Warren Buffett and Amazon (AMZN)

I read a recent comment Warren Buffett made expressing his regret at never having bought AMZN.

As far as I can see–and I’ve never met Mr. Buffett–he’s an urbane, sophisticated, complex individual who chooses a down-home persona to market himself to the world.  I don’t regard anything he says that involves the stock market as being a stray, off-the-cuff remark.  I wonder what he meant.

the top ten

As of March 31st, Berkshire Hathaway’s top ten holdings are, in order:

Kraft Heinz

Wells Fargo

Apple

Coca Cola

American Express

IBM (adjusted down for Buffett’s announced intention to pare his holding by 30%)

Phillips 66

US Bancorp

Charter Communications

Moody’s.

Source:  CNBC (a format that allows easy sorting of the SEC data)

The list comprises 80% of Berkshire’s equities.

 

Yes, despite Buffett’s well-advertised aversion to tech, there are two IT names in the top ten.  But IBM is cutting edge tech circa 1975 and AAPL is a high-end smartphone company looking for a new world to conquer.

the Buffett approach

All these firms do have the signature Buffett look:  they have all spent tons of money developing important consumer-facing brand names.  While that spending has created an enduring consumer franchise, there is no hint of the existence of this key asset on the balance sheet.  Rather, the all-important brand-building expenditure is accounted for as a subtraction from asset value.

The one possible exception to this is Charter, whose cable networks rather than sterling service and extensive advertising give it near-monopoly access to customers.  Here again, however, the ability to gradually write off the cost of constructing those networks through depreciation argues that the balance sheet severely understates their true worth.

The formula, in brief:  the “hidden” value of extensive well-staffed distribution networks plus iconic brands built through extensive spending on advertising and promotion.

limitations

The obvious limitations of this approach are:  that while novel in the 1950s, the whole world has since adopted Buffett’s once-pioneering approach; this would be great if there were no internet undermining the value of traditional brand names and distribution networks.

In other words, a software-driven, internet-based firm like AMZN seems to me to be the last thing that would ever be on the Buffett radar.  It also seems to me that taking AMZN seriously would mean rethinking the the whole Buffett investment approach–not the valuation discipline, but the idea of the value of traditional intangibles–and recasting it in a much techier way.

why not adapt?

Why not do so anyway, instead of kind of limping to the finish line?

Maybe it’s because that doing so would attack the heart of the intangible brand value of Berkshire Hathaway itself–and that attack would come not just from a nobody but from the brand’s most credible spokesperson, the Sage of Omaha himself.

 

what about last Wednesday?

That’s the day the S&P 500 took a dramatic 2% plunge, with recent market leaders doing considerably worse than that, right after the index had reached a high of 2400.

Despite closing a hair’s breadth above the lows–normally a bad sign–the market reversed course on Thursday and has been steadily climbing since.  The prior leadership–globally-oriented secular growth areas like technology–has also reasserted itself.

My thoughts:

–generally speaking, the market is proceeding on a post-Trump rally/anti-Trump agenda course.  Emphasis is on companies with global reach rather than domestic focus, and secular change beneficiaries rather than winners from potential government action that have little other appeal

–while trying to figure out whether the market is expensive or cheap in absolute terms is extremely difficult–and acting on such thoughts is to be avoided whenever possible–the valuation of the S&P in general looks stretched to me.  Tech especially so.  This is especially true if corporate tax reform ends up being a non-starter.  My best guess is that the market flattens out rather than goes down.  But as I wrote a second or two ago absolute direction predictions are fraught with peril

–tech is up by 17.0% this year through last Friday, in a market that’s up 6.4%.  Over the past 12 months, tech is up by 35.2% vs. a gain of 16.8% for the S&P.  Rotation into second-line names appears to me to be under way, suggesting I’m not alone in my valuation concerns

–currency movements are important to note:  the € is up by about 10% this year against the $, other major currencies by about half that amount.  Why this is happening is less important, I think, than that it is–because it implies $-oriented investors will continue to favor global names

–the next move?  I think it will eventually be back into Trump-motivated issues.  For right now, though, it’s probably more important to identify and eliminate faltering tech names among our holdings (on the argument that if they can’t perform in the current environment, when will they?).  My biggest worry is that “eventually” may be a long time in coming.

 

 

the stock market cycle–where are we now?

As I wrote yesterday, stock market price-earnings multiples tend to contract in bad times and expand during good.  This is not only due to well-understood macroeconomic causes–the effect of higher/lower interest rates and falling/rising corporate profits–but also from psychological/emotional motivations rooted in fear and greed.

(An aside:  Charles McKay’s Extraordinary Popular Delusions and the Madness of Crowds (1841) and Charles Kindleberger’s Manias, Panics and Crashes (1978) are only two of the many books chronicling the power of fear and greed in financial markets.  In fact, the efficient markets theory taught in business schools, which denies fear and greed have any effect on the price of financial instruments, was formulated while one of the bigger stock market bubbles in US history, the “Nifty Fifty” years, and a subsequent vicious crash in 1973-74, were taking place outside the ivory tower.)

