Author: subir

Dead Cat Bounce: Intra-day swing of 700 Dow points, ending down 200

Dead Cat Bounce: Intra-day swing of 700 Dow points, ending down 200

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Futures this morning were up over 500 points, most of the trading during the day was above the 16,000 level between 250 and 400 points up. But we’ve closed at 15,666, the lows of the day.

Though yesterday’s numbers were eye-popping, today is arguably going to create more jitters. Big intra-day swings that end on lows scare traders. Though China and Japan were down, most of Europe and Asia was up. So the stage was set for an uptick in the US. Which reminds me of the senior equities trader who once told me “Europe does nothing at all till 1pm when the Americans come in to set the tune”. The negative close means the three largest markets, China, Japan and the US closed down today.

There’s the inevitable talk of painting the close. And there is the competing view that the morning session was just a dead cat bounce.

The real story is that Chinese over-investment in infrastructure and capital goods is grinding to a halt (they’ve built more roads, rails and apartments than they need). It’s all fueled by large increases in borrowing which is what causes most bubbles. Given the size of the Chinese economy, this has had an impact on resource prices (who is going to use all that oil and iron). At the margins, this will impact US businesses, especially the global behemoths. There are some parallels to the US situation in 1928, also coming at the end of a period of extensive capital investment (also in railroads) and when the US was emerging as a major economic powerhouse.

The backdrop is that US stocks are at cyclically high valuations, at least as measured by longer-term ratios like CAPE. This coupled with a 7 year long rally means a lot of people are rightfully wondering whether stocks can go higher.

As an aside, over 80% of stocks on the Shanghai exchange were untradable yesterday. Many of them because they hit the daily limit of a 10% fall in prices, the rest are suspended at the request of company management.

The real risk is China, not Greece – 2015 Q2 Letter

The real risk is China, not Greece – 2015 Q2 Letter

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Two inflection points long in the making appear to have arrived simultaneously over the past few weeks. In Europe, negotiations between Greece and Euro-zone countries that have lent to Greece appear to have broken down; and in China, the stock market has taken a remarkable tumble. In itself, the Shanghai market’s steep fall is not surprising or remarkable (this was a market which had risen 150% over the previous year), but it is interesting in terms of what it portends for other markets and factors in China.

The various actors in the Greek/Euro crisis have indulged in brinksmanship for a number of years. The ECB, Euro-zone countries and the Greek government have stumbled from one crisis to the next, taking action only when forced to do so. And when they have acted, the result is to defer rather than reach resolution. It is clear to us that no final resolution of Greece’s sovereign debts can be made without some debt relief. The Greek economy has shrunk enormously under the weight of uncertainty and austerity policies. None of the modeled targets for growth have been met and Greece’s debts are now a larger multiple of Greek GDP (180%) than ever before, largely because of the sharp decline in GDP. A sudden growth spurt may solve that, but given high unemployment, it is difficult to see that materializing without some level of debt relief to lower the amount of the outstanding loans and interest payments. In reality, the only thing that has been achieved thus far is that Greek loans have been moved from the balance sheets of European banks to the balance sheets of European nations. European (and international) banks that lent to Greece, knowing the risks, were bailed out. There has been no such deliverance for Greece itself, and, despite frantic 11th hour negotiations, we do not expect one in the coming days.

A crucial factor that has made the crisis much worse for ordinary individuals in Greece is the absence of a pan-European deposit guarantee scheme. Bank customers in the US have enjoyed a federal guarantee for their deposits since the 1930s. This guarantee currently applies to the first $250,000 on deposit at an FDIC covered institution and has been the primary reason the US has avoided widespread bank runs by retail customers for the past 80 years. In contrast, deposit guarantees and guarantee funds in Europe are run at the member state level. So Greece guarantees the deposits in its banks up to 100,000 Euros. Of course, Greece (unlike the US federal government) has no ability to actually print Euros on demand. That means most bank customers treat its deposit insurance with justified skepticism. Greek banks too cannot count on the European Central Bank to lend to them freely in a crisis. There is an emergency lending facility, but it works through the member state central banks and let’s just say relations between Greece and the ECB are not exactly amicable at the moment.

These two factors taken together explain the phenomenon of Greek pensioners queuing for hours to withdraw the maximum amount permitted from their bank accounts each day (60 Euros). They do not trust the funds will be covered by deposit guarantees and Greek banks are limiting withdrawals, afraid they will run out of Euros.

As a study in contrasts, we have Puerto Rico, which is facing a similar government debt crisis, largely brought on by similar factors (mismanagement, misstatement of financial data, etc.). Yet, the impact is limited to the government’s ability to issue more debt and the value of its bonds. Puerto Rico’s bank will face no runs and will continue to function even if the government runs out of money. They are regulated and insured at the federal level. So, though Puerto Rico’s debt crisis is very serious, and will likely require some level of write downs, its banking system continues to hum along and is not at risk. If the European Union had a similar bank deposit guarantee system, we believe the Greek crisis would not have been as severe.

Lastly, what makes the Greek case significant and holds the market’s attention is not the size of Greece’s debts, which at around 300Bn are large, but not enormous. A 30% write-down of those debts would be 100Bn, some individual banks took write-downs in the 30-70Bn range during the financial crisis. Clearly Greek creditors (EU countries for the most part) could survive a 30% write-down.

What concerns the markets is that the Greek crisis lays bare an uncomfortable truth. The European Union is both unable, and unwilling to act decisively or with coordination in a crisis. The reasons are myriad, but to us, it has been particularly striking to hear World War I and II era rivalries and events repeatedly invoked by some commentators and even senior politicians. A skeptical observer might say that the institutions created to avoid the recurrence of war on the European continent seem to be hell-bent on re-living them. In contrast, though, we in the United States have had the traumatic experience of reliving civil war-era animosities over the past few weeks, those fervently invoking a North/South divide are firmly in the fringe and have been for at least a century. The same cannot be said of Europe.

We have been wary of asset prices and debt burdens within China for a number of years. Some of those concerns have bubbled to the surface in the last few weeks as the Chinese domestic market has endured a series of dramatic losses with many stocks hitting their down limits and several have halted trading entirely. Companies can also ask to suspend their own shares and many have. Most observers have expected such a crash since the on-shore Shanghai market has risen over 75% this year. What was underappreciated is how much of this rise has been driven by large numbers of first-time retail investors, many of them buying stock on margin (borrowed money). The conditions appear to resemble the state of the US market on the eve of the 1929 and 2000 stock market crashes. In certain ways, there are broader parallels with 1929. China is at roughly the same stage of relative development with the US that the US was to the UK in 1929. China has also seen massive investment in capital infrastructure with declining returns, not unlike the US investment in railroads in the 20s. Lastly, there are large quantities of questionable loans on the books at Chinese banks. Taken together, this story is much bigger and could have much wider repercussions than that just a few down days in a large emerging market.

The final consideration is political. Though there is a lot of tittering at the prospect of the Communist party attempting to support the stock market, this is driven by legitimate fears of political unrest if a severe downturn were to materialize. Coupled with factionalism within the party, such a downturn could make for a very volatile period in China, politically speaking. The impact is likely to be felt across commodity sectors (where China remains a major consumer), and a risk of contagion to other markets. In the short term, we expect the US markets will be seen as a relative safe haven. Though clearly, as one of the three largest economies in the world, any Chinese downturn will affect global market values.

