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.

 

 

 

 

 

 

is 4% real GDP growth possible in the US?

the 3% – 4% growth promise

One of Donald Trump’s campaign promises is to create 3% – 4% GDP growth in the US.  Is this possible?

The first thing to note is that this is real GDP growth, meaning after inflation has been subtracted out.  I’m not sure Mr. Trump has ever clarified this–or that he wouldn’t be nonplussed by the question–but his appointees to head the Treasury and Commerce departments have said real is what they mean.  Also, 4% nominal (that is, including inflation) growth is about what the US has been churning out in recent years.  So promising 4% nominal growth would be like P T Barnum putting up his “This way to the egress” sign.

where does growth come from?

Simple models are usually the best (as in this case, feeling embarrassed when calling them “models” is a good indicator of simplicity).  Growth can come either by having more people working or by having workers be more productive, meaning churning out more output per hour.

more workers

Having more people working is a function of demographics.

Each year, the population of the US rises by about 0.8%.  Half of that comes from children being born to people already residing in the US; half comes from immigration.  If we take increases in the population as a proxy for increases in the workforce, then demographics can generate a bit less than 1% trend growth in GDP.

This also means that if Mr. Trump carries through on his threat to deport 3% of the workforce and restrict entry of immigrants, not only will the social consequences be shameful, he will make it that much harder to achieve his GDP objective.

productivity

Given that demographics will likely either not change, or will change in a negative way, getting to the low end of the 3% – 4% range will only be possible if worker productivity rises.   Let’s make the optimistic assumptions that the Republicans’ white supremacy rhetoric doesn’t discourage any potential immigrants and that there’s no increase in deportations.  If so, productivity gains would have to be at least +2.2% per year to achieve the low end of the GDP growth goal.

If +4% growth isn’t simply “marketing” in the worst sense of that word, the Trump camp must believe that productivity can be boosted to +3.2% per year.

An aside:  My first stock market boss was a vintage 19th-century capitalist.  He believed that increasing worker productivity meant boosting the workload–and making employees work longer hours for the same pay.  (No, there was no company store where we were forced to buy meals; yes, we had to basically provide our own office supplies.)

That’s not correct, though.  Productivity improvement comes through better employee education/training and by employers investing in labor-enhancing machines (back then, it would have been computer workstations, or in my firm’s case, pencils).

productivity today

Productivity today has been stuck at around +1% per year growth for about a decade.  During the housing bubble, when the US was furiously churning out many more new dwellings than the country could afford and banks were making crazy no-documentation mortgage loans (websites were also sprouting up to show low-income renters how to buy a house and scam the system for a year of “free rent” before foreclosure), we got to maybe +2.8% for a number of years.  But the last time the US rose above 3% was in the 1950s, when industry in Europe and Japan had been destroyed by war.

my take

I hope Wilbur Ross can do what he says.

I think +4% growth is simply hype–and that Mr. Ross, if not Mr. Trump, knows the situation.

The trend in manufacturing is to replace humans with robots. That’s the most straightforward way to achieve productivity gains. Output climbs steadily; output per worker goes up faster.  However, the number of employees shrinks drastically.   For many displaced workers supporting Mr. Trump, this may be a case of being careful about what you wish for.

 

 

 

 

 

value investing and mergers/acquisitions

buy vs. build

When any company is figuring out how it should grow its existing businesses and potentially expand into other areas, it faces the classic “buy or build” problem.  That is to say, it has to decide whether it’s more profitable to use its money to create the new enterprise from the ground up, or whether it’s better to acquire a complementary firm that already has the intellectual property and market presence that our company covets.

There are pluses and minuses to either approach. Build-your-own takes more time.  The  buy-it route is faster, but invariably involves purchasing a firm that’s only available because it has been consigned to the stock market bargain basement because of perceived operational flaws.  Sometimes, acquirers learn to their sorrow that the target they have just bought is like a movie set, something that looks ok from the outside but is only a veneer.

when the urge is greatest

Companies feel the buy/build expansion urge the most keenly at times like today, when they are flush with cash after years of rising profits.

so why isn’t value doing better?

Many economists are explaining the apparent current lack of capital spending by companies by arguing that firms are opting in very large numbers to buy rather than to build.

The beneficiaries of such a universal impulse should be value investors, who specialize in holding slightly broken companies that are trading at large discounts to (what value investors hope is) their intrinsic value.  Growth investors, on the other hand, typically hold the strong-growing companies with high PE stocks who do the acquiring.

