the new coronavirus

A little more than 17 years ago, the coronavirus SARS (Severe Acute Respiratory Syndrome) surfaced in China.  Despite occurring at what proved to be the onset of a new bull stock market, SARS cast a months-long pall over world stock exchanges, particularly those in Asia and notably Hong Kong.

Two key reasons:  this was the first coronavirus many investors (myself included) had seen, so it was especially scary;  rather than quarantine infected individuals, local authorities in China decided to cover up the presence of the disease, so SARS had a chance to spread unchecked for several months.

 

The coronavirus MERS (Middle East Respiratory Syndrome) only captured world attention for a few days then it emerged in 2012.  Overall economic/stock market conditions were favorable.  Authorities moved quickly to contain its spread.  And investors had already seen how SARS played out.

 

The new coronavirus, which doesn’t have a snappy acronym yet, comes from China and is a relative of SARS.  One might expect that its impact on stock markets will be more like that of MERS than SARS.  Two caveats:  it is hitting China just as the annual New Year travel/spending/celebrating holiday is beginning; and markets have been rising for years.  Economic activity is healthy but not awesome, and is beginning to slow in the US.  Ex Hong Kong and mainland Chinese bourses and travel-related stocks, however, the new virus will be the possible trigger for a selloff, in my view, rather than a cause.

 

Boeing

BA has lost about a quarter of its value since fatal accidents caused its newest 737 model civilain aircraft to be pulled off the market.  Stories are starting to circulate (that I’m hearing them suggests “starting” may not be the best word) that the Sage of Omaha is beginning to buy Boeing (BA) stock.   The rationale?   …a value investor‘s belief that the company’s woes are temporary and that all the probable bad news is already discounted in the stock price.  Buffett has positions in several airline companies and in at least one supplier to BA, so he arguably would have better insight than most into the BA situation.

initial thoughts

How plausible is this?  Is the rumor based on fact or simply launched by a third party with an agenda?  …if the former, is this a repeat of Buffett’s foray into IBM, another questionable trip down memory lane?  what’s BA’s price to book, price to cash flow?  I don’t know.

I’ve never owned BA during 25+ years managing other people’s money.  I’ve never felt a compulsion to investigate it, either, even though I worked for a long time in value-oriented shops where BA was often a topic of discussion.  But I was curious about what interest in BA might not only say about the company but also about the temperature of the market.  So I took a quick look.

I went to the Fidelity research area to get some relevant ratios, in this case the P/CF and P/B.  I found:  $185 billion market cap, P/B of negative $7+ or so a share and P/CF of 30x–not what I would have called a “value” buy.  I decided to take another step and look at BA’s September quarter 10-Q  on the SEC Edgar site.

the latest 10-Q (9/19)

random-ish figures:

–BA has total assets of $133 billion.  Of that $13 billion is plant and equipment, $12 billion is goodwill and other intangible assets and $75 billion is customer financing.  So this is not a plant and equipment story.  It’s about intangible assets, craft skill/ proprietary company know how, being a national champion.

–Book value is negative.  How so?  The most important reason is that over the years BA has spent over $50 billion buying back its own stock, including $1 billion+ during the first nine months of 2019.  Accountants deduct that expenditure from net worth.  Another $15 billion gets subtracted though”comprehensive loss” related to pension plans.  Ex those items, book value would be about $65 billion, meaning the stock is trading at about 3x adjusted book.  Again, not an obvious value story.

–Cash flow, which was about $12 billion during the first three quarters of 2018 is slightly negative for the comparable period of 2019.

my take

The idea behind the typical value stock is that the company has assets that have lost value for now because of economic circumstances or lack of skill of current management.  Once economic conditions improve and/or management is replaced by more competent executives, their value will shine through again.  That’s because the assets haven’t been destroyed, they’ve just been misused.

I don’t think that’s the case here.  The assets in question are intangible.  The strongest, I think, is that BA is one of only two global large commercial aircraft manufacturers–and the only one in the US.  As for the rest, if press reports are correct, BA tried to solve a hardware problem (very heavy engines) with software, a dubious proposition at any time, according to my coder son-in-law.  Worse than that, BA may have been less than forthcoming with regulators about potential risks with this solution.  As for myself, I’d go to considerable pains to avoid flying on a 737 MAX, given that the penalty for a mistake is so high.

So I don’t get bullishness about BA for two reasons:  I think intangibles like craft skill and industrial software can melt away in short order in the way, say, a chemical processing plant can’t.  Also, given what I think is the severity of BA’s problems, I don’t think a loss of a quarter of the company’s stock market value is an overreaction.  If anything, I think it’s an underreaction.

 

 

 

 

 

 

 

 

 

 

thinking about 2020

where we are

The S&P 500 is trading at around 25x current earnings, up from a PE of 20x a year ago.  Multiple expansion, not earnings growth, is the key factor behind the S&P rise last year.In fact, earnings per share growth, now at about +10%/year, has been decelerating since the one-time boost from the domestic corporate income tax cut cycled through income statements in 2018.  Typically earnings deceleration is a red flag.  Not so in 2019.

EPS growth in 2020 will probably be around +10% again.