On balance, we view the bursting of the Chinese equity bubble and antecedent effects as more significant than the Greek debt crisis. In terms of wealth impact, they certainly are — the Chinese stock market has lost over $3Tn over the past few weeks. That is ten times the amount of outstanding Greek debt. Margin balances owed by Chinese investors are larger than Greek debt. The real concern, though, is that the stock market bubble in its rise and fall, may lead to a bigger reckoning of Chinese financial institutions which are holding real-estate and provincial debt. As the real-estate sector has slowed, demand for land, which constituted a crucial source of funding for Chinese provinces, has dried up. Both real-estate developers and Chinese provincial government debts are looking very weak and they are widely held by Chinese banks and investors.

In general, we recommend appropriate caution for investors. Though the US markets may appear to be isolated from events in Europe and China, and might even benefit from some short-term “flight to safety”, they will eventually be impacted, and current valuations stateside do not bode well for that reckoning.

We continue to believe that investors will be well served to reduce exposure to risk assets in their portfolios and move some money into short term bonds and cash while awaiting a better buying opportunity.

2015 Investment Themes: The bells that toll

2015 Investment Themes: The bells that toll

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  1. If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. Short term rates after the tech wreck and 9/11 were kept below 2.0% for 3 years. For one of those years, rates were at 1.0%. Since the financial crisis of 2007/2008, rates have been kept below 0.25% for over 6 years. Both the level of the rates and the duration of the rate cut is extraordinary.

 

  1. No one rings a bell at the top of the market: US stock markets ended the year at almost three times the lows reached at the bottom of the market less than six years ago. We expected sharp corrections last year that failed to materialize. We are renewing our call this year and urge equities investors to exercise caution. And while we recognize the US stock economy looks healthier than those overseas, we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory.

 

  1. Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. The challenges are different, but as impactful for economies with internal imbalances created by over-investment in infrastructure such as China, and those facing enormous upheaval and political instability like Turkey. In the Chinese case, we are particularly concerned about the state of local and provisional government finances. We expect emerging market stocks and bonds to underperform developed markets this year.

 

  1. Commodities weighed down: With a slow-down in emerging markets and the global economy in general, we expect commodity prices to continue to come under pressure. While prices in certain commodities may stabilize, we do not expect a bounce back to levels seen in recent years.  We see commodities finishing the year flat to negative.

 

  1. The trouble with oil: We do not expect oil prices to substantially recover in 2015. It is clear that major OPEC participants in the middle-east are keen to minimize the profitability of oil as a source of funding for rebel groups in the region. They are also responding to medium-term strategic threats from unconventional oil producers (shale, deep sea, and tar sands) by forcing prices to levels that makes investment in such projects unprofitable. Continued unrest in major oil producing regions (Middle East, Russia, Venezuela) does not seem to have impacted supply or prices. We expect brent crude prices to remain under $60 by year’s end.

 

  1. Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view.

 

  1. Euro Crisis, back to the future: The Euro and Greek debt crises have faded from world news headlines over the past three years. A series of loans by the EU and IMF have succeeded in bringing down interest rates on Greek debt. In the past two months, however, a confluence of factors have roiled European markets. An impending election and veiled threats to renege on prior commitments by the party leading in Greek polls (Foriza) weigh heavily. We also expect court rulings on whether the European Central Bank can follow in the Fed’s footsteps with quantitative easing . Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro.

 

  1. Junk bonds get kicked to the curb. If, as we expect, interest rates rise over 2015, the long winning streak of high yield bonds will likely come to an end.  Junk bonds have benefitted from the Fed’s zero interest rate policy as savers have been forced to invest in increasingly lower quality bonds in order to find yield.  With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk.

 

  1. Growth in Renewables: 2008 saw high flying clean energy stocks taken to the wood shed when oil prices collapsed.  The thinking then was that renewables were not viable in a world flush with cheap energy.  While that thesis made sense seven years ago, the renewable industry has grown in leaps and bounds since.  Utility scale solar and wind projects have proven to be viable sources of energy as costs have come down and demand for renewable power has increased globally.  With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors.  We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place.

 

  1. The Russian question: 2014 has been a disorienting year for Russia. Ukraine, a neighboring state with long historical ties to Russia saw enormous unrest leading to a revolutionary change in government and the potential breakup of the country into Eastern and Western factions. Russian forces occupied and appear to have annexed the region of Crimea. Meanwhile, declining oil prices have placed substantial pressure on Russian public finances and may begin to erode support for Mr. Putin among both the grassroots and his oligarchic supporters. It is difficult to see non-traumatic paths out of the morass. Under Putin’s leadership, Russia’s structural problems (declining population, aging industrial base, and undiversified economy) have become worse. We are bearish on Russia and expect the Russian market to underperform in 2015.
2014 Themes: Year-End Review

2014 Themes: Year-End Review

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2014 Themes: Year-End Review

 

  1. × The bond decline continues: …The 20 year treasury began 2013 at 2.63% and ended the year at 3.70%. We wouldn’t be surprised to see it exceed 4.50% by the end of 2014….  We were flat out wrong on this prediction. Increasing uncertainty overseas drove demand for treasuries that was not countered even by the unwinding of the Fed’s bond buying program. 20 year treasuries ended 2014 at 2.49%, while the 30 year was at 2.76%.

 

  1. × Equities: Last Call at the QE punchbowl …These will put a lot of pressure on stock prices. With multiples at cyclical highs, conditions are ripe for a significant correction, especially in US markets. We advise investors to avoid complacency and prepare for a potential 20%+ correction in 2014.  We were wrong on this prediction as well. The S&P 500 ended the year up almost 13% and earnings were at an all-time high for the index.

 

  1. ? Bitcoins backlash: …Despite the concerted efforts of many conspiracy theorists, we do not see a major reckoning for fiat currencies in the offing and therefore continue to caution against allocations to alternative or commodity based currencies. We were right on this call. Bitcoin prices fell from over 750 at the beginning of 2014 to start 2015 under 300.

 

  1. ? Social Media Mania: …We are long-term believers in the transformative potential of technology, but do not believe current valuations are anywhere near reasonable. Investors will have to be a lot more selective in 2014 if they are to avoid the kind of fall we saw in the early 2000s. We expect to see several of these high-flying tech IPO darlings come back to earth this year. A number of 2012 and 2013’s high-flying social media IPOs saw prices collapse, this included companies like Twitter, Yelp, Zynga, Groupon. Others like Facebook and LinkedIn retained or regained their heights.

 

  1. ? Go Global or Go Home: …We believe media companies with strong properties are on the cusp of another period of growth in market-share. At reasonable valuations, they represent an attractive long-term investment. At the same time, we believe strong regional, cultural media properties will also find traction in their home markets and any areas with affinity. This is more of a long-term prediction and we expect to evaluate it over time.

 

  1. ? Commodities Wane: Commodities, for the most part, have been in a relatively flat holding pattern since the 2008 bubble. We expect commodity prices to remain weak or stagnant throughout 2014. We do not anticipate large rises in economic activity in the offing, which means commodity prices will remain depressed.  We do not expect gold or other precious metals to recover and anticipate further declines. We were right on this call, almost spectacularly so on oil, which fell almost 50% to under $60 a barrel. Gold was largely flat. The S&P/Goldman Sachs Commodity Index lost 35% over the course of the year.

 

  1. × Wages and Profit: The past few years have seen corporate earnings rise while average wage income has stagnated along with labor costs as a portion of GDP. We expect 2014 to reverse some of this trend as a declining unemployment rate and an evolving political climate make for higher wages and a higher minimum wage floor. We believe this will put pressure on industries and companies that rely on a large, low-paid work-force. After-tax corporate profits as a percentage of GDP rose to over 10% during 2014. This is higher than at all previous periods in US history. The last period that came close was 1929, the eve of the Great Depression when they reached 9.1%. Pre-tax corporate profits hit 12.5%, tying the prior high set in 1942 when companies benefited from increased demand for industrial goods as the US entered World War II.

