I’ve just updated my Keeping Score page for February 2019.
Late last week, KHC reported 2Q18 earnings. The figures were disappointing. More importantly, the company announced it is:
–cutting the $.625/quarter dividend to $.40,
–writing down the value of its intangible assets by $15.4 billion (about 28% of the total) and
–involved in an SEC inquiry into the company’s accounting practices for determining cost of goods sold. Apparently prompted by this, KHC boosted CoG for full-year 2018 by $25 million in 4Q18.
The stock declined by 27% on this news.
What’s going on?
KHC is controlled by famed investor Warren Buffett’s Berkshire Hathaway and by 3G, a group of investment bankers behind the consolidation success of beer maker Anheuser-Busch Inbev.
As I see it, Buffett’s principal investing idea continues to be that markets systematically undervalue “intangible assets,” accounted for as expenses, not assets–namely, successful firms’ brand-building through advertising/marketing and superior products/services. This explains his preference for packaged goods companies and his odd tech choices like IBM and, only after all these many years of success, Apple. All have well-known brand names cemented into public consciousness by decades of marketing expenditure.
3G believes, I think, that in most WWII-era companies a quarter to a third of employees do no useful work. Therefore, acquiring them and trimming the outrageous levels of fat will pay large dividends. Remaining workers, arguably, will figure out that performing well trumps office politics as a way of climbing the corporate ladder, so operations will continue to chug along after the initial cull.
These beliefs account for the partners’ interest in KHC.
My take here is that the investing world has long since incorporated Mr. Buffett’s once groundbreaking thinking into its operating procedures, so that appreciating the power of intangibles no longer gives much of an investing edge. (Actually, KHC suggests reliance on the fact of intangibles may make one too complacent.) As to G3, it’s hard for me to figure how companies fare after the dead wood is eliminated.
The most startling, and worrying, thing to me about the quarter is the writedown of intangibles. My (admittedly quick) look at the KHC balance sheet shows that total liabilities and tangible assets–working capital and plant/equipment–pretty much net each other out. This means that shareholders equity (book value) pretty much consists solely in the intangibles that drive customers to buy KHC’s ketchup and processed cheese foods. That number is now 28% lower than the last time the company looked at these factors. Did all that decline happen in 2018? Is this the last writedown, or are more in the offing?
The fall in the stock price seems to me to correspond closely to the writedown. I’d expect the same to hold the in the future. And it’s why I think the risk of further writedowns is a shareholder’s biggest worry.
–A dividend reduction is always a red flag, especially so in a case like this where the payout has been rising. It suggests strongly that something has come out of the blue for the board of directors. However, KHC appears to be indicating that cash cows are being divested and that loss of associated cash flow is behind the dividend cut. I don’t know the company well enough to decide how cogent this explanation is, but it’s enough to put the dividend cut into second place on my list.
–an SEC inquiry is never a good sign. In this case, though, it seems that only small amounts of money are at issue. But, if nothing else, it points to weaknesses in management controls, supposedly 3G’s forte.
–Experience tells me the whole story isn’t out yet. I’d want to know whether KHC is taking these actions on its own, or are the company’s lenders, its auditors or the SEC playing an important role?
–This case argues that the intangible economic “moats” that value investors often talk about have less protective value in the Internet/Millennial era than in earlier, slower-changing times.
In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary. Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.
The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017. Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%. This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad. But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure. Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.
Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.
A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century. Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries. But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.
Who’s left to absorb the extra supply that’s on the way? …US individuals and companies.
The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries. No one really knows.
Three additional observations (by me):
–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free. It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers
–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and
–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields. And that would immediately trigger stock market weakness. If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.
A straightforward analysis of what Mr. Trump is doing would be:
–tariffs slow overall growth and rearrange it to favor protected industries. There’s no reason I can see to believe something different might happen in the US
–apart from the third world, protected industries tend to have domestic political clout but to be in economic trouble. In my experience, these woes come more from bad management than from foreigners’ actions
–the go-it-alone approach is a weak one, since it provides ample scope for a target country to shop tariffed goods through an intermediary
–the apparently arbitrary way the administration is acting will cause both domestic and foreign corporations to reconsider future capital investment in the US.
There are, however, two other issues that I think have long-term implications but which aren’t discussed much.
–tariffs may cause industries that have moved abroad to retain labor-intensive work practices (and continue to use dated industrial machinery) in a lower labor-cost environment to return to the home country. If such firms come back to the US, it won’t be with the old machinery. New operations will be very highly mechanized. In other words, one likely response to the Trump tariffs will be to accelerate the replacement of humans with robots in the US.
–as I see it, China is at the key stage of economic development where, to grow, it must leave behind labor-intensive work and develop higher value-added industries. This is very hard to do. The owners of low value-added enterprises have become very wealthy and powerful. They employ lots of people. They have considerable political influence. And they strongly favor the status quo. The result is typically that the economy in question plateaus as labor-intensive industries block progress. In the case of China, however, the threat that the US will effectively deny such firms access to a major market will kickstart progress and deflect blame from Beijing.
