Tuesday, November 14, 2017

GE and Value Creation (Destruction)

      Perhaps the most common theme of this blog is that value creation comes from lean, well managed companies that have sufficient barriers to entry to be able to produce reliable and growing cash flow streams.  It is much less likely to come from financial transactions and restructurings.  The key is to focus on the details of running each specific business and let the stock market and the macro economy take care of themselves.

       GE seems like a company that should be doing well by these criteria.  It has a dominant market position in a variety of important businesses.  But it has fumbled across the board.  Costs, including overhead and management compensation, were allowed to expand without sufficient justification.  The Board grew to an unwieldly size.  Accounting became so complex that accountability and incentives were compromised.  As a result, in the current year the company managed to see its stock fall 40%.  Quite a miraculous for a large firm in a market that has risen 15%.

      This is a case where stockholders deserve to be angry.  Often collapses in stock prices occur because of factors that management could not anticipate or control like the financial crisis or the drop in oil prices.  But in the case of GE, it is hard to find such explanations.  Management deserves most of the blame.

      In my view, the path forward is not more restructuring, but cost cutting and attention to the details of the individual businesses.  The division that makes locomotives, for example, does not to be sold.  Railroads are four times as efficient as trucks on a ton per mile basis.  As energy costs grow and environmental issues become more pressing, we will need more rail and that means more locomotives.  That is a business that GE should make work.  There are many others.

Monday, November 13, 2017

Education and Social Media

      Becoming educated is not easy or natural for most people.  Were it like learning to walk, we would not need this immense social infrastructure of schools, teachers, administrators, assignments, exams, grading and so forth.  Educating young people requires a lot of pushing, cajoling and enforced discipline.  And it takes a lot of time.

      On the other hand, there are things that are naturally of interest to young people like, cool, gossip, physical appearance, social status and the like.  Those things command their attention without the need for all the outside influence and support real education requires. 

       The economic goal of social media is grab attention and to sell it.  The way to grab attention is to guess what people naturally want to look at and then let sophisticated software continuallly refine the offering in order to keep a person's attention.  You can get a pretty good idea of how this process comes out by looking at the cell phone of a 14-year old (if you can ever get hold of one.)

       From a social standpoint, the process of giving the young what most grabs their attention is a bit like selling drinks to alcohloics.  And great algorithms can be very expert in mixing the most enticing drinks - drinks that can easily crowd out the drugery of learning algebra.

       What does this have to do with a blog on investing?  A lot.  Education is the investment that society makes in its people.  The payoff is a more civil society and a stronger economy.  Social media is reducing the return on that investment but the social media firms do not bear the cost. 

Tuesday, November 7, 2017

Another Indicia of Excess

      Low real interest rates encourage investors to leverage their investments.  As long as prices are rising or stable, this leverage results in higher returns.  But if prices start to drop, it can lead to fire sales and insolvency.  Therefore, you would hope that as asset prices rise investors might conclude that the risk of a collapse was rising as well and cut back on leverage.  No such luck.  As the chart shows, the run-up in stock prices has been accompanied by a marked increase in leverage.  If there is a sudden drop in prices, it could quickly turn into a route.


Monday, November 6, 2017

Bitcoin and the Fed

      At the outset let's be clear on the relation between Bitcoin and blockchain technology.  Blockchain technology is one of the most important economic innovations in decades.  It has the potential to revolutionize transacting and record keeping.  Its developers, if we ever find out who they are, should be at the top of the list for the Nobel Prize in economics.

      Bitcoin applies the block chain technology to a crytocurrency.  For more details on the economics of Bitcoin, I recommend the blog of my colleague Aswath Damodaran.

       The massive price increase in Bitcoin has generated a great deal of attention and controversy.  In my view, Bitcoin is the most sophisticated chain letter in history.  As Prof. Damodaran notes, Bitcoin is not an asset because it provides no cash flow and is not a commodity because it provides no useful service.  It is at best a poor substitute for national currencies.  But despite these deficiencies, it is an ideal vehicle for the development of a speculative bubble because the risk of transacting has been removed.  I am definitely in the camp that Bitcoin is a modern day tulip and is headed to a collapse similar the that which occurred in Holland in the 16th century.

      How does the Fed fit in?  In my view, the nearly decade long experiment in negative real short-term interest rates and quantitative easing has led to an almost pathological search for investment return.  And nowhere is that pathology more clear than in Bitcoin.  I cannot get a haircut these days without my barber asking me about Bitcoin.  He says he bought at $3,000 and has more than doubled his money.  I hope he sells soon or he may have to cut a lot of hair.

Thursday, November 2, 2017

Tesla Below 300 GE under 20

      It has been a long time coming but Tesla is finally starting to be valued like and automobile company - which it is.  That means it has to compete with numerous experienced companies in a highly capital intensive industry.  It also has to deal with the same labor relations that other car companies do.  At $300 the valuation still looks high relative to my DCF models, but it is leaving the ludicrous zone.