 

  1. ? Health-Care Strengthens: Gains in the Health-Care Index have outpaced that in the broader markets by about 10% in 2013. 2014 is the first year the impact of the Affordable Care Act will be felt in revenues of insurers and health-care providers. We expect health-care revenues will rise and the sector will continue to outperform the broader market this year as well.  The S&P healthcare service index rose over 24% during 2014. The healthcare equipment index rose over 18%. Both handily exceeded the overall S&P gain.

 

  1. ? Atlantic tug of war: The Euro has appreciated against the Dollar over the course of 2013, as the European fiscal crisis has been pushed off center stage. We believe the Fed’s tapering will reverse this move and we will begin to see the dollar appreciate as rates rise in the US. We were right on Euro valuation, the Euro fell over 12% during 2014 to end the year under 1.20.

 

  1. ? Water Works: We have been concerned about water-related infrastructure for a number of years. Most population growth is occurring in regions with limited access to large quantities of fresh water and this problem is more acute than any issues with power generation. We believe consumers and regional planners have begun to appreciate this as well and we will see a rise in investments directed towards water infrastructure. Major engineering companies and water utilities should benefit, as will firms with consumer products that improve efficiency.   While we view this as a long term investment trend, 2014 saw US water-related stocks substantially outperform the S&P 500 index.  The Dow Jones US Water Index was up 24.67% for the year.
2014 Q3 letter: Rates and Revolutions make the world go ’round

2014 Q3 letter: Rates and Revolutions make the world go ’round

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The summer of 2014 has been one of revolutions with unrest spreading across much of Central Asia and the Middle East. Towards the end of September, we also saw a protest movement begin to take hold in Hong Kong. The common thread running through so many of these events is the democratic aspirations of a younger generation—a generation that, through the use of social media, now has instant access to much of the world’s current events and can compare the conditions of their own country with the rest of the world. When this comparison highlights unresponsive, ossified political and economic institutions, this generation demands change. This is happening in ways both big and small, and the United States is not immune as we can see from the manner in which the protests in Ferguson, MO snowballed. In a very real sense, these events are a testament to the radical advances in personal communication technology made over the past few decades. It is also a testament to the soft power of the world’s market-oriented democracies, which are viewed as a role-model by much of the world.

Change though, is by definition disruptive, and these revolutions, both big and small, are no exception. The most violent ones in the Middle East and Ukraine have disrupted life and trade in many ways. The destruction of human and physical capital will, in many countries, take years to mend. US markets have seemed immune to these political events, but that can change quickly.

For investors, the bigger question is in the timing of Federal Reserve’s next steps. Over the course of 2014, the Fed has unwound its highly unusual program of bond purchases. These purchases have helped buoy the bond markets and kept long-term rates low for an extended period. These historically low rates have allowed many creditors to refinance medium and long-term debt at attractive terms. Meanwhile, an unprecedented program to keep short-term benchmark rates at near 0% has helped banks shore up balance sheets and spurred some investment. As bond investors well know, low yields on the safest investments have pushed many into investments riskier than they would otherwise tolerate.

Since late 2007, the Federal Reserve has used every tool in its arsenal to shore up business conditions in the US. They have also developed new ones (including bond purchases that expand the Fed balance sheet) and radically expanded the scope of traditional methods. The most unorthodox of these policies have been almost completely unwound (the Fed is expected to officially end its bond purchasing program on Oct 29th). What is left is an unusually low short-term interest rate and large bond holdings which will roll off over time. In previous public comments, Federal Reserve governors have said they will carefully consider labor market conditions before amending the current interest rate policy. The market has widely read this as waiting for a headline unemployment number under 6%. Headline unemployment as reported on October 3rd was 5.9%. Though most observers agree the labor market is still not robust—which is apparent when we see the extraordinary numbers of discouraged and involuntary part-time workers—we have had zero rates for nearly six years now and many on the board of governors are uneasy with that length.

The US election cycle may play a role in the timing of an interest rate rise, but we do not expect the Fed to move before the upcoming midterm election in November. Similarly, we do not expect them to move rates dramatically in a presidential election year. This means 2015 might be the best opportunity for the Fed to gradually bring rates up from 0% to some nominally “normal” level (say 2.0%) and then pause to take stock and wait out the election. In our view, this is the likeliest scenario, absent another major market upheaval.

Since 2009, the winding down of Fed stimulus programs have led to selloffs in equity markets. We expect Oct/Nov of 2014 to be no different and recommend clients remain defensive with their allocations. If the Fed is serious about ending further stimulus, the stock market will need to stand on its own two feet. Given recent record highs, we are skeptical that equity prices will continue their meteoric rise in the absence of Federal stimulus and with the threat of impending rising interest rates on the horizon. 2014 has already seen the beginnings of a correction in more speculative stocks (the Russell 2000 small cap index is down approx 5% year-to-date through 9/30 and down nearly 10% since its peak in early July). If we see a correction, we expect there will be buying opportunities where quality companies can be had at discount prices.

In other news, after 5+ years of residing in the Flatiron area, we have recently relocated our office to Midtown. Our new contact info is as follows:
261 Madison Ave, 10th Flr
New York, NY 10016

Tel: +1.646.450.9772
Fax: +1.929.244.0256

Regards,

Subir Grewal                                               Louis Berger

2014 Q1 Letter: High Frequency Trading and the average investor

2014 Q1 Letter: High Frequency Trading and the average investor

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Dear Friends,

The first quarter of 2014 saw an uptick in stock market volatility as a change in Fed leadership and Russia’s annexation of Crimea caused some investors to rethink investment and trading positions. The Dow Jones Industrials finished the quarter -0.72%, the S&P 500 +1.3% and the Nasdaq 100 was +0.54%.

Meanwhile, after a poor showing last year, bonds bounced back in Q1, outperforming equities. The Barclays Aggregate Bond Index finished the quarter +1.97% while the Barclays Municipal Index saw gains of +3.32%.

Though these movements are not large, there have been significant moves in particular sections of the market. In 2013, certain internet and biotech stocks rose to excessively optimistic valuations, but 2014 has seen particular weakness in these names. We believe this indicates the broader market is nervous to some degree about growth prospects with many participants taking profits in what they perceive to be the weakest and most speculative names.

The dramatic events in Ukraine have also jittered investors, particularly those exposed to Russian assets or consumption. The risk of rising tensions and economic sanctions against high-spending foreigners has depressed luxury goods makers and brought a chill to higher end real estate in major global metropolis. At the same time, we have seen Chinese investors and companies spooked by falling demand and regulatory actions in China.

January saw Janet Yellen officially step into her new role as Fed Chair, replacing the departing Ben Bernanke. In March, she held her inaugural press conference, which seemed to go well, until she was asked a follow-up question about when she expects interest rates to be raised. She had used the term “a prolonged period” which a reporter asked her to clarify.

Unlike her predecessors, who would have either ignored the follow-up question or provided a maddeningly vague answer, Yellen, in what may have been an attempt to shed light on the traditionally opaque Fed, answered “It’s hard to define but, you know, probably means something on the order of around six months.” US stocks immediately sold off on this comment, as investors interpreted this to mean that the Fed’s easy money policy would end sooner than originally thought.

This incident reinforces our view that markets have become far too reliant on the Fed’s easy money policy. We expect risk assets (namely stocks) will continue to be under pressure as the Fed winds down its stimulus program.

