the EU today: structural adjustment needed

Let’s assume that my description of the EU ex the UK is correct–that beneficiaries of the traditional order (the elites) are, and will continue to be, successful at thwarting structural change that would rock tradition but produce higher economic growth.

How should an equity investor proceed?

There are two schools of thought, not necessarily mutually incompatible:

–the first is that in an area where there is little growth, companies with strong fundamentals will stand out even more from the crowd.  This lucky few will therefore gain much of the local investor interest, plus the vast majority of foreign investor attention.  If so, in places like continental Europe or Japan one should look for fast-growing mid-cap companies with global sales potential for their products and services.  These will almost certainly outperform the market.

The more important question for an equity investor is whether they will do as well as similar companies domiciled and traded elsewhere.

–my personal observation is that the general malaise that affects stock markets in low-growth areas like Japan or the EU infects the fast growers as well.  The result is that they don’t do as well as similar companies elsewhere.  I haven’t tried to quantify the difference, but it’s what I’ve observed over the years.

It may be that the local market is offended by brash upstarts.  It may be that local portfolio managers deal only in book value and dividend yield as metrics.  It may simply be the fact that local laws prevent owners from eventually selling to the highest bidder, thereby damping down the ultimate upside for the stock.  One other effect of a situation like this is, of course, that entrepreneurs leave and set their companies up elsewhere.

 

The bottom line for a growth investor like me is that these areas become markets for the occasional special situation, not places where I want to be fully invested most of the time.  Because of this, and because of Brexit, the UK assumes greater importance for me.  So, too, Hong Kong, as an avenue into mainland China.  And to the degree I want to have direct international exposure–which means I want to avoid the US for whatever reason–emerging markets also come into play.

 

A final thought:  one could argue that the lack of investment appeal I perceive in Japan and continental Europe has nothing to do with political or cultural choices.  Both areas have relatively old populations.  If it’s simply demographics, signs of similar trouble should be appearing in the US within a decade.  I don’t think this is correct, but as investors we should all be attentive to possible signs.

 

thinking about 2016

At present, world stock markets appear to me to be obsessively focused on the smallest details of the here and now.  This may be fine for short-term traders, but getting caught up in this mindset is the surest recipe for trouble for us as long-term investors.  Our biggest advantage against professional traders is taking a longer view.

So it makes sense that we should be shifting our focus toward the new year, even though (actually, because) I think the markets have yet to do so.

My thoughts (which will be presented in more detail in my yearly strategy posts in a few weeks):

interest rates

Rates will be somewhat higher a year from now than today.  The Fed, however, has made it clear that the journey back from emergency-low rates to normal–that is to say, from zero to perhaps 2% for overnight money–will take years.  In theory, higher rates make fixed income relatively more attractive to investors than stocks, mimplying that the stock market suffers price-earning multiple contraction.  I’ve written a number of times, and I still believe, that virtually all of this contraction has long since been factored into today’s stock prices.  Even if this is incorrect, next year’s rise is going to be quite small.  Absent a crazy panic, the potential headwind from PE contraction is likely to be extremely small.  

world economies

–the US will continue to be strong

–the EU has bottomed and will gradually strengthen, so next year will be better than this

–China ‘s transition from export-oriented growth to expansion led by domestic consumer spending is happening at a satisfactory pace.  While traditional economic indicators, which are generally speaking all focused on exports (the wrong place to look), continue to be ugly, overall economic growth next year will be at least as good as in 2015

–natural resource-producing emerging countries will continue to have troubles.  The main issue will not be lower commodity prices.  It will be dealing with excessive debt taken on when companies/governments believed in a perpetual commodities boom, and adjusting private/government spending downward to deal with lower levels of commodity income.

 

More tomorrow.

natural resources and economic growth

I ended up with my first stock market job, more or less by accident–and without any finance experience or training–in the late summer of 1978.  A few months later, the firm’s oil analyst was headhunted away and I took his place.  Within a couple of years (an MBA from NYU at night along the way) I had picked up a bunch of metals mining companies, too, and was in charge of the firm’s natural resources research.