Where are we now?

My take:

2008-09  PEs contract severely and remain compressed until 2013

2013  PEs rebound, but only to remove this compression and restore a more typical relationship between the interest yield on bonds and the earnings yield (1/PE) on stocks.

today  The situation is a little more nuanced.  The bond/stock relationship in general remains much the way it has been for the past several years, with stocks looking, if anything, somewhat undervalued vs. bonds.  But it’s also now very clear that, unlike the situation since 2008, that interest rates are on an upward path, implying downward pressure on bond prices.

In past plain-vanilla situations like this, stocks have moved sideways while bonds declined, buoyed by an early business cycle surge in corporate profits.

Since last November’s presidential election, stocks have risen by 10%+.  This is unusual, in my view, because we’re not at the dawn of a new business cycle.  It comes from anticipation that the Trump administration will introduce profit-boosting fiscal stimulus and reforms.  The “Trump trade” has disappeared since the inauguration, however.  Our new chief executive has displayed all the reality show craziness of The Apprentice, but little of the business acumen claimed for the character Mr. Trump portrayed in the show–and which he asserts he exhibited in in his long (although bankruptcy-ridden) career in the family real estate business.

Interestingly, the stock market hasn’t weakened so far in response to this development.  Instead, two things have happened.  Overall market PE multiples have expanded.  Interest has also shifted away from business cycle sensitive stocks toward secular growth stocks and early stage “concept” firms like Tesla, where PEs have expanded significantly.  TSLA is up by 76% since the election and 57% so far this year–despite the administration’s efforts to promote fossil fuels.  So greed still rules fear.  But animal spirits are no longer focused on beneficiaries of action from Washington.  They’re more amorphous–and speculative, as I see it.

Personally, I don’t think we’re at or near a speculative peak.  Of course, as a growth stock investor, and given my own temperament, I’m not going to be the first to know.  It does seem to me, however, that the sideways movement we’ve seen in the S&P since March tells us we are at limits of where the market can go without concrete economic positives, whether they be surprising strength from abroad or the hoped-for end to dysfunction in Washington.

 

discounting and the stock market cycle

stock market influences

earnings

To a substantial degree, stock prices are driven by the earnings performance of the companies whose securities are publicly traded.  But profit levels and potential profit gains aren’t the only factor.  Stock prices are also influenced by investor perceptions of the risk of owning stocks, by alternating emotions of fear and greed, that is, that are best expressed quantitatively in the relationship between the interest yield on government bonds and the earnings yield (1/PE) on stocks.

discounting:  fear vs. greed

Stock prices typically anticipate or “discount” future earnings.  But how far investors are willing to look forward is also a business cycle function of the alternating emotions of fear and greed.

Putting this relationship in its simplest form:

–at market bottoms investors are typically unwilling to discount in current prices any future good news.  As confidence builds, investors are progressively willing to factor in more and more of the expected future.

–in what I would call a normal market, toward the middle of each calendar year investors begin to discount expectations for earnings in the following year.

–at speculative tops, investors are routinely driving stock prices higher by discounting earnings from two or three years hence.  This, even though there’s no evidence that even professional analysts have much of a clue about how earnings will play out that far in the future.

(extreme) examples

Look back to the dark days of 2008-09.  During the financial crisis, S&P 500 earnings fell by 28% from their 2007 level.  The S&P 500 index, however, plunged by a tiny bit less than 50% from its July 2007 high to its March 2009 low.

In 2013, on the other hand, we can see the reverse phenomenon.   S&P 500 earnings rose by 5% that year.  The index itself soared by 30%, however.  What happened?   Stock market investors–after a four-year (!!) period of extreme caution and an almost exclusive focus on bonds–began to factor the possibility of future earnings gains into stock prices once again.  This was, I think, the market finally returning to normal–something that begins to happens within twelve months of the bottom in a garden-variety recession.

Where are we now in the fear/greed cycle?

More tomorrow.

revisiting (again) value investing

As regular readers will know, I’m a growth stock investor.  That’s even though I spent my first six years as an analyst/portfolio manager using value techniques almost exclusively–and then worked side by side with a motley crew of value investors for a ten-year period after that.

One way of describing the difference between growth and value is that:

–growth investors know when potentially price-moving news will happen (that is, when quarterly earnings are announced) but are less sure what that news will be

–value investors know what the news will be (if they’ve done their job right, they’re holding stocks where the market has already priced in every possible thing that could go wrong.  All they need is one thing to go right).  However, they may have little idea when good news will occur.

 

Each style has an inherent problem:

–for growth, it’s hard to find rising earnings during an economic downturn

–for value, it’s possible that a long time (say, two years) may pass before any of a portfolio’s diamonds in the rough are discovered by the market.  In that case, the manager will likely be fired before the portfolio pays off.  His/her successor will either reap the rewards of the predecessor or will dismantle the portfolio before any good stuff can occur.

