following the money; the fashion industry and working capital

I was reading an article in the Financial Times the other day about pandemic-created issues in the high-fashion modelling agency business–something I’ll confess to knowing virtually nothing about.

Part of my interest is just securities analyst nerdiness. Part is that the FT is a highly reliable source, providing information that’s almost always accurate. Also, I think the story illustrates the more general point for us as investors that a simple look at receivables and payables on the balance sheet can provide a lot of insight into the economic power relationships in an industry.

The main players here:

–the models. They’re freelancers. They get assignments from modelling agencies, pay all their own expenses and get paid after they do the work (in arrears, as the accountants say)

–the agencies. They’re middlemen. They get assignments from branded merchandise companies and fill them with models they’re in contact with. The agencies also get paid in arrears

–the fashion brands. After crafting selling campaigns for their merchandise, they hire agencies to fill their need for photography and runway models. The brands pay in arrears.

in general…

…in a commercial relationship the entity that receives credit (or services in advance of paying for them, which is basically the same thing) is in a stronger position than the one that supplies it.

–Models would seem to be in the worst position of the three groups, since they pay for all their working expenses in advance and get paid only after the assignment is over. In accounting jargon, they are converting an asset on their personal balance sheets, cash, into another, less valuable, asset, receivables (meaning trade IOUs)

–Agencies are in a somewhat better position. They make a few phone calls, get an assignment from a fashion brand (the money from which they list on their balance sheet as a receivable) and line up a model (whose compensation they list on the liabilities side as a payable). Assuming the agency is a money-making enterprise, the receivable is considerably larger than the payable)

–Fashion brands hold the market power. They order a model and pay the agency for services afterwards. They list what they’ve promised to pay the agency on their balance sheets as a payable.

This is the first round of analysis: having all payables and no receivables is the best position to be in; having receivables without payables is the worst. For firms with both, the net of the two–payables minus receivables–is what counts.

round two

Round one is usually enough to get a sense of market power. There are a couple of wrinkles to consider.

–not everybody pays on time; in fact, not everybody pays, period. The balance sheet reserve for doubtful accounts will reveal what a firm’s historical experience has been

–if receivables are due to be paid to you in three months but your payables are due in two weeks, you have a cash flow problem. The typical solution is a growing amount of short-term debt. This situation is also a sign of lack of market power. Customers can demand very favorable payment terms, while suppliers insist on being paid almost immediately.

about the modelling industry in particular

According to the FT, modelling agencies are facing hard times for several reasons. Fashion houses are doing what many big firms do when times are tough–they are slowing down payments to their suppliers. As well, some smaller clients have gone out of business before paying their bills, making those receivables worth little, if anything. Both developments make it harder for agencies to pay models who have already completed assignments.

more changes brewing

Worse for agencies and models, the FT says fashion brands are being forced by travel restrictions and social distancing rules to innovate away from the elaborate, model-intensive runway shows they traditionally stage to introduce new merchandise. The same for elaborate photo shoots used to generate publicity materials. In fact, Gucci and Burberry have both used their own employees as models to launch new collections.

My guess is that many pandemic-forced “fixes” by the fashion brands will become permanent. Two typical motivations: the firms will find that eliminating large in-person events and lavish photo displays will have little negative effect on revenues, so their necessity will begin to be questioned; it’s usually much easier to convince the board of directors to cut large outlays than it is to get the funds reinstated.

Perhaps most important, if I’m correct, the weakening of the scope and influence of these expensive displays, or their demise, will remove a significant barrier to entry for newer, smaller brands.

parts of an email from yesterday

I guess you’ve seen all the stuff about huge buying of options on individual tech stocks, both by Bar Stool-style traders and by Softbank, driving tech stocks up.  My guess is that has ended for now.  If so, it will probably take a week or so for trading in the big tech names to settle down.

I’ve read that when the Tokyo market found out what Son had been up to, and had made $4 billion on speculative options trading, Softbank dropped by 8% (?), losing shareholders $20 billion in market value.  That’s because what he did is bet-the-company crazy.

One of the things I’ve noticed is that some second-line names are doing much better (meaning falling more slowly) than what must be Robinhood-ish favorites.


It’s never clear what triggers a market selloff.  In this case, though, it’s doing a healthy thing by readjusting relative values among different groups of stocks–something I’ve thought would happen by a temporary reversal of leadership in an uptrend.

I think the fact that at zero interest rates stocks are the only game in town means stocks will drop to some longer-term trend line, stabilize, and then begin to move up again.  A hope, not a belief–at the close today NASDAQ seems to have hit the bottom of a channel it’s been in since April.  (It’s also about 25% above its March high, which says these are not bargain-basement levels.)


Over the past 5 trading days, NASDAQ is down by -9.2%, the S&P by -5.5%, and the Russell by -4.7%, so there is outperformance of a sort by the R2000.
Very often after a big selloff, market leadership changes.  That didn’t really happen in March, although afterwards the R2000 began to keep up more with the S&P for several months.  My sense is that the market wants to broaden out to find non-tech stocks that will do well over the next year or two.  This is why consumer discretionary names have been doing well recently.  But because some kinds of tech are going to be long-term winners, the move has to be based on finding consumer names that have good growth prospects, not just that they’re in another sector. 