High frequency trading has been in the news over the past several weeks with the release of a couple of high profile books that delve into the guts of the equities marketplace. The steady demise of physical trading floors and the advancement of technology has moved virtually all trading volume onto electronic venues. Inevitably, the vast sums at stake have led to an arms race amongst trading firms. We’ve known for some time that major market-makers have been doing their utmost to gain physical proximity to exchange computers so they can see orders as quickly as possible. The exchanges (which have over the past fifteen years transformed themselves from member-owned organizations to for-profit publicly traded corporations) have not been shy in tapping this new revenue stream. In our view, this is not any different from the old days when traders who participated in the market would buy an exchange membership so they could walk onto the floor and be in the middle of the action. There was an informational advantage to seeing the activity of the actual participants on the floor, this advantage still exists, but the venue is electronic. Most investors will never have cause to consider high-frequency trading or being part of the market on an exchange floor. This is highly specialized activity requiring very specific skills, which is why exchange memberships were limited, and why there are only a few successful HFT firms.

The move to electronic market-making has been largely beneficial for investors. Costs to execute transaction have fallen. Investors who would pay brokerage commissions in the hundreds of dollars now pay a handful of dollars for the same. But the far larger impact has been on bid-offer spreads, the difference between the price at which the market is willing to buy and sell a particular stock. With decimalization, these have fallen from one-eight or one-sixteenth of a dollar down to a cent or less in most cases. Most individual investors will not generate orders that are the target of HFT algorithms since they are too small to generate predictable patterns.

What has changed, and does concern us, is that some exchanges are changing rules at the behest of HFT firms. There has been a profusion of order types for interest, the vast majority of these are not used by the average investor (of any size). They’re exclusively used by the programs run by HFT shops to discover what market participants are doing without running afoul of securities regulation. In a sense, the exchanges have been responding to customer demand, since much of their revenue now comes from HFT firms, but this is short-sighted. The true clients of stock exchanges are the investors and listed companies (and by extension the investment advisors and brokers who represent them). Prior to de-mutualization, leadership at exchanges knew this and balanced the interests of their members (who were on the floor every day trading and making markets) and those of investors and corporate issuers. It seems this balance has been skewed and some electronic exchanges may have become captive to the interests of the firms who generate the most revenue for them. This short-term thinking, and the belief that obeying the letter, rather than the spirit of our laws (which broadly aim for investor protection) is what worries us.

In other news, we recently hired a new intern named Daniel Sobajian. Daniel comes to us from Columbia University where he’s majoring in political science. Daniel is also founder of Studentsdo.org, a non-profit he started while in high school that provides school supplies to needy students in southern California.

Louis recently published an article on the website greentechmedia.com. The article investigates the risks of investing in crowd-sourced clean energy projects, specifically Solar Mosaic. You can read the article by logging onto greentechmedia.com and running a search for Louis Berger.

Louis Berger                                                                    Subir Grewal

2014 Themes: Use Extreme Caution

2014 Themes: Use Extreme Caution

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Dear Friends,

We’d like to start off by wishing you a very happy and healthy 2014. We trust you enjoyed the holiday break with family and friends.

At the beginning of each year, we put together a list of our top 10 investment themes and predictions for the year ahead.  We’ve done this now for four years, and our fifth installment is enclosed. We hope our perspective helps inform your view of the current and future investment climate.

We’ve also graded ourselves on our 2013 themes: we were wrong on one, right on seven, and are giving ourselves half a point for two. Eight out of ten is a very good score in the investment world. However, our celebration is tempered by the fact that we were rather wrong on our call for equities. Developed market stocks performed very, very well in 2013 with the US leading other markets.

That has not deterred us from applying our value methodology to equities in looking forward. We continue to caution investors to be wary of US stock prices which are currently rather high.  For most investors, we would recommend a moderate underweight towards stocks in their portfolio, but there are other ways to implement a cautious view towards equities.

The New Year also brings with it an opportunity to make decisions on certain tax and retirement plan issues. We encourage clients to think about the following, and we are happy to discuss them in more detail:

  • If you haven’t already, this may be a good time to put together a household budget for 2014.
  • Review your 401k contributions for 2014 to confirm you’re saving enough for retirement.
  • You have until tax day to make a 2013 contribution to an IRA. The limit for 2013 is $5,500 ($6,500 if you’re over 50).
  • If your financial plan is at least two years old it may be time to revisit it along with your will, life insurance and other long-term financial documents.

We hope you have a chance to review our themes for 2014. We look forward to speaking with you to review your accounts for the start of the year and we’d be pleased to address any other questions you might have.

Regards,

 

Louis Berger                                                                                        Subir Grewal

 

 

  1. The bond decline continues: 2013 was not a good year for bonds, particularly longer term (20+ year) bonds which saw double digit losses.  With the Fed’s announcement that “tapering” (aka stimulus removal) will begin in January, market participants should brace for higher rates/yields and lower bond prices.  While we don’t foresee a rapid rise in rates (the Fed should be able to prevent a shock), we think the trend will continue.  The 20 year treasury began 2013 at 2.63% and ended the year at 3.70%.  We wouldn’t be surprised to see it exceed 4.50% by the end of 2014.  If it approaches 5%, we think it would provide a good entry point for investors to begin taking positions in longer dated bonds (10+ year maturities) again.
  2. Equities: Last Call at the QE punchbowl: The US and global equities rally has been underway for almost five years now and US indices have roared back, setting all time record highs in 2013.  As most market participants know, the economy, while improving has not done most of the heavy lifting.  Stocks and earnings have benefitted most by the easy money/stimulus policies of the Fed.  Ben Bernanke’s era as Fed Chairman has come to a close, but not before a pre-announced reversal in policy as the Fed attempts to unwind their QE program.  This will likely cause interest rates to rise which will create a tougher earnings climate and contracting PE (Price-Earnings) multiples for most companies.  These will put a lot of pressure on stock prices.  With multiples at cyclical highs, conditions are ripe for a significant correction, especially in US markets. We advise investors to avoid complacency and prepare for a potential 20%+ correction in 2014.
  3. Bitcoins backlash: 2013 saw the “virtual currency” bitcoin garner a great deal of interest, and publicly-announced investments from some high-profile personalities. In our view, bitcoins are no different from tulips in Amsterdam during the early 17th century.  They are the latest incarnation of speculative manias that invariably end in tears.  What sets bitcoins apart from the South Sea Bubble, Railroad mania, Florida Real-Estate and even Tulip Mania, is that the speculative premise is even more unlikely than all prior episodes.  Bitcoins are generated expending the same sort of worthless effort that gold miners do when mining gold from underground veins, refining it and storing it back in underground vaults. The entire process adds no value to human life except for those amongst us who gain intrinsic satisfaction from knowing some dull, heavy, yellow metal is being held on our behalf. Perhaps the one thing we can say about bitcoins is that mining them does not result in the terrible environmental impact that mining gold does. Despite the concerted efforts of many conspiracy theorists, we do not see a major reckoning for fiat currencies in the offing and therefore continue to caution against allocations to alternative or commodity based currencies.
  4. Social Media Mania: 2013 has seen a handful of very high profile IPOs from social media companies.  Some of these companies have minimal revenues and in many cases no prospect of increasing them without significantly degrading the user experience.  Numerous companies are trading at stratospheric P-Es above 200. We are long-term believers in the transformative potential of technology, but do not believe current valuations are anywhere near reasonable. Investors will have to be a lot more selective in 2014 if they are to avoid the kind of fall we saw in the early 2000s. We expect to see several of these high-flying tech IPO darlings come back to earth this year.
  5. Go Global or Go Home: One of the defining characteristics of the telecommunications revolution of the past two decades is that the world has never been closer.  For the first time in history, a large portion of the human population, particularly the elite, richest sliver, consumes the same media. Baywatch was the first globally syndicated show watched across the world for its universal appeal and it first aired 25 years ago. For US investors, this globalization represents an opportunity since the world is largely consuming American media (particularly when it comes to children’s entertainment). We believe media companies with strong properties are on the cusp of another period of growth in market-share. At reasonable valuations, they represent an attractive long-term investment.  At the same time, we believe strong regional, cultural media properties will also find traction in their home markets and any areas with affinity.
  6. Commodities Wane: Commodities, for the most part, have been in a relatively flat holding pattern since the 2008 bubble.  We expect commodity prices to remain weak or stagnant throughout 2014. We do not anticipate large rises in economic activity in the offing, which means commodity prices will remain depressed.  We do not expect gold or other precious metals to recover and anticipate further declines.
  7. Wages and Profit: The past few years have seen corporate earnings rise while average wage income has stagnated along with labor costs as a portion of GDP. We expect 2014 to reverse some of this trend as a declining unemployment rate and an evolving political climate make for higher wages and a higher minimum wage floor. We believe this will put pressure on industries and companies that rely on a large, low-paid work-force.
  8. Health-Care Strengthens: Gains in the Health-Care Index have outpaced that in the broader markets by about 10% in 2013. 2014 is the first year the impact of the Affordable Care Act will be felt in revenues of insurers and health-care providers.  We expect health-care revenues will rise and the sector will continue to outperform the broader market this year as well.
  9. Atlantic tug of war: The Euro has appreciated against the Dollar over the course of 2013, as the European fiscal crisis has been pushed off center stage.  We believe the Fed’s tapering will reverse this move and we will begin to see the dollar appreciate as rates rise in the US.
  10. Water Works:  We have been concerned about water-related infrastructure for a number of years. Most population growth is occurring in regions with limited access to large quantities of fresh water and this problem is more acute than any issues with power generation. We believe consumers and regional planners have begun to appreciate this as well and we will see a rise in investments directed towards water infrastructure. Major engineering companies and water utilities should benefit, as will firms with consumer products that improve efficiency.

