Mike Lipper’s Monday Morning Musings
2018 Lessons Should Be Learned
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
The biggest benefit from living are the lessons that could have made us healthy, wealthy, and wise. To ourselves and our loved ones the biggest losses are those lessons we could have learned and didn’t. 2018 has been a tumultuous year, but it gave us numerous opportunities to learn to improve the way we think and thus shift the odds of future results favorably.
We should have learned to reduce the use of labeling as a part of decision making, particularly in terms of labeling people with a single identity. This was brought home in 2018 in cheap polling to make political and investment decisions. Think of yourself, how many words would be appropriate to describe you as a person, as a family member, as a voter, or as an investor? We use easily descriptive labels as a short-cut to building the ultimate equation for decision making, without allowing room for contrary modifications imbedded within each level, e.g. child of, native language, health condition, source and quantity of debts and composition of assets, etc. This is not a new phenomenon, William Shakespeare’s plays often spent the first act describing or labeling the main characters and their current condition, only to change readers views by adding humor, pathos, and most of all surprises in later acts. He delivered an unexpected conclusion and a great opportunity to learn about the human condition.
Investment Lessons - Trillion Dollar Mislabel
In 2018 the media crowned Amazon, Apple, and Microsoft as candidates to reach a stock market valuation of $1 Trillion. They all used technology, operated globally, were leaders in sales for some important aspect of their business, and compared with the older industrial leaders were relatively young companies. Marketers quickly branded the three stocks along with a few others as a new investment asset class and produced highly focused investment strategies using them as a single investment. Yet they are very different, particularly in terms of their 2017 annual numbers, as shown below:
Range of Reported 2017 Results
High Middle Low
Return on Equity 49% 21% 13%
Return on Assets 16% 7% 3%
Operating Margin 32% 27% 2%
Revenue per employee($000) $2,013 $841 $314
Net Income per employee($000) $451 $126 $5
Sales Growth 31% 23% 16%
Price/Sales 7x 4x 3x
Price/Earnings 218x 44x 13x
Clearly there is very little similarity among the three trillion-dollar candidates. One is the leader in four measures and the other two are both leaders in two different measures. Each stock can be appropriate depending upon both time horizon and tolerance for volatility. Amazon is the fastest growing and its valuation assumes the rate of growth will continue indefinitely and does not discount for single man risk. It could be a worthwhile stock for very long-term time horizon investors who can take advantage of periodic volatility. A great investment for grandchildren with doting grandparents.
Apple is evolving into a quasi-annuity producer based on its store and mail order ecosystem. (While people did not realize it, the main auto companies thought they were doing the same with their annual introduction of new/improved cars and a predictable scrappage rate, which worked if the new cars were attractively priced and life-styles did not change). Apple is the only one of the three that I directly own and I’m happy to own it because its numbers and prospects are what a private company would want. Thus, I am comfortable with it today as a value-oriented holding. Microsoft is fundamentally a software manufacturer for its own devices and products of other manufactures. Because of the cyclicality of demand, it requires higher margins to carry it through changes in cycles. In recent years it has been more successful with its newer products and services. All three will benefit from “the cloud”, but there will be a shakeout in the path to the cloud and this could produce disproportionate surprises.
Market and Economic Statistical Mislabels
Even before Biblical times there were records of seasons and agricultural cycles. While there was some periodicity in their occurrence, it was chalked up to weather patterns which were in the hands of the gods and did not occur with mathematical predictability. Today we label these cycles mathematically if they drop by 10% - 20% from their prior highs. We use two continuous quarters of economic declines as a measure of recession. These mathematical measures are not connected to the cause, frequency, and duration of the poor results. In an ever-changing world I question if these measures have anything but media value. Thus, I do not believe that the stocks traded in NASDAQ are in a bear market and those listed elsewhere are not.
To me the causes of both bear markets and economic declines are man-made. Bear markets are caused by excess speculation that dries up investor reserves, either through direct commitment or through borrowings that provide the large amount of leverage used by speculators. Recent reports show that margin debt, free credit balances and short interests have been declining instead of expanding as in most speculative surges. (We can still experience stock market declines, but they are unlikely to be severe). I do not hold out the same relaxed attitude for the credit markets, as they are showing signs of speculation as new participants buy covenant-lite provisions at interest rates that are too low for the possible increases in defaults.
Economic and financial declines are the results of political and business leaders attempting to keep an aging expansion going beyond its normal life. Most US CEOs of public companies are in place for five years and most politicians are focused on their next election, typically in two to four years. In each case their rewards are very time sensitive. Their choices of action favor current stimulus rather than long-term solutions to fundamental problems, which include the integrity of education, enforcement of laws and regulations, immigration controls, health care, defense, and the development of new generations of leadership.
Thus, it is clear to me and others that there will always be bear markets, recessions, and depressions. Louis XIV recognized this with his statement “after me, the deluge”, as he weakened both the power structure by centralization and the economy by spending on continuous wars. Having written that, I echo St. Paul’s plea to avoid retribution “not now”, I believe we need to experience more unwise speculation, higher capital expenditures by business and even larger deficits before we suffer our deluge.
Two Warnings
This somewhat comforting view can be disturbed by two potential problems:
- Firstly, China’s leaders clearly see the challenge in their race to become relatively rich per capita before they become too old to work productively. Their cities need to continue to absorb those leaving rural areas of the country, which is straining under the weight of excess capacity as it transitions to more service and consumer-based jobs. This pivot must avoid reduced debt payments, particularly to government sponsored banks and to some shadow banking groups. The authorities are willing to sacrifice the underlying equity if both the banks and employment can be saved. These actions are not just of academic interest to the rest of the world. Just as countries can and do export inflation and deflation, they can export credit problems too. The way they do it is by passing risk onto external owners of credit and equity. This is already happening as China opens up to foreign investment. Some of the foreigners may be sufficiently skilled in working through Chinese bankruptcies, while others may experience serious losses that show up on their own books. This risk and the decline in the purchase of imports, or foreign branded merchandise made or assembled locally, can make China a different risk for the rest of the world, particularly the US and its multinationals.
- The second problem is that there is a significant chance that the next major economic cycle we experience after a likely recession is going to be quite different than those of the past thirty years. Consumers and businesses will accelerate their dependence on global trade. Countries can no longer afford the expense of national champions. Any place in the world where there is a perceived high margin business will be under attack. Many will be disrupted. Political leaders will eventually shift their alliances from local employment centers to national, if not international consumption bases. Some future political leader will say “We are all Consumers”. Technology and education, not schooling, will penetrate former protected positions. We will be surprised and suffer some pain as we work through these experiences. Hopefully our descendants will benefit.
December 30 Conclusion
Monday will be the last trading day of a year and is one we would not like to re-live. But there is a slight chance we could have an explosive day in the markets on Monday. If it were to happen, a few lucky managers could claim a wining year, where most of us will have to admit that we lost some money for clients on paper in 2018. More importantly, 2018 investment performance should be looked at in comparison to the double-digit gains of 2017 and the good gains of the last ten years. More importantly, our clients should understand that occasionally we collectively can suffer losses and not lose position for better results in the future.
We wish 2019 will find our readers healthier, wealthier and wiser.
Question of the week:
How much of your portfolio is managed for a bear market, recession, and recovery?
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html
https://mikelipper.blogspot.com/2018/12/news-focus-may-drive-investment-success.html
https://mikelipper.blogspot.com/2018/12/investment-memory-friend-or-foe-answer.html
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