The market hasn’t gotten conviction yet with this idea, probably in large part because Trumponomics gets loonier by the day.  The near-term economic outlook in the US had already been deteriorating before his latest China ideas, and won’t have a chance to be better unless he’s defeated in November.

Then there’s the human side of things. Who’d have thought we’d see George Wallace reincarnated, or the Waffen SS recreated, or scary abuse of power in the Justice Department–or that the Joint Chiefs would feel the need to say they would not obey any Trump orders to use troops to deny Americans their civil rights.

 
The last two paragraphs both bear on stocks like NWL.  Arguably, NWL is a true “value” name.  That is, all the bad stuff–and more–that could reasonably be expected to happen has already taken place and been factored into the stock price.  So it has some downside protection. It’s also economically sensitive and non-tech; and maybe if management can use the company’s assets competently, good things will happen. 

Another way of putting this is that in a world where TSLA can be down 30% in a week maybe the value formula of dead money for now with the hope of upside later on isn’t so bad to have as part of a portfolio.

Warren Buffett and the Japanese sogo shosha

Yesterday, Warren Buffett announced that one of his insurance companies, National Indemnity, has acquired 5%+ positions in each of the five largest general trading companies (sogo shosha) in Japan. The yen currency asset exposure this creates is reportedly hedged through National Indemnity’s ownership of yen-denominated liabilities.

Buffett has given no rationale that I’ve seen for his purchase, although press reports point to stock prices at 75% of book value.

As it turns out, I spent a lot of time studying the Japanese trading companies at one point in my working career. I was a significant shareholder in Mitusbishi Corp. for a couple of years, and got to know that company quite well.

The general trading companies grew in importance to the Japanese economy after WWII as the country became a growing exporter of all sorts of goods. Each of the large industrial conglomerates (zaibatsu/keiretsu)–Mitsubishi, Mitsui, Sumitomo…–consolidated all its dealings with foreign countries, especially trade finance, in a single entity, its in-house trading company. Given that Japan is a natural resource-poor country, lacking energy resources in particular, the keiretsu were tasked by Tokyo with arranging for steady energy supplies. This task fell to the sogo shosha, as well.

The obvious investment attraction of the sogo shosha is that they’re cheap. On the other hand, they tend to remain cheap, for several reasons:

–the trading companies are embedded in the old samurai-era conglomerate structure. This is the most rigidly hierarchical, stuck in the mud part of the Japanese economy. They are tightly bound to the conglomerate whose name they bear and a re not free to make the economically best decisions for themselves

–they tend to have hundreds of subsidiaries, without any apparent desire to rationalize their structure

–they’re basically finance companies, which tend to trade at low multiples

–in the energy area, they act as national champions, not necessarily as profit-maximizing entities for themselves.

It will be interesting to see whether in this case Buffett is much more deeply knowledgeable about these Japanese firms than I am or whether this is another case of beefing up tech exposure by buying IBM because it looks cheap.

the Fed’s new inflation stance

Fed Chair Powell, speaking virtually at what would otherwise be the annual monetary policy conference in Jackson Hole, Wyoming, set out a new protocol yesterday for what the Fed would do if the US ever had inflation (a sustained period in which prices in general rise) again.

The old policy was to begin to choke back economic growth by raising interest rates once price increases started to roll, with the objective of holding inflation at or below a 2% annual rate. The new policy is basically to not be so eager, but rather to sit back for a while and see what happens.

Why the change? What does it mean?

some context first

The late 1970s was a baaad time for the US economy. Politicians had successfully arm-twisted the Fed into running an extra-loose money policy for most of that decade. This ended up creating runaway inflation, an economy-killing disease thought to only be found in the worst third-world countries (and Weimar Germany, of course). Prices were rising at close to an 8% clip in 1978, with 11% in prospect for 1979 and progressively bigger figures after than.

Families began to turn their paper money into physical things as fast as they could so that inflation wouldn’t eat into value. They accumulated large inventories of everyday items, on the idea that they’d only be more expensive later on. This hoarding itself drove prices up more. Companies began to borrow heavily, thinking they’d make money just by repaying fixed-rate loans in inflation-diluted dollars. They used the funds to acquire hard assets–real estate developments or gold mines or cement plants or ships–that had absolutely nothing to do with their core businesses but which they told themselves would be inflation-proof and maybe even rise in value.

To shatter the belief in ever-rising prices, and the loony-tunes behavior it sparked, Paul Volcker raised the fed funds rate to 20% in early 1980 and kept it ultra-high until mid-1981, causing a deep recession. This also made prices fall, breaking the inflationary spiral that had developed in the late 1970s. This left families trying to figure out what to do with eight years’ worth of canned goods and corporate boards stewing about their brand-new gold mines–just as the gold price began a fourteen-year swoon.

a 2% target

As inflation and nominal interest rates both continued to decline for decades (the 10-year Treasury yieldid about 5.7% in 1999), theoretical economists began to discuss what the ideal inflation rate might be. They arrived at 2% as their ultimate goal. The Fed decided to see if it could accomplish this with the real economy.