 

2013 Themes: Snakes and Ladders – Year End Review

2013 Themes: Snakes and Ladders – Year End Review

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At year-end, we review our economic themes for 2013.  We give ourselves 8 out of 10 points, for 7 themes that hit the mark, and two that were partially realized.  We were flat out wrong on one.

  1. üEurope lingers: “…In our view, the European Union will have to provide financial assistance to one or more peripheral countries in 2013, we believe this may be delayed till after the German elections to limit the impact on the Merkel government.”  Cyprus did indeed receive an emergency bailout in 2013. The European crisis continues to be a concern and none of the peripheral European countries have as yet exited the bailout mechanisms put in place.  Spain, Greece, Romania, Cyprus, Portugal and Ireland all received funds in 2013.
  2. ? Asia slowdown: “The biggest Asian economy is showing some growing pains… We believe China will underperform other emerging markets over the next year.” Chinese GDP growth is officially estimated at 7.6% for 2013, markedly lower than the double digit rates it has achieved in prior years.  The Shanghai composite’s total return for 2013 was 3.56%, while the Hang Seng was down 2.84%. Neither are stunning returns, but emerging markets performed poorly as a whole in 2013. The MSCI Emerging Markets index lost 4.9% and Brazil, Turkey and Indonesia all performed worse than China.
  3. ûEquities: “…We believe… there is a strong probability that stocks will be in for a very rough ride… we believe stocks with strong balance sheets, robust business models and high-quality earnings will outperform.”  We were wrong on this call. Though the MSCI World Quality index returned 27.74%, MSCI Europe Quality index returned 21.52% and the S&P High Quality Index returned 32.44%, they were matched by the broader markets. The MSCI World returned 27.37%, the S&P 500 32.39% and MSCI Europe 25.96%.  Lower quality, speculative stocks have led recent market gains fueled by sustained quantitative easing.  Though there was some mid-year volatility, US stock markets saw a sustained rise in 2013.
  4. üThe myth of hyper-inflation: “…the Federal Reserve has bought over two trillion dollars in Treasury and MBS debt over the past four years… When it begins to sell its bond holdings, vast amounts will be taken out of the money supply, putting a damper on any inflation. This is why we find inflation protected bonds relatively unattractive.” TIPS performed poorly in 2013, the Barclays US Treasury TIPS index lost 8.61% for the year. We see virtually no sign of inflation in the US at the moment and do not believe it is a concern for the immediate future.
  5. üA rude awakening for bonds: “The Fed has been providing price support for long-dated bonds with its large purchase program and low interest rates. When that price support stops and the market has to stand on its own, we expect bond prices to collapse and rates to rise… we find long-dated bonds extremely risky and prefer floating rate, short-duration and international bonds.” Long term treasuries were a poor investment in 2013. The Barclays US Treasury 20+ year bond index lost 13.88% as yields on 30 year treasuries rose from 3.04% to 3.96%.
  6. üThe Sun also rises in Japan: “…We see Japan’s demographics stabilizing and a generational change underway in Japanese business creating an entrepreneurial surge. We believe this presents an attractive opportunity for equity investors.” Though most of the market surge occurred in the first quarter, Japanese markets have held on to gains this year and the MSCI Japan index returned 27.16%, the best performance in many years.
  7. üGold: “…We continue to hold that the price of gold is elevated beyond fundamentals and not sustainable. We see demographic changes that are steadily eroding Asian demand for gold, removing this long ranged support. We expect gold prices to drop in 2013.”  We were right here. Gold prices have dropped almost 28% in 2013, from over 1600 to 1170.
  8. ? The death of the PC has been greatly exaggerated: “…Despite being overshadowed by its cooler, touch-sensitive cousins, the traditional computer remains the one device capable of performing the whole range of computing functions. It will remain an essential business tool for years to come. We think it’s a little too early to call the death of the computer, and that certain PC-related stocks will outperform in 2013.” PC sales are estimated to have dropped some 11% in 2013 to around 300 million, with tablet/smart-phone sales surging. That said, in some cases, PC stocks saw enormous gains in 2013 (HPQ 100.33%, MSFT 43.69%, DELL 39.02%, Lenovo 36.1%) even though smart-phones and tablets have continued to encroach on PC functionality.  So while the trend away from PCs continues, 2013 proved that many PC-related companies remain viable businesses.
  9. üNetwork everything: “…Over the course of the next decade, we expect to see more devices linked to the broader Internet for specialized and general function. This will include cars and household appliances, opening up new use cases and opportunities for businesses positioned to produce the right set of products and services. We believe the technology sector in general, and Internet infrastructure firms in particular, offer attractive growth potential over the next decade.” We continue to see upticks in the number of devices connected to the Internet and though it is still early for this prediction, the S&P North American Technology Index return 34.57% in 2013, outpacing the S&P 500 and MSCI World.
  10. üAlternative Energy: “…Alternative energy at utility scale is approaching cost parity with conventional energy generation, and a nascent environmental movement is developing in the emerging world. These two trends are changing the equation for alternative energy and 2013 should see an increase in investment flows towards non-conventional sources of energy. We think prices are relatively depressed and the sector offers attractive value for long-term investors.” Alternative Energy did indeed make a strong comeback in 2013 and more attention is being focused on the industry. The S&P Global Clean Energy Index returned 48.42% for the year and the Nasdaq Clean Edge Green Energy Index returned 89.34%.
Tech and Bonds, the bigger they are the harder they fall: 2013 Q3 letter

Tech and Bonds, the bigger they are the harder they fall: 2013 Q3 letter

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Dear Friends,

We hope you had a pleasant summer with family and friends.