The oil industry was (and still is) really non-intuitive–more about my early adventures tomorrow.  Today I want to write about the mining industry, which is a little more straightforward.

natural resources in the 1970s

I started out by reading the annual reports and 10-Ks of the major base metals mining companies for the prior five or six years.  What stood out clearly was that all the firms held very strongly a series of common beliefs, namely:

1.  that global economic growth would continue to be strong for as far into the future as one could imagine,

2.  that the availability of all sorts of base metals–lead for batteries, copper for wiring and tubing, iron ore for steel, and so on–was a necessary condition for this growth

3.  that, therefore, demand for base metals would grow at least in lockstep with GDP increases.

Implicitly, the companies also assumed that:

4. that oversupply was highly unlikely,

5.  that substitution among raw materials–like aluminum or PVC for copper–wouldn’t be an issue, and

6. that, because of 4. and 5., the selling price of output from future orebody discovery/development would never be a concern.

CEOs’ conviction was buttressed by reams of computer paper containing economists’ regression analyses “proving” that all this stuff was true.

a massive investment cycle…

Naturally, the companies, not risk-shy by nature, went all in across the board on new base metals mine development.

As I was reading these documents in 1979-80, the first (of many) massive new low-cost orebodies were coming into production.  This wave turned out to have been enough to keep most base metals in oversupply–and a lot of mines unprofitable–for the following twenty-five years!!!  Miners were also in the midst of a massive switch to exploring for gold, where high value deposits could be developed quickly and at low-cost–causing, in turn, a twenty year glut of the yellow metal.

…that didn’t work out

The mining CEOs turned out to be wrong in a number of ways:

–like any capital-intensive commodity business where the minimum plant size is huge, industry profits for base metals are determined by long cycles of under-capacity followed by massive investment in new mines that causes long periods of over-capacity

–although it wasn’t apparent in the 1970s, substitution of cheaper materials has been a chronic problem for base metals.  Take copper.  There’s aluminum for heat dissipation and wiring, PVC for plumbing, and glass/airwaves for audiovisual transmission.

–Peter Drucker was writing about knowledge workers as early as 1959.  Nevertheless, the mining companies and their economists weren’t able to imagine a world where GDP growth might not require immense amounts of extra physical materials.

I’ve been looking for a sound byte-y way to put this all into perspective.  The best I can do is a gross oversimplification:

–real GDP in the US has expanded by 245% since 1980.  Oil usage is up by about 10% over that period; steel usage is down slightly.  The supposed dependence of GDP growth on increased use of natural resouces simply isn’t true.

Why am I writing about this today?

…it’s because I continue to read and hear financial “experts” say that weak oil and metals prices imply declining world economic activity.  To me this argument makes no sense.

 

 

 

overnight: sharp drop in the yen, global stock market rally

what’s going on

A month or so ago–I don’t remember the exact timing–the Japanese central bank expressed concern that its weak yen policy was great for export-oriented companies but was hurting ordinary citizens, since food, fuel and other daily necessities are generally priced in dollars.  So these items cost a quarter or a third more today than they did before Abenomics kicked in.  The Bank of Japan intimated strongly that, because of the deterioration in citizens’ living standards, it was no longer interested in further yen weakness.

This morning in Tokyo the Bank reversed course and voted 5 – 4 to increase the amount of extra money it’s pumping into the economy, in what is now an all-out effort to create 2% inflation.

The yen has dropped by about 2.5% against the dollar, as I’m writing this just at the NY open.  The Japanese stock market rose by about 5% on the announcement.  Europe and US stock index futures are up as well.

my take

As I’ve written, probably too many times, I think Abenomics will end in tears.  Continuing currency weakness will just make the ultimate bad outcome worse.  That’s because I believe the root cause of Japan’s quarter-century economic malaise is that the country has chosen to defend its traditional way of life at the expense of economic progress.  One result has been to perpetuate a culture of covering up industrial/manufacturing mistakes.  Fukushima Daiichi is a terrible example; Takata airbags are the latest.  Impossible legal and cultural bars, many erected in the 1990s, still exist to removing from power people at the top of the pagoda, so to speak.

Continuing currency weakness will, in theory, buy more time for change to occur.  Admittedly, I’m no longer in close contact with the Japanese economy, but I don’t see any signs that effective change is happening.  Without it, the depreciation of the yen will mostly mean a massive loss of national wealth–and more time in power for incompetent industrialists.

(In my view, France and Italy have almost exactly the same issues.)