And it succeeded. Some years ago, however, it and other national central banks began to realize that while they’d done a bang-up job getting interest rates down, they had somehow lost the ability to get them, even temporarily, to move in the other direction. What was once an aspirational downside goal had suddenly become an unattainable ceiling.

How so? Who knows. The result is that the world has been constantly been flirting with deflation–the bane of the Great Depression of the 1930s. Whoops.

back to Powell’s statement

I think he’s saying two things:

–given the gigantic amount of government debt run up by Trump administration bungling and its questionable decision to fund the lion’s share in very short-term instruments (which disguises the extent of the damage but puts the country at risk should rates begin to rise), he is not about to create a new crisis by prematurely raising short rates

–given that monetary theory has trapped us in a place where traditional policy tools don’t work so well, Powell would like to see us well above the 2% line before he begins to tighten

Yields went up by a mere 0.05% on the announcement, meaning Wall Street had been assuming the Fed would remain an island of calm in a sea of administration economic madness.

end game (iii): if Biden wins…

As I mentioned earlier in the week, the investment implications of a Trump reelection are straightforward. As an American, I’d be deeply shocked and disappointed by the implied repudiation of traditional American values. As an investor, I’d expect a continuation of the “flight capital” market we have been in for some time, with a return of the domestic economy-centric Russell 2000 names to the bear market they had been in for most of Trump’s time in office, until late March of this year.

I find the stock market consequences of a Biden victory much harder to handicap. My thoughts so far:

–the transition of power might not be smooth. Trump has already declined to say he will accept the election result if he loses. He has begun to disrupt mail service on the, perhaps mistaken, idea that this will suppress more votes for Biden than for him. More “dirty tricks” may be in the offing. He may also end up testing the limits of the law by pardoning himself for any crimes he may have committed before or while in office.

Worries about abuse of power may have some negative effect on stocks around election time. It’s equally possible, though, that, sensing defeat, traditional Republicans will distance themselves from Trump in advance (as some seem to me to be already doing this), signalling that party loyalists should no longer follow Trump, thereby minimizing the damage he might otherwise do. It’s hard to know, but it says volumes about Trump that musing about what amounts to a post-election coup attempt doesn’t sound totally crazy. Can we be even remotely similar to Moscow 1991?

–interest rates will likely remain low for a long time. This is a distinct plus for stocks, for three reasons: they will remain attractive vs. the two other liquid asset classes, cash and bonds; bonds are unlikely to fall in price because of rising short-term interest rates, a development that would lead investors of all stripes to rebalance away from stocks; and the cost of carrying the mammoth amount of debt run up under Trump–with more possibly needed to repair damage he has done–will remain low. In fact, as I’m writing this, there are reports that the Fed will soon announce its intention to retain near-zero interest rates for the next half-decade

–income taxes will certainly go up, both for wealthy individuals (this doesn’t matter so much for the economy as a whole because the rich don’t tend to change their spending very much as income goes up and down) and for corporations. This latter means the 50% or so of S&P earnings that come from US operations will fall by, let’s say 8%. The resulting 4% drop in overall earnings is not good, but it comes closer to being a rounding error in analysts’ estimates than a serious shortfall. In today’s volatile stock trading, it amounts to maybe two or three down sessions in a row

–on the other hand, there’s lots of low-hanging economic fruit begging to be picked. The Trump economic program is a hodge-podge of wackiness, whose effect has been to please rich donors but to retard overall GDP growth, not foster it. Closing the borders to immigration, for example, shrinks GDP expansion by more than a third. Placing tariffs on imports has squeezed real incomes; retaliation has decimated the revenues of exporters, especially farmers. Trump’s central concept–restore low-wage manual labor jobs to the US while driving computer and engineering firms out of the country because they employ non-white foreigners–is about as loony as it gets. So too encouraging Detroit to keep on making gas-guzzlers while the rest of the world turns electric. Hard to quantify, but just ending insane programs has got to be good

–there are thornier issues to face, as well. Trump left actual tax reform both out of the name and the provisions of the Tax Cuts and Jobs Act of 2017, which did nothing to address sweetheart industry tax breaks that have long since passed their sell-by date. National infrastructure is four years older and creakier without having been touched …nor have Social Security or Medicare problems been addressed

–then there’s other senseless Trumpish stuff, like the ultra-strange attack on the viability of major domestic research universities, a national treasure, by denying deep-walleted foreigners access to them. The point is there are enough shoot-yourself-in-the-foot Trump things to just stop doing, for the resulting positives to dwarf the losses from a higher corporate tax rate and reversal of the tax giveaway to the rich.

my preliminary conclusion

Delegitimize white racists and let foreign workers back in and the country will be on the road to economic expansion again. No more crazy gains like in 2020 so far, but a shot at +10%. Maybe all the running next year will be in domestic consumer names.