The third quarter of 2013 saw global financial markets encounter some turbulence, driven largely by fears of central bank monetary tightening. The Federal Reserve issued a series of statements early in the summer, essentially warning investors the era of large-scale monthly bond purchases and ultra-low interest rates was approaching an end. The wordsmiths at the Fed settled on the word “taper”; we assume in the hopes of conjuring an image of a slow, gentle ride into the QE sunset. Of course, the bond market’s response was anything but gentle as investors began aggressively selling long-dated bonds. Our view for some time now has been that long-dated bonds could see sharp, sudden drops in value if rates begin to rise. The summer was a reminder for bond investors of how suddenly this can happen. On May 1, the 10 year treasury yield stood at 1.66%. By early July, it had risen past 2.66% (a full one percent move) – a level not seen since August 2011, during the summer debt ceiling negotiations. After witnessing the speed at which bond yields spiked, the Fed backtracked on its tapering guidance and yields have dropped a bit. However, we would caution bond investors not to succumb to complacency. There is a high likelihood rates will rise much higher over the next several years. We remain convinced that long-term bonds offer very low prospective returns and recommend short term and floating rate fixed income investments as an alternative.

We won’t spend much time on the budget morass in Congress, except to say we wish there were more responsible adults in the negotiating room. At the time of this writing, Congress is unable to pass a budget which has led to a government shutdown. Meanwhile, an even more critical deadline looms in two weeks, when the US Treasury reaches the debt ceiling set by Congress and is unable to pay for contracted services and perhaps even repay Treasury bondholders on time. This annual cycle of budget brinkmanship has made many bond market participants seriously re-consider the once unthinkable idea that the US may default on debt obligations. Should Congress decide to flirt again with default, we expect a replay of 2011 where stocks sold off and bond yields rose.

Over at the wsqcapital blog, we recently published a piece about how interest rates impact stocks and business enterprises in general. In the post, we listed four ways in which rising interest rates impact stocks:

  1. Investors and analysts use interest rates to value stocks by discounting future earnings or dividends. As rates rise, the present value of a future dollar drops, depressing valuation multiples.
  2. Rising rates make bonds a more attractive investment alternative for investors.
  3. Rising rates also mean higher borrowing costs for companies forcing them to reduce investment expenditure to meet increased financing costs on existing debt.
  4. Businesses and governments use higher interest rates to evaluate future projects; marginal projects or investments are shelved if they are no longer viable due to higher borrowing costs, slowing activity.

All these factors in tandem weigh on stock prices and are reasons for stock investors to be cautious when interest rate increases appear likely. The current low interest rate environment and monetary easing has pushed up stock valuations and we believe there is limited upside for investors when the market is already trading at 17 times earnings, well above the historic average of 14. That said, we continue to see pockets of value within certain sectors that have fallen out of favor with investors.

The past few months have also provided a few stark reminders of the speed at which technological changes can impact companies previously considered unassailable. A list of former blue-chip tech stocks that have fallen on lean times include: HP and Dell. Furious competition from Asian manufacturers and low levels of product differentiation have decimated PC makers. The rise and fall of these companies seems positively glacial though, when compared with the fate of firms producing cellphones and mobile technology in general. Palm, Motorola, Nokia, and even Blackberry have found their once-enviable businesses hollowed out as touch-screen driven smartphones were created and then adopted with fervor by consumers and businesses.

In some ways, the mobile phone sector has made the same transition Internet companies did a few years earlier. Early internet usage revolved around e-mail and very simple forms of media. As bandwidth and processing power improved, usage migrated to much richer media including video. This trend continues as film and TV distribution steadily migrates to the Internet. Mobile phones followed a very similar trajectory. The first internet connected phones offered very simple and limited functionality. As data capacity improved, Blackberry was able to create a compelling product by offering reliable e-mail service on your phone. Palm meanwhile continued to be the gold standard in mobile organizers with its pilot line of digital assistants. Touch-screen enabled smartphones starting with the iPhone pushed aside all other devices by offering a single package that was capable of taking pictures, making calls, receiving e-mail and providing a more vibrant mobile Internet experience than ever before. A rich internet experience on a device that fits in your pocket became the must-have application for a younger generation accustomed to constant connectivity.

In retrospect, it all seems rather obvious. However, it would have been difficult to predict, on the eve of the iPhone’s debut, that one of the biggest winners in mobile technology would be Apple. There was little to suggest then that the former PC maker, which had almost gone under a few years prior, would emerge with the winning solution. It would have been tougher still to see that Apple’s primary competitor would be an open software platform offered by a competitor with limited interest in making devices and a business strategy that revolved almost entirely around offering services and search on smartphones. Yet, Google has marched ahead of Apple in terms of platform penetration with its Android product. We have a better handle on technology than most, but we continue to caution investors that the pace of change in the business of technology is frantic. Business models that looked bulletproof only a couple of years ago, now lie in tatters. To be an effective investor in the technology sector requires constant vigilance.

We continue to advise investors to keep their portfolios oriented towards long-term goals and exercise some caution, by maintaining judicious limits on their holdings of long-term bonds and speculative stock. Both the interest rate and equity cycles suggest lower future returns from risky assets.

Regards,

Louis Berger                                                                                        Subir Grewal

Interest Rates and Stocks: comparing numerators and denominators

Interest Rates and Stocks: comparing numerators and denominators

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For the past couple of years, we have been highlighting to our clients the fact that the market value of their bond portfolios will drop when rates rise. This is especially true of long-bonds.

However, we haven’t often explictly discussed the impact this can have on stocks. All else being equal, rising interest rates exert downward pressure on stock prices. There are four reasons for this:

Institutional investors and analysts use interest rates to value stocks by discounting future earnings or dividends. As rates rise, the present value of a future dollar drops, depressing valuation multiples.

In standard financial analysis, a stock is modeled as a very long bond (a perpetual) with uncertain interest payments (dividends or earnings). If we do this, the dividends are estimated as an annual or quarterly stream, and this is discounted back to today using the appropriate discount rate. As you can imagine, when the discount rate rises, this raises the denominator of the fraction and the current value of a fixed dividend stream falls.

Borrowing costs for companies rise, which means more revenue is diverted to satisfy financing requirements.

Any firm with variable rate debt or a need to roll over debt will encounter a higher cost of funding, and if all else stays the same, these higher payments eat into income available to shareholders. In the dividend discount model we described above, this reduces the value of the numerators, which of course leads to a fall in the current value of the dividend stream.

Higher rates also result in lower economic activity as  households and businesses find a larger percentage of their wallet share going to fund interest payments.

Businesses evaluating future projects use higher rates to review their attractiveness; marginal projects or investments are shelved since they are no longer profitable, reducing earnings growth.

At the same time, rising interest rates change the calculus for future projects and investment. A company building a new factory or launching a new product will analyse the future earnings and weigh them against current costs. Projects that look good when borrowing costs or rates are at 4%, may not be economically feasible at 6%.  Apart from financials, real-estate is the sector most sensitive to rates, but so is any heavy industry with significant capital costs.

Rising rates make bonds more a more attractive investment alternative for investors.

This is perhaps the simplest and most under-appreciated reason that higher interest rates lead to lower stock prices. As investors evaluate various investments, rising rates make bonds appear more attractive.

The counter-argument to these is that rising rates in our modern central bank led monetary regime imply broad confidence in the economy. We accept that this is broadly true, but will leave it till a later date to review the historical record.

Yelp, I’m drowning in the medium

Yelp, I’m drowning in the medium

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A story about the founding of Yelp led us to wonder why Zagat didn’t create Yelp. The core idea (reviews by consumers) is exactly identical, and the Zagats had their brainstorm in 1979. Why couldn’t they translate the phenomenal success of their printed reviews and their formidable brand into an online presence with a moat that would deter everyone else?