If I’m correct, the effect of trying to restore WWII-era industry in the US will, ironically, achieve the opposite. It will accelerate domestic change in the nature of work away from manual labor. And it will run interference against the status quo in China, allowing Beijing’s efforts to become a cutting-edge industrial power to gather speed.
I’ve updated my Keeping Score page for January’s movement in the S&P 500.
In the late 1970s Deng Xiaoping was forced to tackle the gigantic mess that central planning had made of the Chinese economy during Mao’s rule. The problem: highly inefficient, loss-making, corruption-infested, Soviet-style (feel free to add more negative, hyphenated adjectives) state-owned enterprises dominated the industrial base. The products were poor; the books more fiction than not. Deng’s solution was to adopt Western-style capitalism under the banner of “Socialism with Chinese Characteristics.” This meant pulling the plug on bank credit and political favor for state-owned enterprises and redirecting support toward the private sector.
The result has been 30+ years of economic growth so strong that it has vaulted China from nowhere into first place among world economies. In fact, the PRC is now 10%+ larger than #2, the US, using Purchasing Power Parity as the yardstick.
According to an astute observer of China, Nicholas Lardy, writing in the Financial Times, however, current Chinese leader Xi Jinping has not simply been cracking down on the cumulative excesses of the private sector over the past couple of years. He has also reversed Deng’s policy in favor of building up the state-owned sector again. Lardy thinks this decision is reducing China’s annual GDP growth rate by a whopping two percentage points.
I’m not sure why this is happening. But for China, the highest economic principle has never been about achieving maximum sustainable GDP growth. Rather, it’s whatever is necessary to maintain the Communist Party in power. Reduction in GDP growth is a secondary concern.
I don’t know how this affects China’s stance in tariff negotiations with the US, especially since White House economists seem to be suggesting that the US economy is already beginning to contract under the weigh of current tariffs plus the government shutdown (increased tariffs slated for March will only deepen any decline). From a longer-term point of view, though–and assuming Chinese policy doesn’t change–for a company to simply have exposure to China will no longer be any guarantee of success.
issues for the S&P 500 in 2019:
–about half the earnings of the S&P come from outside the US. For 2019, that’s not a good thing, since China is slowing down (more tomorrow) and the UK’s ham-fisted approach to Brexit is stalling business activity in the EU
–in the US,
—-last year’s corporate tax cut is no longer a source of year-on-year aftertax earnings growth
—-tariffs continue in place. Tariffs redistribute, but in the aggregate also slow, economic growth. The current ones are designed to shift economic energy toward sunset (often private) industries and away from ones with better prospects. Some, like those on steel and aluminum, appear arbitrary, adding a layer of uncertainty to the whole process
—-the government shutdown is already pushing the US economy from a plodding advance into reverse, according to White House economists. The central issue is a border wall, which, if news reports are correct, was originally intended only as a memory aid for a candidate who couldn’t remember his key policy positions very well
—-the lack of sensible–or even coherent–economic strategy from Washington is making corporations accelerate domestic restructuring plans and to question future investment in the country. The administration’s hostility to admitting highly skilled foreign workers based on their religion/ethnicity is making the shift of r&d activity across the border to Canada an easy decision
In short, an embarrassing parade in Washington of own goals/self-inflicted wounds.
where to look for growth
The business cycle isn’t going to be much help. In times like this, the defensive sectors–utilities and telecom, and, to a lesser extent healthcare and consumer discretionary–typically come to the fore. But utilities + traditional telephone now amount to much less than 10% of the S&P. More important, both areas are in the throes of fundamental alteration that is damaging to incumbents. This leaves us with healthcare and consumer discretionary.
In both these areas, I think it’s important not to implicitly take a business cycle approach. A key factor here is Millennials vs. Baby Boomers.
In very rough terms, a Baby Boomer earns about twice what a Millennial does. But Millennials are entering a period of rapid growth in wages. In contrast, as Boomers retire, their incomes are typically cut in half. It seems to me that in all consumer areas it’s important to concentrate on firms that serve mostly Millennials, and avoid those (department stores are an easy example) that serve mostly Boomers, no matter what the level of current profits is.
My personal belief is that Americans don’t approve of making money from others’ illnesses. That’s the simplest reason (there are others) I can give for avoiding hospitals or nursing care or other healthcare service providers. But the premise of no business cycle help implies as well looking for smaller, more innovative, say, medical treatment development, firms …early-stage companies with the potential for explosive growth.
In the tech area–a more business cycle-sensitive area than healthcare–I think seeking out smaller, more innovative firms is also the way to go (but I always say this). In a so-so economy these should continue to prosper. The big risk is that they would likely be hurt very badly if the administration continues to add to the damage to the domestic economy that it is already doing.