So, while the new tide of central bank money into the world will likely make markets move higher for a while, its main effect will probably be to smooth over economic bumps in the road for the US and China.  We should enjoy the ride.  But we’ve also got to think about how to defend ourselves from the ultimate negative consequences for Japan–and anyone who does business with/in the Land of Wa.

 

 

 

long-term market themes (iv): Millennials vs. Baby Boomers

In a population of roughly 300 million in the US, about a quarter consists of Baby Boomers, born in the years immediately following WWII.  Another quarter are Millennials, born in the 1980-90 period.

During virtually my entire career, the economic behavior of Boomers has had the most important demographic impact on the stock market.  But the leading edge of this group is already entering retirement–and being gradually pushed off the Wall Street stage by Millennials who are just entering the workforce in force.

This phenomenon is already having an impact on the stock market, I think.  But we’re probably only in the early stages of what will be an increasingly important change.

Two thoughts:

short-term

1.  The standard economic toolkit for dealing with recession is to shift economic power away from savers (Boomers) and toward spenders (Millennials).

To some degree, this influence has been offset in the first post-Great Recession years by the difficulty Millennials have had in finding jobs as they finish school.  But employment is becoming progressively easier to come by.  And we know the Fed is planning on keeping an emergency recession-fighting regimen in place for at least the next few years.

Speaking in over-simple terms, the emergency plan of any central bank is to make interest rates negative in real terms.  During the emergency (we’re now ending year five) the elderly and the wealthy, who tend to save rather than spend and who have a strong preference for fixed income, lose out in a serious way.  Their wealth diminishes in real terms as they receive interest payments on their  savings that are less than the amount that inflation subtracts from their purchasing power.

Younger, less affluent people, on the other hand, get free lunch.  They can borrow at very low rates, sometimes less than the rate of inflation.  In the latter case, they get free money.  They can also easily be in the situation where, say, the condo/house they buy goes up in value, while the real value of their mortgage shrinks’

By taking money away from savers and putting it into the hands of people who have a strong tendency to spend, the government spurs economic growth.  Not fair, maybe, especially to Boomers, but that’s the way the system works.

Advantage:  Millennials.

the longer term

2.  Younger people want different things from what their parents have.

Some of this is, depending on your perspective, either the perversity of youth or boldly striking out in a new direction.  My parents lived in the suburbs, so I’ll live in the city.  They have PCs and flip phones (ugh!), so I’ll use tablets and smartphones–and I’ll become a social media guru.  They read newspapers, I’ll use the internet…

There’s also a stages of life component to this.

–Twenty- or thirty-somethings buy houses, furniture…, cars and suits (or other work clothing).

–Sixty-somethings buy jewelry and cruises.  They downsize their houses and move to low-tax warm-weather locales.  Or maybe they retire to the vacation house they bought ten years ago.

For my entire investment career, the changing purchasing patterns of Baby Boomers have been perhaps the most important factor in figuring out how to play the Consumer Discretionary sector–which is arguably the single most important one for a portfolio manager to outperform the S&P 500.

I think it’s still possible to hitch your star to the Baby Boom and outperform.  But not for much longer, as the Boom wanes and Millennials wax.

long-term market themes (iii)

software as a service/ cloud computing

Once, when I was younger and more foolish, I owned shares in the Japanese company Olympus for a short time (this was in the late 1980s – early 1990s, long before the financial scandal that ultimately brought the firm to ruin).

What interested me was Olympus’s endoscope business. An endoscope is an apparatus that consists of a monitor, a computer and a long fiber optic cable encased in a hose.  Doctors feed the cable into the body of a patient to check out the state of his insides.

This business is supposed to work on the razor/razor blade model.  That is, the big money is in replacing the cable-in-a-hose, which Olympus recommended doctors do every three years or so.

Olympus had a problem, though.  Its salesmen could never persuade doctors to replace their cable/hoses.  They’d have marketing campaigns where they’d warn the docs that the cable might snap off inside the patient’s body if it got too old.  But even that cut no ice.  I guess doctors figured the patient is sedated and that they could extract the broken pieces, if need be, without anyone being the wiser.

So far, there’s no obvious investment angle–just a recipe for trouble.

But…

…in the US Olympus had switched from selling endoscopes to doctors to leasing them.  The sales pitch was that monthly payments matched the doctor’s cash inflow better.  The buyer also took on no debt and was no longer responsible for maintenance/upgrades.