 

At times, I do buy what I conceive of a value stocks.  Intel when it was $19, trading at 8x – 9x earnings and yielding almost 4% (I’ve since sold most of what I own) is an example.  But deep value investors would scoff at the notion that this is truly value.

 

For some time, I’ve been maintaining that value investing has lost its appeal in the 21th century.  Two reasons:

–the stronger one is that the shelf life of physical plant, traditional distribution networks and brand names is no longer “forever” in a globalized, Internet-driven world.  So buying companies that are rich in such assets but not making money is much, much riskier today than it used to be.  Such assets can erode in the twinkling of an eye.

–a weaker claim would be that while there are still value names, it’s hard/impossible to fill out a portfolio of, say, 100 of them, which is the traditional value portfolio structure, in today’s world.

 

I’m rehashing the growth/value debate here because I’m thinking the stronger position isn’t as unassailable as I’ve believed.

More tomorrow.

 

economics in the US vs. identity

The Financial Times has recently added an interesting new Opinions columnist, Rana Foroohar.  In her column yesterday, she writes that while the Democrats believe that they lost the presidential election because of misogyny and racism, the more likely cause is wage stagnation and job insecurity.  In other words, long-time Democrats voted Republican in the last election in spite of the victors’ abhorrent social views, not because of them.  Further, she implies that by continuing to seek favor from large corporates as well as by taking up the former Republican mantle of mindless legislative obstruction, the Democratic party risks further establishing itself as part of the economic problem, not the solution.

Clearly, the Democratic leadership doesn’t believe this, although personally I think Ms. Foroohar is correct.  Moreover, as Ms. Foroohor notes, the issue of job insecurity and wage stagnation is a dynamic one, not static.  As recent research from the University of Cambridge suggests, and the emergence of self-driving cars illustrates, the range of human tasks subject to replacement by machines is continuing to expand, putting more blue-collar jobs as well as some white-collar occupations as risk.

So this central issue is not going to go away.  It’s going to get bigger.

 

Social issues aside, a stock market investor must, I think, address two questions:

–how to participate through stock selection in the substitution of hardware/software capital for labor, and

–how closely continuing political dysfunction in the US resembles the situation in Japan thirty years or so ago, in which a foolish political defense of the status quo in the face of structural change has resulted in a decades-long impairment of GDP growth there.

 

 

the case for Europe …and how to play

We can divide the mature stock markets of the world into three groups:  Japan, the US and Europe.

My long-held view is that Japan is a special situations market, where disastrous economic policy, hostility to foreign investors of all stripes a shrinking working population, make putting in the time to understand this intellectually fascinating culture not worth the effort for mainstream companies.

That leaves the US and UK/EU.

the case for Europe

Looking across the Atlantic, Europe appears to be a big mess.  It has, so far, not really recovered from the recession of 2008-09.  Grexit continues to be an issue, although relatively minor.  But there’s also Brexit, with the additional possibility that Scotland will vote to secede from the UK.  And there’s possibility that Marine Le Pen may become the next French president.  She advocates Frexit + repudiation of France’s euro-denominated debt.  In her stated social views, she’s the French version of Donald Trump.  On top of all this, the population of the EU is older, and is growing more slowly, than that of the US.  In a sense, the EU is the next Japan waiting for unfavorable demographics to take its toll.

What, then, could be the case for having exposure to Europe?

Three factors:

–the plus side of Donald Trump–tax reform, infrastructure, end to Congressional dysfunction–now appears to be at best a 2018 happening.  In a relative sense, then, Europe looks better than it did a few months ago

–the EU began its economic rescue operations several years later than the US did.  Because of this, one way of thinking about the EU is that it’s the US with, say, a three-year lag.  If that’s correct, we should expect growth there to be perking up–and it is–and to remain at a somewhat better than normal level for a while.

–the mass of Middle Eastern refugees pouring into the EU has produced near-term political and social problems.  However, many are young and well-educated.  So as they are assimilated, they will provide a boost to the workforce–and therefore to GDP growth.

how to play Europe

the UK

Brexit will be bad for the UK economy, I think.  Although much of the damage has already been done through depreciation of sterling, UK multinationals, especially those with exposure to the EU are, conceptually at least, the way to go.  Even here, though, it’s not yet clear how access to these markets will be restricted as the UK leaves the European Union.  So the UK probably isn’t the best way to participate.

the Continent

Since we’re talking about local GDP being unusually good, multinationals are likely to be underperformers.  EU-oriented firms will be the stars.  Small will likely outperform large.

the US and China

About a quarter of the profits of the S&P 500 are sourced in Europe.  So US-based, EU-oriented multinationals are also a way to play.

Another 10% or so of S&P earnings are China-related.  Because China’s largest trading partner is the EU, some of the glow from the EU will rub off on export-oriented Chinese firms.  Here I haven’t yet looked for names. But it may be possible to play the EU either through Chinese firms listed in the US or through US multinationals with China exposure.  I’d put this group at the tail end of any list, however.