       GE, on the other hand, is the only major company that I have modeled that is undervalued.  In today's bubbly market, everything I look at seems very expensive.  GE under $20 is starting to look like a bargain.  Maybe not a big enough bargain to pull the trigger, but definitely a big enough bargain to follow closely.

Friday, October 27, 2017

Amazon and GE earnings

    For the third quarter of 2017 GE net income after tax was 1,836 million.  The quarter was universally assailed as a disaster for the company and the stock dropped sharply.  Amazon's net income for the third quarter as 197 million.  On the announcement of that number the stock jumped more than 130 dollars.  If you ever needed evidence on the importance of expectations and the fact that investors take account of the long-term you need look no further.

Wednesday, October 25, 2017

Making Sense of "Short-termism"

            Short-termism just won’t die.  Despite obvious counter examples like Amazon, Tesla and Netflix it clings to its long-term life.  But beyond the counter examples, there is a bigger conceptual problem with the idea of short-termism, namely that it overlooks the obvious fact that all hard information is short term.  Companies report their information quarterly.  All the information from past quarters is old news.  The only new hard financial data the market gets is this quarter’s performance.  It never gets hard data about the “long term.”  Of course, a lot of people have beliefs about what the long term looks like, in particular corporate CEOs.  But those beliefs are probabilistic projections, not data.  The only data are the short-term quarterly reports and possible other releases of financial data.  But by definition all that information arrives “right now” – in the short term.

            Thomas Bayes laid down the basis for understanding how information affects beliefs more than two centuries ago.  Bayes was aware that with regard to the future all we can have are probabilistic beliefs.  He called these initial beliefs the prior distribution.  For example, I have a prior distribution of beliefs regarding what Tesla’s earnings will be over the next five years.  When information arrives, such as Tesla’s quarterly report, Bayes shows how rational actors will revise their probabilistic beliefs.  He calls the revised beliefs the posterior distribution. 

            Bayes theory makes it possible to have a more meaningful discussion of short-termism.  In the context of his analysis, the market would be “too short-term oriented” if investors revise their prior distribution “too much” in response to quarterly information.  This of course begs the question of how much is “too much?”  The most common complaint that executives seem to have is that in response to negative financial information investors revise their long-term beliefs too far downward and as a result the stock price drops significantly.  But the key thing to realize is that investors are still pricing the stock based on their expectations for long-term performance, they have just adjusted those expectations more than the CEO would like.  All valuation is “long term.”  What people disagree about is what that long-term looks like and how those long-term views should be revised as information becomes available.

Tuesday, October 24, 2017

The Market Forest Fire Analogy

      Fire fighters often complain about the downside of fire prevention.  By preventing small fires, the fuel for large ones continues to accumulate and dry out.  Then when conditions are right - hot days and high winds - conflagrations can occur.  This "boom and bust" fire cycle has been a continued problem in my home state of California.

      The interesting question is, does the same logic apply to central banks and asset price busts?  For instance, in the years leading up to 2000 and 2008, central bank policy was loose and asset prices rose sharply.  (Tech stocks in the years before 2000 and housing prices in the years before 2008.)  John Taylor, currently one of the leading candidates for Chairmanship of the Fed, argues that had the Fed followed his rule and tightened in 2004/2005, the housing collapse and associated great recession could have be alleviated or avoided.

      This leads to the question of whether the Fed should target asset prices.  The standard answer has been no.  The Fed should target inflation in consumer prices, but not asset prices.  But in recent times, it has been booms and busts in asset prices that have caused most of the economic damage.  It is not surprising, therefore, that a debate has arisen in academic circles over the targeting of asset prices.  Given my view expressed in this blog that asset prices are again approaching unsustainable levels, driven in my by investors reaching for yield and taking on more leverage, I find the argument that the Fed should pay attention to asset prices increasingly convincing.

Sunday, October 22, 2017

2 + 2 = 7 In the Market

       Amazon trades at a P/E of 250.  Facebook is 40.  For Air BNB, Tesla and Uber the P/Es are undefined because they don't have profits yet.  The list goes on for many tech companies.  The high P/Es reflect the rapid expected growth in profits and cash flow as companies like these disrupt the businesses of traditional firms.

       While all this disruption has been going during the recovery from the financial crisis, real economic growth has been sluggish - averaging about 2%.  That is a particularly low rate for an economic recovery.  Nonetheless, the S&P 500 has risen by a factor of about 4 - ignoring dividends!  That increase is not due to tech companies alone.  Prices and valuations have risen pretty much across the board.  As the Economist reports, P/Es of old line industries like hotels, credit cards, consumer proucts and so on are all well above historical averages so the market is expecting meaningful growth there too.  This leads to the question, who does the market expect tech companies to disrupt.  If the overall economic growth remains near 2%, the only way for tech company profits to growth far in excess of that is to take business from old line firms.  But those old line firms are also expected to grow faster than 2%.  It is as if 2 + 2 = 7.  That arithemetic is another reason why I am worried about current market valuations.