US sales skyrocketed.  So, too, did profits–because factored into the “more convenient” lease payments was cable replacement every three years.

The lightbulb’s gone on, I figured.  Next step is rolling out the leasing model worldwide.  So I bought the stock and sat back waiting for the earnings surprises–and stock price appreciation–to roll in.

They never did.  In a dot-connecting failure I’ve come to think of as characteristic of most Japanese manufacturers, Olympus thought leasing was ok for Americans but for no one else.  Once I realized this, I sold–without making or losing much money, as I recall (meaning it probably was worse than that).

Nevertheless, this experience taught me a valuable thing about market dynamics:

–when people, particularly medium- or small-sized businesses, own expensive equipment, they’ll ride it until it dies.  Then they’ll revive it, with duct tape and string if necessary, and continue to use it until it falls apart. Even then, they may keep it around for spare parts.

This is a particular problem with software, since it doesn’t often cease to function.  All the power resides with the buyer.

–on the other hand, when people lease stuff, and the large initial capital outlay is turned into a much smaller recurring expense, the obsessive desire to squeeze the final dollar of value out of the equipment disappears.  Market power swings decisively to the seller.

In the case of software, the benefits of this move are especially big, since many of the costs of distribution of the product go away. Everything is done automatically over the internet.

That’s the power of software as a service.

Another thing:  during the transition period between ownership and leasing, surprisingly large numbers of customers–who have previously been using what are, in relative terms, Stone Age tools–sign up.  ADBE is a case in point.

sketching out long-term stock market themes (ii)

competition

1. Some (not many) domestic-oriented US companies are mentally living in a past that no longer exists, making them particularly vulnerable to competition.

How so?

WWII had two immediate effects on US industrial companies:  their domestic installations were the only plant and equipment  still left standing after the conflict in Europe and Japan, so they had eager customers, no matter what the quality of their output; and a generation of leaders abroad, grateful for American assistance in rebuilding, gave preferential treatment to American firms.

This wasn’t “normal,” and it’s no longer the case.  Those leaders are long-since retired.  When China thinks of the US, it thinks of the Boxer Rebellion, not WWII.

2a.  The Internet has destroyed many barriers to entry, or “moats,” as the academics like to say.

–It allows large, established firms to control far-flung manufacturing and distribution networks remotely.

–It allows them to stitch these networks together out of both owned and third-party pieces, so they can keep high value-added pieces in-house and farm out the rest.

–It allows fledgling firms to mount low-cost social media product awareness campaigns, to open their own online storefronts and also to distribute through third-parties like Amazon.

As a result, the embedded value of many years of past advertising campaigns no longer sets the bar for creating public interest in a new product.  Slowly building your own bricks-and-mortar retail presence, your own warehouses and your own fleet of delivery trucks isn’t needed to get wares into the hands of customers, either.  And you don’t need to lay out tons of your own capital to build an effective supply chain.

2b.  A recent article in the Financial Times points out that the US has about 5x the mall space per capita as the UK, 6x as much as in Japan and 8x as much as in Germany.  To the extent that retailers have signed long-term leases to rent this space, it can act as a ball and chain around a firm’s ankles, as online replaces bricks-and-mortar.

3.  Emerging economies understand that the ticket to entering the developed world is technology transfer.  That requires offering multinationals a low-cost workforce and state-of-the-art plants to induce them to open up in their country so locals can learn how to work in, and ultimately run, a manufacturing business.  This means a constant stream of new manufacturing plant coming into existence, undercutting the value of existing capacity (developing governments are looking for employment and technical education, not profits).  Developed countries’ only effective response is continual modernization and innovation.

4.  Hydraulic fracturing (“fracking”) is lowering the cost of producing natural gas and oil.  So far, fracking is happening mostly in North America.  So it’s principally a boon to manufacturers here, like chemical companies, that use hydrocarbons as feedstocks.  It’s also putting more money into the hands of American consumers, who (thanks to a uniquely misguided government energy policy in the US) use double the oil and gas per capita of anyone else.

We’re already seeing foreigners building new energy-intensive plants in the US to try to level the paying field.  Great for the balance of trade and for domestic employment.

The bottom line:  this is no longer a rest-on-your-laurels world for established companies.  For investors, this means the odds on backing younger “disruptive” competitors are better today than they have historically been.