Of course, Zagat does have a website, and you can even get and write reviews on it. But to use it, you have to sign up for a subscription. That is the relentlessly logical solution from their perspective. After all, why would Zagat cannibalize the valuable revenue stream they drive from selling their slim brown books by making the reviews and ratings available online for free? Yet, this perfectly reasonable decision made them an also-ran on the Internet, ultimately fit for a purchase by Google to bootstrap their location review content. If Google hadn’t bought Zagat, the end would have been even more ignominious.  As most reviewers would have migrated to online sites, Zagat would have died a long, comfortable death as it’s core subscriber base aged into a comfortable retirement.

There is a lot that can be said about this, one of the more obvious things is that most companies are reflections of their founders.  The broader truth though is what Marshall McLuhan outlined in Understanding Media, or in the soundbite, The Medium is the Message. The new medium of the Internet has transformed not only message delivery and message representation, but the message itself, and us as well. Any entity that fails to adapt to the new medium is relegated to the archives. It has even changed human and societal behavior and will continue to do so, inexorably. This is as true for restaurant reviews as it is for books. And thanks to ipads, as true for your parents as it is for toddlers.

The medium of the Internet has its own relentless logic, content has to be speedily delivered, ideally at no cost, look fresh, be current, as comprehensive as the world, and appeal to very exacting, specific tastes. Oh, and you have to make the audience feel they have a voice, either through forums or direct interaction. Absent these features, you’re paddling against a powerful tide. Zagat misunderstood one feature of the Internet and that left enough of a crack open for Yelp to eat their lunch, and dinner.

Tale of two economies

Tale of two economies

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“There’s only four things [America does] better than anyone else: music, movies, microcode (software), and high-speed pizza delivery.” — Neal Stephenson, Snow Crash.

There are increasingly, two different economies in the country, the knowledge economy, and the physical economy. The knowledge economy is thriving, since that is most of what we export nowadays and much of our lives are lived online. However, technology employs only part of the American workforce, and everyone working in the physical economy (construction, building, materials) is hurting. People who had been furloughed from the plant in prior recessions, only to come back to work when conditions improved five months later, are now facing the prospect of long-term unemployment.  How the US recovers from this particular recession will depend on how well this transition is managed.

We wrote the paragraph above in October 2009, almost four years ago.  The labor force participation numbers from September make it seem prescient. Rosie the iconic riveter did lose her job and never got another. The Bureau of Labor and Statistics tracks labor force participation (those working or seeking work), and this has dropped from 66.4% in January 2006 to 63.2% in August 2013. Some of that drop represents baby boomers retiring or retiring early, but that does not explain the entire 7 million people who are no longer working or looking for work. Some of them are discouraged from years of disappointment. The toll in lost opportunity and human skill for the economy represents a permanent loss. These years, for those workers, cannot be reclaimed.

That Internet in your pocket is disrupting the world.

That Internet in your pocket is disrupting the world.

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 400px-Mobile_phone_evolutionWe don’t often write about individual companies on our blog since we feel all investments need to be considered in the context of a portfolio and an investor’s objectives. We will be making an exception here, since we’re gong to discuss the evolution of an industry where the pace of creative destruction has been frantic, and it’s futile to write about these trends without mentioning the companies and products that embody them.

The FT published a letter one of us wrote about how open-source development has impacted smartphone evolution. Open-source tools and systems are the foundations for the current generation of mobile devices. The two dominant operating systems for smartphones, Google’s Android and Apple’s iOS have open-source roots. Most people will recognize that Android is a Linux build, but iOS which is a Darwin variant, and therefore a direct descendant of BSD (early open-source Unix). That Apple does not license iOS is largely irrelevant, an engineer who has worked on Unix systems will find iOS a warm, fuzzy, familiar environment.  As long as Apple and Google don’t stray too far from this well-understood environment, future generations of internet engineers will find few barriers to developing for its devices and systems.

It’s not just about operating systems though.  Companies that build commodity, widespread platforms, whether software or hardware have come to realize that openness is a virtue, and often a necessity. Their platforms are tool-benches which are only as useful as the tools or applications that external developers create for them. Integrated Development Environments and core development tools for internet-enabled applications tend to be relatively open and community maintained as well. The list is extensive, but includes Linux, Apache, Eclipse, MySQL, Python and other tools that are part of the essential plumbing and growth of the Internet.  Virtually every Internet startup we know of begins  life with a Linux installation running Apache, often a cost-effective virtual machine at Amazon’s AWS or countless other providers.

What Apple unleashed with the iPhone wasn’t only a device that appealed to consumers and looked beautiful; of more significance to its future trajectory was that the development platform is similar to Mac OS-X, so large numbers of developers could quickly learn to write applications for the device. Where prior generations of phone app developers struggled to understand a carrier and phone-maker’s system, with an occasionally tweak to low level network infrastructure like WAP, iPhone developers were on familiar ground, within an environment that looked pretty much like a trimmed down OS-X, and with similar development tools. This is what made the explosion of apps on the iPhone so rapid.  Android has been able to compete only because it’s largely Linux and apps for it are written in Java, both of which are even more widely adopted and used amongst Internet developers.

Microsoft is only in the running because someone at the company had the good sense to kill Windows CE and commit to a common platform for desktops and mobile devices, combining the development communities. Perhaps surprisingly for the platform providers, content is king, and that is where they need to differentiate themselves. Traditional media (music, tv, movies) is owned by traditional interests and will generally seek to be platform agnostic and available everywhere. The differentiating factor is new media created by a younger creator and applications created by enthusiastic communities of developers. Nurturing these and adapting to their needs will be the path to success for the platforms. As an aside, if you agree that smartphones are computing devices, since smartphone shipments overtook PC/Laptop shipments last year, it’s only a matter of time before the most widely installed operating system on the world’s computing devices is no longer windows but some Unix variant.

Meanwhile, within the space of a few years, stalwarts of the early phase of consumer mobile telephony and computing have had near-death experiences or been devoured by firms they would not have considered competitors a few years prior. Motorola, Palm, Ericsson, Qualcomm and now Nokia fell on their swords or came perilously close to doing so.  Blackberry, which seemed unassailable even four years ago is facing an existential crisis.  Revenue streams and margins that seemed robust were eroded with frightening speed.

We wonder of course, about what happens next in this industry.  The first lesson for investors is that the product cycle in mobile technology is immensely quick and margins compress with dizzying speed. In our view, no company in the mobile computing world has a business model that we say with confidence will support strong or even positive margins seven years out.

What we do know is that hardware is quickly becoming less of a differentiating factor.  Most current smartphones have roughly equivalent hardware.  Nokia might have a slightly better camera, Apple may have a better display, and HTC may have the best low-light camera around, but that is not enough to make a difference. Most consumers will not notice the difference. And that means smartphone hardware makers are going to find the next few years tough going.

The platform vendors, Apple, Google, perhaps Amazon and with some luck Microsoft, are better positioned. They should be able to retain income from media purchases on their storefronts (iTunes, Google Play, Amazon Kindle) and can continue to develop additional streams of subscription-like income. The ubiquity of mobile phones with rich data ability should mean strong revenues for mobile network equipment makers and services since infrastructure worldwide will need to go through a few upgrade cycles over the next decade (and Nokia may well find a second life as a business in that space).