About half the earnings of the S&P come from the US, a quarter from Europe and the rest from emerging economies.  The US will likely be the weakest of the three areas this year, as ongoing tariff wars take a further toll on agriculture and manufacturing, as population growth continues to wane given the administration’s hostility toward foreigners, and as multinationals continue to shift operations elsewhere to escape these policies.  On the other hand, Europe ex the UK should perk up a bit, emerging markets arguably can’t get much worse, and multinationals will likely invest more abroad.

 

interest rates:  the biggest question 

What motivated investors to bid up the S&P by 30% last year despite pedestrian eps growth and Washington dysfunction?

Investors don’t buy stocks in a vacuum.  We’re constantly comparing stocks with bonds and cash as alternative liquid investments.  And in 2019 bonds and cash were distinctly unattractive.   The yield on cash is close to zero here (elsewhere in the world bank depositors have been charged for holding cash).  The 10-year Treasury started 2019 yielding 2.66%.  The yield dipped to 1.52% during the summer and has risen to 1.92% now.  In contrast, the earnings yield (1/PE, the academic point of comparison of stocks vs. bonds)) on the S&P was 5% last January and is 4% now.

The dividend yield on the S&P is now about 1.9%.  That’s higher than the 10-year yield, a situation that has occurred in our lifetimes only after a bear market has crushed stock valuations.  In my working career, this has happened mostly outside the US and has always been a clear buy signal for stocks.  Not now, though–in my view–unless we’re willing to believe that the current situation is permanent.

The situation is even stranger outside the US, where the yield on many government bonds is actually negative.

In short, wild distortions in sovereign bond markets, a product of unconventional central bank measures aimed at rescuing the world economy after the 2008-09 collapse, have migrated into stocks.

How long will this situation last and how will it unwind?

 

more on Monday

 

 

 

 

Keeping Score, November 2019

I’ve just updated my Keeping Score page for November.  Given the absence of mutual fund selling in October, not a bad result.

autos, emissions and Trumponomics

I’ve followed the auto industry since the early 1980s, but have rarely owned an auto stock—brief forays into Toyota, later Peugeot (1986) and Porsche (2003?) are the only names that come to mind.

 

The basic reasons I see to avoid the auto manufacturers in the developed world:

–chronic overcapacity

–continuing shift of intellectual property creation, innovation, brand differentiation—and better-than-commodity profits–from manufacturers to component suppliers

–the tendency of national politics to influence company operations and prospects.

 

In addition, the traditional industry is very capital intensive, with a high capacity utilization required (80%?) to reach breakeven.  The facts that unit selling prices are high and new purchases easy to put off for a year or two mean that the new car industry is highly cyclical.

More than that, today’s industry is in the early stages of a transformation away from units that burn fossil fuels, and are therefore a major source of air pollution, to electric vehicles.  The speed at which this change is happening has accelerated over the past decade outside the US because pollution has become a very serious problem in China and because automakers in the EU have been shown to have falsified performance data for their diesel-driven offerings in a poorly thought out effort to meet anti-pollution rules.

California, which had a nineteenth-century-like city pollution problem around Los Angeles as late at the mid-1970s, has led the US charge for clean air.  It helps its clout that CA is the country’s largest car market (urban legend:  thanks in part to GM’s aggressive lobbying against public transport in southern CA in the mid-20th century).  CA has also been joined by about a dozen other states who go along with whatever it decides.  The auto manufacturers have done the same, because the high capital intensity of the car industry means building cars to two sets of fuel usage specifications makes no sense.

 

Enter Donald Trump.  His administration has decided to roll back pollution reduction measures put in place by President Obama.  CA responded by agreeing with Ford, VW, Honda and BMW to establish Obama-like, but somewhat less strict, requirements for cars sold in that state.  Trump’s reposte has been to call the agreement an anti-trust violation, to claim the power to revoke the section of the law that permits CA to set state pollution standards and to threaten to withhold highway funds from CA because the air there is too polluted (?).

 

Other than pollical grandstanding, it’s hard to figure out what’s going on.

Who benefits from lower gas mileage cars?     …Russia and Saudi Arabia, whose economies are almost totally dependent on selling fossil fuels; and the giant multinational oil companies, whose exploration efforts until recently have been predicated on demand increasing strongly enough to push prices up to $100 a barrel.

Who gets hurt by the Trump move?     …to the degree that it prolongs widespread use of inefficient gasoline-powered cars, the biggest potential losers are US-based auto firms and the larger number of US residents who become ill in a more polluted environment.  Why the car companies?  Arguably, they will put less R&D effort into developing less-polluting cars, including electric vehicles.  The desertification of China + disenchantment with diesel will have Europe and Asia, on the other hand, making electric cars a very high priority.  It wouldn’t be surprising to find in a few years a replay of the situation the Detroit automakers were in during the 1970s—when cheap, well-built imports flooded the country without the Big Three having competitive products.

It’s one of the quirks of the US stock market that it has very little direct representation of the auto industry.  So the idea that profits there will be somewhat higher as the firms skimp on R&D will have little/no positive impact on the S&P.  Even the energy industry, the only possible beneficiary of this Trump policy, is a mere shadow of its former self.  Like Trump’s destruction of the American brand—Apple has dropped from #5 in China to #50 since his election—all I can see is damaging downside.

I think the Trump policy is intentional, like his trade wars and his income tax cut for the super-rich.  The most likely explanation for all these facets of Trumponomics is either he doesn’t realize the potentially grave economic damage he’s doing or it’s not a particularly high priority.