Tag Archives: Portfolio management

yesterday’s report on US crude oil supplies

November 3, 2016 By in oil, oil and natural gas, Uncategorized Tags: , , , , Leave a comment

the EIA

Each week the Energy Information Administration (EIA), an independent statistical agency in the Energy Department that collects, analyzes and publishes extensive amounts of energy data, releases a report on US inventories of crude oil.

background

Over the past quarter-century, the typical US crude oil inventory stock level has been around 325 million barrels (excluding the Strategic Petroleum Reserve of 700- million barrels).  The figure shows some seasonal variation in most years, peaking in late Spring – early Summer and reaching a low point in late Winter.  But these swings have usually been relatively mild.  Before the current period of oversupply, for example, the weekly figure had never come in above 375 million barrels.

Between August 2014 and May 2016, however, the inventory number rose steadily from 331 million barrels to 510 million.  Since then, the figure has been gradually declining.  That, and talk of OPEC members placing a ceiling on the cartel’s overall production, have created the belief among speculators on Wall Street that the worst of the global crude oil oversupply might be behind us.

…until now.

the November 2nd report

The November 2nd EIA report shows crude oil inventories leaping by a huge 14.4 million barrels,to a total of 483 million.  While even the 468 million barrel inventory figure of a week ago is way above normal, the shock  to financial markets is that the change–typically one or two million barrels in either direction in any given week–is so big and that it is in the direction of more oversupply.

Even though one data point doesn’t make a trend, this one appears to have let a lot of air out of the balloon of crude oil bulls.

 

I’m still on the sidelines.  I continue to think we won’t the first clear signal of the state of the crude market until the seasonally slack period in late January – early February.

 

 

 

 

the changing nature of competition

October 31, 2016 By in Industry Analysis, internet, Portfolio management, securities markets, Uncategorized Tags: , , Leave a comment

Happy Halloween!!

This is the continuation of my post from last Friday.

A generation ago, establishing a competitive edge in a business was about having plant and equipment, operating that physical capital efficiently and, for consumer-facing firms, advertising to create and maintain a brand image.

First mover advantage was often key, since it might allow the initial entrant to achieve economies of scale (lower unit costs) in manufacturing or marketing that would discourage potential rivals  by making their path to profits prohibitively long and expensive.

The Internet, and the rise of China as a low-cost contract manufacturing hub, changed all that.  Supply chain management software did allow vertically integrated companies to coordinate actions much more efficiently.  But it also gave smaller, more focused firms the power to create virtual integration using third-party supply chain partners.

 

Today’s competition, particularly in the consumer arena, is as much about services as physical products.  The development of internet-based social media has made it much easier for a fledgling niche product to find a voice without spending heavily on traditional advertising.

Knowledge and relationships have replaced plant and cumulative advertising expense as “moats” that protect a firm from competition.

 

These developments present two problems for stock market investors:

–the first one is straightforward.  Comparing a stock price with the per share value of tangible balance sheet assets (Benjamin Graham) may no longer provide relevant buy/sell signals.  Nor will supplementing this analysis by including intangibles (Warren Buffett), using, say, the sum of the past ten years’ advertising expense.

A very successful value investor friend of mine used to say that there are no bad businesses, there are only bad managements   …and bad managements will invariably be replaced.  In an overly simple form, he thought that so long as he could see large and growing revenue, everything else would take care of itself.  Broken companies were actually better investments, since their stock prices would leap as new managements created turnarounds.

As I see it, in today’s world this traditional approach to valuation is less and less effective–because assets no longer have the enduring worth they formerly did.

–first mover advantage is probably more important today than in the past.  But while network effects are readily apparent, a company’s development stage, where the network is growing but the source of eventual profits is unclear, can be very long.  And it may be difficult in the early days to separate a Fecebook from a Twitter.

 

So while we can all dream of finding a profit-spinning machine that has high turnover and negative working capital, today’s versions are inherently more vulnerable than those of a generation ago.  They may also come to market in their infancy, when what kind of adults they’ll tun into is harder to imagine or predict.

 

are high margins better than low ones?

October 28, 2016 By in contribution margin, margins, Retail, Uncategorized Tags: , , , 1 Comment

This post is indirectly about Amazon’s retailing business, although it has much wider implications.

My answer:  not necessarily.  It depends on what kind of company we’re talking about.  Note, also, that this is a topic that’s badly misunderstood, particularly in the financial press, which clings to the simple assumption that high margins, of themselves, are better than low ones.

 

The apparent virtue of having high margins is clear.  Companies that have, for instance, essential intellectual property protected by high patent/copyright/manufacturing-knowhow walls, can achieve selling prices that are much greater function of the usefulness of their products/services to customers than of their production costs (this latter is the functional definition of a commodity company).  Software firms can easily achieve 50%–or maybe 80% or 90%–operating margins for their wares.

 

Most distribution companies–both wholesale and retail–don’t work this way, however.  They thrive through low margins, high inventory turnover and careful working capital management to achieve superior financial results.  In fact, for these companies high margins are a threat, not a boon.  Why?    …because high margins attract competition.

the low-margin model

Here’s a (highly simplified) account of how the low-margin model works:

the simplest case

A warehouse holds inventory of $1 million.  It constantly replenishes its stocks, and pays cash immediately for new supplies, so that it always has $1 million invested.  It marks items up by 5% over its costs.

Let’s say the company generates an average of $525,000 in sales per month.  That means it turns over about half its inventory (a turnover ratio of 6x/year) each month, earning operating income of $25,000.  $25,000 x 12 = $300,000 in operating profit per year.  Applying a 1/3 income tax rate, it produces $200,000 in net income.  That’s a 20% return on invested capital. Not bad.

a more favorable one

Let’s now imagine that the company can turn its inventory once a month (turnover ratio = 12).  This means it earns operating income of $50,000/month, or $600,000 per year. This translates into $400,000 in net income. That’s a 40% return on capital.

nirvana

Let’s say the company turns inventory once a month but is large enough or important enough to suppliers that they no longer ask for payment on delivery.  Instead, they are willing to wait for 30-45 days.

Now the company has zero/negative working capital, i.e., no capital invested in inventory.  It’s return on investment is now infinite.

 

Yes, this third case is probably too good to be true.  But it illustrates the enormous, badly-understood, power of high inventory-turnover companies.

 

A post on potential troubles in paradise on Tuesday.

 

 

stocks vs. cash

October 25, 2016 By in Portfolio management, Uncategorized Tags: , , , Leave a comment

At present, cash yields zero.  Investors who hold cash receive safeguarding of their deposits but no financial return.

Stocks carry no guarantees against loss.  At present, the S&P 500 yields about 2%.  One might reasonably estimate that yearly capital gains will average, say, 6% over longer periods of time.

A guaranteed zero vs. a possible +8% per year.  To my mind, not exactly a compelling case for cash.

In theory, and in practice during the 1970s- 1980s, investors have shifted large amounts of money from stocks to cash when the returns on cash have been high enough.

Hence, the thought-experiment question:  how high would short-term interest rates have to be to trigger serious reallocation away from stocks in favor of cash?

My answer:  I don’t know for sure.

In my experience, during periods of much higher interest rates than are the norm today, when short rates would get above half of the expected return (of about +10% per year) on stocks, then money would begin to shift away from equities.  That flow would accelerate–causing stocks to begin to stall–if short rates got to 60% of the expected return on stocks.

 

My conclusion is that short rates would have to get well above 3% in today’s world before reallocation becomes a worry.

If so, a rising Fed Funds rate is something to keep an eye on but not a serious current threat to stocks, in my view.