On the announcement of a bid, the target company typically goes up.  The bidder’s stock, on the other hand, usually goes down.  That’s partly because the bid is a surprise, partly because the target is perceived to be priced too high, partly simply because of arbitrage activity.

All this leads up to my point.

Over the past couple of years, growth investing has done very well.  Value has lagged badly.  How can this be if merger/acquisition activity continues to be large enough that it is making a significant dent in global capital spending?

 

 

oil and gold: finding the commodity cycle bottom

I got my first couple of portfolio manager jobs in the 1980s because one of my industry specializations as  a securities analyst was natural resources.  Back then, there were an enormous number of mining analysts in an information industry based in London.  The large size and vitality of the analyst community were partly because there had been an enormous spike in the prices of gold and oil in the late 1970s-early 1980s. So investors were willing to pay handsomely for information and interpretation.  Also, the prevalent economic theory of the day, since proved to be woefully incorrect, held that a necessary condition for global economic growth was a continuously expanding supply of mineral resources.

When the Chinese economic expansion-driven commodities boom began a decade and a half later, I found that, unsurprisingly after 15 years of no one being interested, the entire stock market information infrastructure for metals had disappeared.  There were still the odd steel or oil analyst around eking out a living and staggering toward retirement, but little else, either in London or New York.

As far as I can see, from an information perspective the situation is at least as bad today.  In the perverse way that Wall Street works, however, that lack itself is the basis of the positive thesis for mining in general.

industry characteristics

Mineral extraction industries are very capital-intensive.  This means that projects typically require large amounts of up-front money. But they can often continue, once up and running, for long periods without new funds being put in.

Mining projects often have very long lives.

Very often, projects are also huge.  This is partly the nature of the beast, partly a function of the temperament of the people who run minerals companies.  This means that new supply is often added in gigantic chunks.  New supply almost invariably arrives in amounts way above the increase in demand and typically, therefore, marks the high water mark in terms of price.  Boom and bust, boom and bust–the rhythm of these markets.

finding the bottom

Falling prices indicates that there’s more supply than demand.  In theory, that situation can be reversed either by demand expanding or by supply contracting.  In practice, the first rarely happens.

What establishes the bottom for these markets, in my experience, is a price decline that’s deep enough to force high-cost capacity to close.  This does not mean the price at which companies stop earning a financial reporting profit.  That price is too high.  That’s because it includes as an expense a non-cash allowance for recovering the money spent to open the project.  A company can also be compelled to sell at unfavorable prices by creditors.

What actually matters is the point at which the out-of-pocket cash cost of getting output out of the ground is less than what it can be sold for.  That’s the point at which projects begin to shut themselves down.  They may not do so immediately.  They may continue to bleed in the hope of an imminent turnaround.

For gold, the relevant figure is around $850 an ounce, I think.  Oil is a bit more complicated, but the magic number is likely about $40 a barrel.

More tomorrow.

 

 

oil at $80 a barrel–a Saudi plot?

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.

 

 

 

“New World Order”: Foreign Affairs

The July/August 2104 issue of Foreign Affairs contains an interesting conceptual economics article titled “New World Order.”  It’s written by three professors–Erik Brynjolfsson (MIT) , Andrew McAfee (MIT) and Michael Spence (NYU)–and outlines what the authors believe are the major long-term trends influencing global employment and economic growth.  I’m not sure I agree 100%, but I think it’s a reasonable roadmap to start with.

Here’s what the article says:

the past

Globalization has allowed companies to exploit wide wage differentials between countries by moving production from high-cost labor markets close to consumers to low labor cost areas in the developing world.  Former manufacturing workers in high-cost areas enter the service sector to seek employment, depressing wages there.

This period is now ending, as relative wage differentials have narrowed.

now

Relative labor costs are at the point where manufacturing plant location is determined by other factors.  These include:  transportation cost, turnaround time for new orders and required finished goods inventory.  This implies that manufacturing can be located closer to the end uses it serves.  However, globally higher labor costs also imply that new factories will be much more highly mechanized than before.  Robots replace humans.

As a result, wage growth will remain unusually subdued.

the future 

Although returns to capital have avoided the erosion that has befallen labor over the past generation, this situation won’t last.  Long-lived physical capital is being replaced by software (note:  the majority of investment spending done by US companies is already on software).

