relies on interviews with professional Wall Street analysts, it could be that cutbacks on the sell side have diminished the available information.  Or it might be that the sell side is preparing for the day (coming soon, I think) where it will begin to charge cash instead of soft dollars for their research.  So brokers may have already begun to limit the information they will release for free.

If it’s not the first of these, we’ll all have to become a little more creative in how we access basic data.

At least there’s still the FT.

 

21st century retailing: my trip to Home Depot

This is another mountain-out-of-a molehill thing.

We have Toto toilets in our house.  Toto is the leading brand in Asia and has been making significant inroads in the US over close to two decades.  Yes, they’re the toilets that play music, heat the seat, double as a bidet and make fake urinating noises (a Japanese must)–but we just have plain old toilets.

The other day, I went to the local Home Depot, which, by the way, sells Toto toilets, to get a replacement part for one of ours.  A friendly employee showed me where the replacement parts were–all aftermarket brands, not Toto, but that was ok with me–and which was the right one. The replacement didn’t look much like the broken part, but the employee assured me that it would work.

It didn’t.  And, in fact, in looking back on my trip, the HD employee may, strictly speaking, have only told me that that was all they had.  If so, kind of embarrassing for me, since for most of my working life I was on the alert for verbal gymnastics aimed at papering over problems.

Rather than launch a telephone search for a plumbing supply store in the neighborhood that might carry the part I needed, I found it on Amazon.

 

Around the same time, I found I needed a replacement part for a Weber grill.  Same story.  HD sells Weber grills, but not replacement parts.  So, after a wasted trip to the local HD store, I ordered from AMZN.

 

What’s interesting about this?

In the early days of the internet, there was lots of speculation about the “long tail,” meaning that e-retailers like AMZN would make most of their money from selling obscure items that potential buyers couldn’t find in bricks-and-mortar stores.

A great story   …just not the case back then.  Just like bam, online exhibited the “heavy half” phenomenon, i.e., 80% of the business came from 20% of the items.

 

But maybe the long tail is beginning to come true.  It’s not because weird stuff that no one really wants has suddenly come into vogue.  Instead, I think computer-driven inventory control programs that eliminate slow-moving items from a store’s offerings may have gone too far.  Yes, carrying fewer items has the beneficial effect of requiring fewer employees and less floor space.  But at some point, the process begins to have negative consequences, as well.

For instance, it’s training me not to go to a physical DIY store, so I’m not passing by enticing end cap displays or being tempted by the sparkly high-margin junk arrayed along the checkout line.

 

My experience as an analyst has been that any cost-control measures always seem to go too far.  They work for a while, but the continual application of the same process somehow eventually ends up creating the opposite of the intended effect (yes, experience has made me a Hegelian, after all).  This may be what is starting to happen with inventory control programs that retailers use.

If I’m correct, this is another plus for AMZN.