public utilities and California wildfires

public utilities

The idea behind public utilities is that society is far worse off if a municipality has, say, ten companies vying to provide essential services like power and water to citizens, tearing up streets to install infrastructure and then maybe going out of business because they can’t get enough customers.  Better to give one (or some other small number) a monopoly on providing service, with government supervising and regulating what the utility can charge.

The general idea of this government price-setting is to permit a maximum annual profit return, say 5% per year, on the utility company’s net investment in plant and equipment (net meaning after accumulated depreciation).  The precise language and formula used to translate this into unit prices will vary from place to place.

The ideal situation for a public utility is one where the population of the service area is expanding and new capacity is continually needed.  If so, regulators are happy to authorize a generous return on plant, to make it easier for the utility to raise money for expansion in bond and stock markets.

mature service areas

Once the service area matures, which is the case in most of the US, the situation changes significantly.  Customers are no longer clamoring to get more electric power or water.  They have them already.  What they want now is lower rates.  At the same time, premium returns are no longer needed to raise new money in the capital markets.  The result is that public service commissions begin to reduce the allowable return on plant–downward pressure that there’s no obvious reason to stop.

In turn, utility company managements typically respond in two ways:  invest cash flow in higher-potential return non-utility areas, and/or reduce operating costs.  In fact, doing the second can generate extra money to do the first.

How does a utility reduce costs?

One way is to merge with a utility in another area, to cut administrative expenses–the combined entity only needs one chairman, for example, one president, one personnel department…

Also, if each utility has a hundred employees on call to respond to emergencies, arguably the combined utility only needs one hundred, not two.    In the New York area, where I live, let’s say a hundred maintenance people come from Ohio during a blackout and another hundred from Pennsylvania to join a hundred local maintenance workers in New York.  Heroic-sounding, and for the workers in question heroic in fact.  But a generation ago each utility would each have employed three hundred maintenance workers locally, most of whom have since been laid off in cost-cutting drives.

Of course, this also means fewer workers available to do routine maintenance, like making sure power lines won’t get tangles up in trees.

the California example

I don’t know all the details, but the bare bones of the situation are what I’ve described above:

–the political imperative shifts from making it easier for the utility to raise new funds (i.e., allowing a generous return on plant) to keeping voters’ utility bills from increasing (i.e., lowering the permitted return).

–the utility tries to maintain profits by spending less, including on repair and maintenance

The utility sees no use in complaining about the lower return; the utility commission sees no advantage in pointing out that maintenance spending is declining (since a major cause is the commission lowering the allowable return).   So both sides ignore the worry that repair and maintenance will eventually be reduced to a level where there’s a significant risk of power failure–or in California’s case, of fires.  When a costly failure does occur, neither side has any incentive to reveal the political bargain that has brought it on.

utilities as an investment

In the old days, it was almost enough to look at the dividend yield of a given utility, on the assumption that all but the highest would be relatively stable.  So utilities were viewed more or less as bond proxies.  Because of the character of mature utilities, no longer.

In addition, in today’s world a lot more is happening in this once-staid industry, virtually all of it, as I see things, to the disadvantage of the traditional utility.  Renewables like wind and solar are now in the picture and made competitive with traditional power through government subsidies.  Utilities are being broken up into separate transmission and generation companies, with transmission firms compelled to allow independent power generators to use their lines to deliver output to customers.

While the California experience may be a once-in-a-lifetime extreme, to my mind utilities are no longer the boring, but safe bond proxies they were a generation or more ago.

Quite the opposite.

 

 

 

 

 

 

 

the best of all possible worlds/the invisible hand/modern portfolio theory …and stupid stuff

Leibniz

Scientific thinkers of the seventeenth- and eighteenth centuries in Europe described the universe as being like a gigantic, complex, smoothly-functioning watch.  This implies, they argued, that the cosmos must have been made by the supreme watchmaker = God.

G W Leibniz, the inventor of calculus, offered the idea (later lampooned by Voltaire in Candide) that ours is also the best of all possible worlds.  What about war, famine, disease, poverty…?  Leibniz’ view is that though we can imagine a world like ours, only better, that thought-experiment world is not possible.  Put a different way, Leibniz thought that behind the scenes God uses a calculus-like maximizing function for his creation.  The total amount of goodness in the world is the highest it can be.  Were we to make one existing bad thing better, other things would worsen enough that the sum total of good would be reduced.

Adam Smith

Around the same time Adam Smith introduced into economics basically the same idea, the “invisible hand” that directs individuals, all following their own self-interest, in a way that also somehow ends up serving the public interest.  This idea, still a staple of economics and finance, has the same, ultimately theological, roots–that behind the scenes a benificent God is working to create the best possible outcome.

since then

The scientific world has moved on since Leibniz and Smith, thanks to Hegel/Marx (social evolution), Schopenhauer (collective unconscious), Darwin (natural evolution), Kierkegaard (God of religion vs. god of science), Nietzsche (change without progress) and Freud (individual unconscious).

Twentieth-century physicists, starting with Einstein, have suggested that the universe is in fact messier and more unruly than Newton thought.