Software doesn’t have either the total cost or the permanence of capital invested in physical things.  Software can be moved, it can be duplicated at virtually zero extra expense.  To the extent that software replaces physical capital as a competitive differentiator, it makes the latter obsolete.  It, in turn, can be made obsolete by the innovative activity of a small number of clever coders.

Therefore, the authors conclude, returns on invested capital (especially physical capital) are already beginning to enter secular decline.

Where will future high returns be found?

…in the innovative activity of talented, well-educated entrepreneurs.

education

This brings us to a major problem the US faces.  It’s the relative slippage of the domestic education system vs. the rest of the world, and an increased emphasis on rote learning (No Child Left Behind?).

The trio dodge this politically charged issue–they do observe that there’s a direction relationship between the quality of a community’s schools and the affluence of its citizens–by asserting that online learning will come to the rescue.  A child stuck in a weak school system will, they think, be able to in a sense “home-school” himself to acquire the skills he needs to succeed in the future they envision.

my take

What I find most interesting is the presumed speed at which the authors seem to think transition will occur.

–Is it possible that we’ve reached the point where there’s no available low-cost labor left in the world?  If so, this is a dood news/bad news story for low-skill workers.  On the one hand, downward wage pressure will stop.  On the other, robotization is going to take place at warp speed, making it harder to find a job.

Relocation of factories will also have implications for transportation companies, warehousing and even the amount of raw materials tied up in company inventories.

–Does software begin to undermine hardware so quickly?  Certainly this the case with online retailing and strip malls.  But how much wider is this model applicable?

–If the key to future growth is young entrepreneurs, then the sooner we as investors reject the Baby Boom and embrace Millennials the better.  This, I think, is the safest way to benefit in the stock market if the New World Order thesis proves correct.

 

 

thinking about big integrated oils

hedge funds attacking Big Oil?

Over the weekend I read a blog post (which I can no longer find) in the Financial Times pointing out that activist investors are getting set to attack the large integrated oils.

Why?  

They persist in investing in massive long-term, risky, low-return oil exploration and development projects.  It’s what they do.  In the view of the hedge funds, this makes no sense.  The oils would be better off finding better things to do with their cash flow, returning it to shareholders if nothing else.

I doubt that this will happen   ..not that hedge funds may not try to change oil company investing plans, but I don’t think they’ll be successful.

Big Oil is important in developed countries because the companies spend a ton of money securing access to petroleum.  Nations are heavily dependent on oil to fuel industry.  The oil firms get huge tax breaks for finding and developing oil deposits because these nations are heavily dependent on oil to fuel commerce and for heating.  This is especially true in the US, which is unique among richer nations in not responding to the oil shocks of the 1970s by taxing oil to control consumption.  We do this to support our globally non-competitive, but politically powerful, auto industry (most of which went bankrupt in the Great Recession anyway).

Given the strategic importance of oil,

why are the returns to oil exploration low?

A generation ago, they weren’t.  Drilling took place mainly in the developed world, often on parcels leased to the driller by the government.    The landowner got an initial payment plus a modest percentage of any finds.  Projects that made good economic sense when oil sold for $7 a barrel are bonanzas today.  Big Oil got most of that.

In contrast, major exploratory drilling today is done in emerging economies, where the big untapped pools of oil are.  But ever since the first nationalizations of drilling projects in the Middle East in the 1970s showed how one-sidedly favorable production agreements were to the oil majors, terms have been tilted much more heavily toward the host nations.  Today’s production agreements provide little more than a specified return on capital to the oil explorer.  Price hike windfalls go to the host, not the big oil.

In the face of less favorable economics,

why continue to drill?

Three reasons:

–it’s still profitable

–it’s what the oils do best.  The last round of oil company diversifications, admittedly a long time  ago, were unmitigated disasters, and

–the home countries of the major oils need a steady supply of oil to keep industry humming and citizens warm in winter.

It’s this third reason that I don’t think activists see.   

At some point, shale oil may change the situation.  Even so, I figure it would be politically unacceptable for any big integrated to dismantle, or even substantially curtail, its exploration and development efforts.  The worry would be that in times of shot supply, oil would go solely to project developers.  In fact, Asian countries are concerned about this possibility that they’ve designated their big oils as “national champions,” whose job is to secure oils supplies for the home country.  Profits are secondary.

I don’t think Washington, or London, or Paris would allow its oil exploration firms to drop out of the race, even if short-term economic returns to the companies and their shareholders might be better if they did so.