We need to look elsewhere though for the next generation of disruptive business models enabled by the Internet in our Pockets. Fast and cheap connectivity paired with ever more capable devices is quickly turning every waking moment into an interaction between online and offline inputs. We now see the  value we believe now shifts to content providers, creators and geo-location based services, this is where we expect to see the next generation of stand-out businesses emerge. GPS mapping software was in some ways the beginning and location-aware advertising is already here.  In many places, Yelp is becoming the go to source for recommendations. Foursquare could arguably have an even more powerful business model if it could manage to convert itself into a effective loyalty program or customer relationship management application for small and large businesses, but first it needs to get past badge fatigue. Uber and its ilk will transform the taxi industry in most large cities. A new generation comes of age every year that is far more comfortable living life on its phone. They will steadily move their wallets to their phones (Google Wallet, Paypal) just as they have their social interaction (Facebook bought itself a couple of lives by purchasing Instagram). Companies that figure out how to curate useful content and tools for smartphones should prosper (Twitter, Evernote, Dropbox, Pandora, Spotify, Flipboard). Yahoo, if it plays its cards right, may be able to capitalize on Flickr and Tumblr to rejuvenate itself.  They may also want to revisit their roots since curated content will be part of the future of mobile computing. The broader message is that content is king, and content created by an enthusiastic community of creators is what’s needed to build and maintain an engaged audience.

This meld of the physical and virtual worlds has been a long time coming. Regular readers may remember our post on Facebook, Cypherpunk and Psychohistory which referred to Neal Stephenson’s prescient novel Snowcrash. Augmented reality is coming soon, which is why we do not scoff at Google Glass or other wearable computing devices like smart-watches. We will see ever more portable interfaces into the virtual world, and there will be applications for many of them.

It’s not just Middle-Eastern dictators who have learned to respect the power of the computer in your pocket, so will less political entities whose lifestyle and business models rely on things staying the same.

Efficient Markets, Mean Reversion and why chickens come home to roost

Efficient Markets, Mean Reversion and why chickens come home to roost

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450px-Zoo_chicken_roostingA recent article in the Financial times, Clash of the CAPE Crusaders, on the radically different conclusions arrived at by Jeremy Seigel and Robert Shiller when evaluating long-range stock results reminded us of an draft post we had begun a while ago.  This debate between value investors and others has been running for a long time, the latest iteration goes something like this:

EMH camp: Since we know stocks over time out-perform other investments and do not know what stock prices will do tomorrow, it is OK to go ahead and invest in stocks, and you should invest in a broad list of stocks (say an index fund).

Value camp: You should only invest in specific stocks when you have done your analysis, and believe the return from the investment will compensate you for the risk you are taking.

EMH camp: You don’t know what the price of the stock will be tomorrow, so there’s no reason for you to choose to invest today.

Value camp: That is true, but we don’t care about tomorrow, we care about the likelihood of prices being higher 3, 5 or 7 years from now, and that will depend on whether we are buying bargains now, since over time the true value will be reflected in the price. And even if it isn’t reflected in the price, our analysis has given us confidence that this is a good business proposition and the downside is limited. I can show you numerous periods where a purchase of stocks would have resulted in huge losses within relatively short order, and this is generally because prices exceeded value.

EMH camp: But you would have said they were overvalued well before they started to fall, and I would have lost out on some gain, and I know that over the long-term, stocks will do well.

Value camp: True, I admit that I cannot predict when exactly a bubble will end, but I do know when one is underway, and that it will end eventually. I’d rather make a little less, than risk losing a lot.

EMH proponents have always seemed to us like naughty children who hurt themselves periodically while swinging from trees and then blame their parents for not watching out for them. The oft-expressed view that the market always values all investments correctly seems to us a convenient tautology. There are numerous instances of speculative manias running amok, and they generally concern some new technology or market. Wildly optimistic rates of growth are assumed and incorporated into “analysis” by herds of professional investors, while non-professionals rush along in tow.  These speculative mania always end, and with remarkable speed.  We call EMH a tautology since most adherents would say this is perfectly acceptable and a result of new information being incorporated into the marketplace.  Our sympathies lie with the mean-reversion camp and their view that markets periodically overshoot highs and lows, creating opportunities for investors who can anticipate the eventual return to the norm.

We view our role as value-oriented investment advisors to find and understand these under-appreciated pieces of information, to evaluate their impact on investments and position ourselves to take advantage of them.  In Gretsky’s over-used metaphor, we skate to where the puck is going to be.  There are, however, limits to our powers of anticipation. Mean-reversion can take a long-time, and our investors generally have a limited time horizon. This is why, in our role as prudential advisers we generally maintain some investment in stocks in our balanced portfolios. At the same time, we realize that mis-pricings and mean-reversion applies to all asset classes and markets, though the impact may be more extreme in stock markets.  So, for instance, we have been very careful about the types of bonds we have purchased and held for clients over the past few years. We know interest rates cannot be kept at zero forever, and this means long-term bonds offer limited upside and a lot of potential downside. For the past couple of years, we’ve kept bond duration in most client portfolios at very low levels since we have not seen value in long-term bonds.

Commodity supercycles, Windup Girls and Family Farms

Commodity supercycles, Windup Girls and Family Farms

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In our SRI portfolios, we screen companies and industries for those actors who run sustainable businesses. Their usage of resources and fulfillment of broader responsibility counts as much as their financial prospects.  Ocassionally, we step back from our narrow interests in a specific company or industry to look at the broader picture.

We did that recently while reviewing the latest quarterly letter from Jeremy Grantham at GMO. In a note last year, Grantham had highlighted the impact that intensive conventional farming practices can have on the quality of soil. Healthy soil takes many, many decades to develop and the intensive use of pesticides and fertilizers can destroy microbial life in topsoil. Once that happens, it requires a continual regimen of fertilizers to make the land productive.  Intensive commercial farming techniques have killed life in the top soil, and this will have a long-term impact.

Those who’ve read Michael Pollan’s Omnivore’s Dilemma might remember the section on Polyface Farms. Pollan describes Salatin’s effort to rescue a ravaged industrially farmed tract using a complex crop and animal rotation regimen. It requires prodigious  knowledge of the local environment and intellectual rigor on the part of the farmer. The level of effort is a couple of magnitudes greater than that required to flood a field with fertilizers, pesticides and irrigation.

If intensive, fertilizer based farming permanently damages our agricultural production, this will have long-range impact for us. What does the steady depletion of our ability to produce food mean for the economy and our race? The first impact will be felt by the world’s poor, who will be priced out of food. This would lead to a rush to accumulate scarce resources and political unrest, possibly more revolutions like those we are seeing in the middle east.  Since the industrial revolution, the effort we have expended to raise crops and feed ourselves has steadily declined.  In the mid-1800s, fully three-quarters of all American workers lived and labored on farms, that number is under 3% today.  The story of progress in the 20th century has to a large extent been driven by the unshackling of vast numbers from the plough. A world where more human effort is required to raise the same amount of food would be one with lower growth, fewer advances and less comfort.

While, we’ve been thinking about these big trends, we’ve been following the Olympics, and the incessant ads reminding us that “luck” had no role to play in the success of any athlete. The truth, however, is that luck plays a large role. Most of the successful olympic athletes were lucky to be born into families or in nations where they were assured a consistently high caloric intake, access to a top-notch training program, and institutional support from their countries and employers. Meanwhile, many, many people in poorer parts of the world will never have that opportunity. The lottery of birth is truly amazing.

Life occasionally imitates art. For a dystopian vision of where intensive commercial farming and climate change might lead us we would recommend reading The Windup Girl, Paolo Bacigalupi’s richly imagined novel about a world ravaged by climate change, genetic modification and crop failures. Robert Heinlein’s book, The Moon is a Harsh Mistress tackles similar topics, from the standpoint of a colony on the moon. Of course, our salvation may lie in the exploration of our solar system, which is rich in resources. But the space program has been as underfunded as investment in training farmers to use organic practices.

 

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