Nevertheless, the laissez faire assumption of the invisible hand that makes everything ok remains a key element of economic and financial theorizing.

Modern Portfolio Theory

Invented by academics over fifty years ago, MPT is what every MBA student learns in business school.  Its main conclusion is that the highest value portfolio (i.e., the best of all possible portfolios) is the market index.  A cynic might argue that the main attraction of a theory that says practical knowledge or experience in financial markets is useless is that it suits the interests of professors who possess neither.

However, the conclusion is not just convenient for the educational establishment.  It also fits squarely into the 18th century European Enlightenment view of the “invisible hand” guiding the market.

MPT requires a bunch of counter-intuitive assumptions, summed up in the efficient markets hypothesis, including that:

–everyone acts rationally

–everyone has the same information

–everyone has the same investment objectives

–everyone has the same investment time frame

–everyone has the same risk tolerances

–there are no dominant, market-moving players.

Granted all this, one can argue that any portfolio that differs from the market will be worse than the market.

The standard criticism of MPT is that it ignores the bouts of greed and fear that periodically take control of markets.  In fact, even while MPT was being formulated, markets were being roiled by the conglomerate mania of the late Sixties, the Nifty Fifty mania of the early Seventies and the wicked bear panic of 1974, when stocks were ultimately trading below net cash on the balance sheet and still went down every day.

Arguably anyone looking out an ivory tower window should have noticed that MPT had no way of talking about the crazy stuff that was roiling Wall Street almost constantly during that period–and which showed its assumptions were loony.  Nevertheless, theology trumped the facts.

today

In a way, MPT suits me fine.  The fewer people looking for undervalued companies the easier it is for the rest of us to find them.

However, one basic high-level assumption that even professional investors still make is that the economic/political system in the US functions relatively prudently and therefore the economy remains more or less stable.  But in essence this is only a different way of saying the “invisible hand” guides self-interest-seeking individuals in politics toward a socially beneficial result.

I’m not sure that’s true anymore, if it ever was.  For one thing, Washington has relied almost exclusively on monetary policy to fine-tune the US economy over the past generation–encouraging all sorts of unhealthy financial speculation and intensifying social inequality.  Washington has also done less than the ruling body of any other developed country to help citizens cope with dramatic structural economic changes over the past twenty years.  Resulting dissatisfaction has caused the rise to power of newcomers like Donald Trump who have pledged to address these issues but whose racism, venality and stunning incompetence appear to me to be doing large-scale economic and political damage to the country.

This development presents a significant issue for laissez faire theorists in the way deep emotionally-driven market declines do for the efficient markets hypothesis.  As a practical matter, though, the situation is far worse than that:  recent events in the US and UK illustrate, populating the halls of economic and political power with self-serving incompetents can do extraordinary amounts of damage.  Left unchecked, at some point this has to have a negative effect on stock returns.

 

 

 

 

 

 

 

 

 

 

Keeping Score, September 2019

I’ve just updated my Keeping Score page for September 2019.  No sign so far of the traditional actively-managed mutual fund selloff in advance of the Halloween yearend.  I wonder why.  Is this a function of the AI era?   …the fact that passive money under management exceeds actively managed?   …is selling just late?

Will no selloff now mean no 4Q rally?    …that would be my guess.

WeWork (WE) and Wall Street: my take

I’ll start out by underlining that I don’t know enough about WE to have a usable investment opinion about the offering’s merits.  I do have opinions, though.  It’s just that they’re more like my thoughts about the Mets than a way to make money.  Anyway, here goes:

in general

–the WE structure isn’t new.  Think: a savings and loan, or a hotel chain, or an airline or an offshore drilling company, or a container ship firm–or, for that matter, a cement plant or a coal mine.  All these involve owning expensive long-lived assets which are typically debt financed and whose use is sold bit by bit.   Although there may be attempts at branding, with varying degrees of success, in the final analysis these are commodity businesses.

–in good times, this is a favorable structure for a company to have.  Costs remain relatively constant as selling prices rise, so most of the increase drops down to the pre-tax line.  Rental/purchase contracts may limit annual price increases, but investors typically factor in anticipated rises relatively quickly

–in bad times, it’s not great.  Customers may stop purchasing with little notice, sometimes walking away from contracts or renegotiating them sharply downward (using the threat of termination as leverage).  Offshore drilling rigs are an extreme example of feast/famine cyclicality

–because of cyclicality, PE multiples for mature firms with this structure tend to be low.  When such companies come to market, they tend to try to ride a wave of energy generated by previously successful IPOs–meaning that simply the appearance of their offering documents is a sign of potential overheating

WE

–in the case of WE, investor perception appears to be frosty.  This is partly because of what I’ve just written.  Also, from what I’ve heard and read, the 350+-page prospectus is not particularly illuminating (I’ve flicked through it but haven’t analyzed it myself)

 

investment implications

The arrival of the WE prospectus coincides with a sharp selloff in the shares of recent tech-related IPOs.

Two possible reasons:

Wall Street thinks that the marketing campaign for WE heralds the end of the line for the current IPO frenzy, on the argument that the underwriters would be presenting a higher quality offering if they had one.  This is what I think is going on.

The other possibility I see is the week-long, humorous but kind of scary Alabama weather discussion, an episode I think makes anyone question the mental stability of Mssrs. Trump and Ross.

In any event, given that some newly-listed tech names have fallen by a quarter or more over the past week or so, I think it’s time to sift through the ashes.

 

Having said that, I do suspect that a significant rotation away from these former market darlings, triggered by WE but based on valuation, is now underway. This will only mark a fundamentally new direction for the stock market if the tariff wars go away completely.  I don’t think this will happen.  So I’d buy a partial position now and hope to pick up more on further weakness.  Remember, too, that this is a highly speculative corner of the market, so it’s not everyone’s cup of tea.

 

 

Trump’s economic “plan”

So far the Trump administration has launched two countervailing economic thrusts:

income taxes.   

Starting in 2018, the corporate tax rate was reduced from a highest-in-the-world 35% to a more nearly average 21%.  The idea was to remove the incentive for highly taxed US-based multinationals, like pharmaceutical firms, to shift their businesses elsewhere.  In the same legislation the ultra-wealthy received a very large reduction in their income taxes, as well as retention of the carried interest provision, a tax dodge by which private equity managers convert ordinary income into less highly taxed capital gains (this despite Mr. Trump’s campaign pledge to eliminate carried interest).  Average Americans made out less well, receiving a modest reduction in rates coupled with loss of real estate-related writeoffs that skewed the benefits away from heavily Democratic states like California and New York.

Washington made little, if any, attempt to end special interest tax breaks to offset the lower corporate rates.  The result in 2018 was a yoy increase in individual income tax collection of about $50 billion, more than offset by a drop in corporate tax payments of about $90 billion.  Given the strong economy in 2018, the IRS would likely have taken in $150 – $175 billion more under the old rules than it did under the new.

What I find most surprising about the income tax legislation is that the large deficit-increasing fiscal stimulus it provides came at a time when none was needed–after almost a decade of continuous GDP growth in the US and the economy at very close to full employment.

the tariff wars.

Right after his inauguration, Mr. Trump pulled the US out of the Trans-Pacific Partnership, a trade group aiming to, among other things, fight China’s theft of intellectual property.  However, exiting the TPP for a go-it-alone approach hurt US farmers, since it also meant higher (and escalating each year) tariffs on US agricultural exports to TPP members, notably Japan.

Next, Trump presented the tortured argument that: (1) that there could be no national security if the economy were not growing,  (2) that, therefore, the presence of foreign competition to US firms in the domestic marketplace threatens national security,  (3) that Congress has given the president power to act unilaterally to counter threats to national security, so (4) Trump had the authority to unilaterally impose tariffs on imports.  So he did, in escalating tranches.

No mention of the fact that tariffs slow GDP growth, so under the first axiom of Trump logic are themselves a threat to national security.

Not a peep from Congress, either.

Recently, Mr. Trump has announced that he also has Congressional authority, based on a 1977 law authorizing sanctions against Iran, to order all US-based entities to cease doing business with China.

Results so far:

–the predictable slowdown in economic growth in the US

–retaliatory tariffs that have slowed growth further

–higher prices to consumers that have for all but the ultra-wealthy eaten up the extra income brought by the new tax law

–a sharp drop in spending on new capital projects in the US by both foreign and domestic firms

–tremendous pressure by Trump on the Federal Reserve (in a most un-Republican fashion (yes, I know Nixon did the same thing, but still…)) to “debase” the dollar.

Why?

A falling currency can temporarily give the appearance of faster growth.  But it can also do serious, and permanent, damage to a country by reducing national wealth (Japan is a good example).  Its only “virtue” as a policy measure is that it’s hard to trace cause and effect–politicians can deny they are mortgaging the country’s heritage to cover up earlier mistakes, even though that’s what they’re doing.

–an apparent shift in the goal of US trade negotiators away from structural reform in China to resuming purchases of US soybeans

my take

–if there had been a plan to Trump’s actions, tariffs would have come first, the tax break later.  The fact that the reverse happened argues there is no master strategy.  Again no surprise, given Trump’s history–which people like us can see most clearly in his foray into Atlantic City gaming.

–what a mess!

A better way to combat China?    The orthodox strategies are to strengthen the education system, increase scientific research spending and court foreign researchers to come to the US.  Unfortunately, neither major domestic political party has much interest in education–Democrats refuse to fix broken schools in large urban areas and Republicans as a party are now against scientific inquiry.  The white racism of the current Washington power structure narrows the attraction of the US in the eyes of many skilled foreigners.   The ever-present, ever-shifting tariff threat–seemingly arbitrary levies on imported raw materials and possible retaliatory duties on exported final products–means it’s very risky to locate plant and equipment in the US.

For what it’s worth, I think that were the political situation in the US different there would be substantial Brexit-motivated relocation of multinationals from London to the east coast.

investment implications

To my mind, all this implies having a focus on software companies, on low-multiple consumer firms that focus on domestic consumers with average or below-average incomes, and on companies whose main business is in Asia.  Multinational manufacturers of physical things for whom the US and China are major markets are probably the least good place to be.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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