Lending Runs Like a Deere

In reviewing the financials of Deere & Co (DE), I was stricken by the growth in lending. Bill Gates, through his Cascade Investments, LLC, owns nearly 10% of the outstanding stock. In addition, his good friend Warren Buffett was a holder of shares from 2012 through 2016, during which time he made very little return. DE obviously peaked the interest of two clear thinkers and still holds the attention of one of them.

DE has a powerful brand which is even recognized outside the agricultural community. I was fascinated by DE early on because our family owned many of their tractors, including the "A" and the "B" models. We had other older tractors, such as Farmall and Allis-Chalmers, but John Deere had clearly won the day. But what really surprised me was that the other contemporary tractors were better than the "A" and "B," but John Deere's marketing had won out.

In some ways, it does not look like things have changed. DE is still dominating the US agricultural equipment category, but appears to be doing so on a "buy here, pay here" business model. While sales have dropped by over a third over the past few years, the use of DE's balance sheet for loans and leases has nearly doubled. During a period of dropping ag prices as credit naturally dries up, DE has pressed forward employing its own balance sheet to facilitate purchases and gain market share.

If the cycle shifts in the near term, DE will have made an excellent move. However, with global bumper crops, DE faces another year of low ag prices. Compounding the challenges of this cyclicality is DE's business model. Like the auto industry, DE has a structure in which dealerships capture consistently good profitability, while the manufacturer rides a "boom" and "bust" cycle. It will be interesting to see if Bill Gates' long term support or Warren Buffett's concerns end up more relevant.

Is the Whole World really nothing but Numbers?

One of my all-time favorite people claims, "the whole world ain't nothing but numbers." As I study the current business environment, it appears that such claim may be false. On a daily basis, I see financial pricing that does not seem intelligible. It's happened before: 1999.

In 1999, I saw pricing that could not be reconciled to reality. The "tech bubble," as it came to be known after the fact, presented itself as a rational valuation model to fund disruptive technologies based on the revolutionary power of the Internet. The thesis that the Internet would change everything has proven profoundly true. I am actually starting to believe that the Industrial Revolution was a mini-version of the Internet Revolution. (So much for Ted Turner's claim that the internet was simply a place to watch porn.)

In retrospect, Alan Greenspan was correct in assessing that there would be some winners but that it was purchasing a lottery ticket. The idea of paying 9 - 15 times revenue was simply extraordinary. On the other hand, the idea of not giving value to companies simply because they were early stage and without earnings is not sensible. However, financial and mathematical tools are at their worst in such valuation attempts and I was wise to be part of a team that decided we weren't up to the task.

The current environment seems even more daunting. Today it is clear that there are winners who have successfully disrupted the environment. It is unclear that these winners will be allowed unlimited market power - which is what it would take to defend current valuations. This challenge is compounded by an abundance of central bank-driven liquidity that distorts bond pricing. The matter of valuation today is risky and confusing and those who claim otherwise need to explain Berkshire Hathaway's inability to allocate $100 billion in barely one percent yielding cash (pre-tax number).

Infrastructure Idea?

In reviewing Taiwan Semiconductor (TSM), I was impressed that a globally dominant company with a market value of nearly $200 billion was founded by Taiwan in 1987. TSM is nearly five times larger than its closest competitors, dominating a space that is capital intensive and rapidly changing.

It seems so unusual that a country would fund and commit to the development of such an important company. To enable its success, TSM appears to have paid little taxes. The benefits to a country of having a cutting-edge and dominant chip foundry must be tremendous.

It caused me to think about whether or not this could be a means of creating the much needed infrastructure improvements in the U.S. It seems that the issues surrounding our lack of infrastructure improvement are 1) regulatory - the myriad of "red tape" makes such large scale projects impossible, 2) competitive issues - if regulatory issues were cleared, who would deserve the "win" on such contracts and 3) technological - how do we find a way to invest in technology leaps like NASA.

Perhaps the Taiwanese have a sound idea. Could there be a US Infrastructure Manufacturing company (USIM) that would be granted powers that would make regulatory hurdles easier, given capital from the US government by way of lowered taxes and provided a "think tank" environment like the old school IBM and AT&T - where most of our great inventions were created?

Progress Treating Addiction? (TMS)

This month's National Geographic (September 2017) takes the topic of addiction. Although much research has been done, much ink has been spilled and many dollars spent, success in the treatment of addiction (on a basis of five years or longer) has not improved since the advent of 12-step programs over 70 years ago. Yet one treatment caught my eye.

The article highlights a treatment (or "technique") called transcranial magnetic stimulation (TMS). In addicts, neuroscientists discovered that that the region of the brain that inhibits behavior was abnormally quiet. If these quiet brain cells were activated or stimulated, then the addict might gain power to overcome the compulsion to use. This is critical as "lack of power is the dilemma."

In a sample group, TMS was much more successful than traditional approaches. However, the sample set was small and not placebo-controlled, as well as for an extremely short period of time - one month.

Intuitively, the idea is sound and has been successfully applied to depression and migraines. In the case of depression, TMS has to be repeatedly applied as the conditions of depression recur. It appears likely that the same pattern will occur using TMS for addition. So while it does not appear to be a permanent fix, it certainly has relative merit to drugs with their attendant side effects.

A wonderful book called "The Body Keeps The Score" by Van der Kolk seems to hold out what causes the recurrence. By focusing attention on treating the symptom rather than treating the cause, treatments are inevitably going to be overridden by the underlying condition. In addict parlance, it's why "the disease is doing pushups even when someone is sober."

Crosstex Energy

I have placed this grid describing the stock price returns of Crosstex for a 10 year period of time.  It illustrates a couple of points.  The first is that numbers compound geometrically, not arithmetically. Here is a real life example of gains totaling about 440% and loss was about 90%.  Added together would create a value of 350% over ten years.  Instead, it was a nearly 130% gain.  The lesson?  There are several, but probably the most important is that volatility is only good when you understand what you are investing in.  If you did, 2008's downturn would have been a huge buying opportunity. If you did not, you might have sold at the wrong time.

I bring this grid up partially because I still don't understand the company. Crosstex was a midstream pipeline company that was merged with Devon Energy's pipeline assets to form Enlink in 2014. Pipeline companies have again gotten headline attention as their prices have dropped precipitously.  In 2008, I started analyzing the company when the stock price was at $33.  There were two reasons that I decided to study it.  First of all, a well-known investor named Glenn Greenberg had taken a large position in the stock.  Second, the company's headquarters were within a couple blocks of my home; I could walk to a meeting with management.

BMD - Underappreciating Currencies

For years, I have put the topic of currency movements in the "don't understand, won't understand" pile of information.  But I have changed that.  I have officially set up a folder on my computer labelled "currencies."  It is still empty, but it's my first step in moving to at least "don't understand, can't understand."

For a long time, currencies have been fairly routine.  After World War II, leaders got together and created the Bretton Woods accord.  Part of the plan was to encourage world trade as a way of healing from the horrendous war that just occurred by encouraging world trade.  World trade is extremely difficult when currencies are disruptive.  By setting up mechanisms to smooth currency movements, world trade is encouraged.  It seems to have worked fairly well, until recently.

Suddenly, dramatic declines in the Brazilian real (pronounced "hey - ow"), the Russian ruble and the Japanese yen have made investment analysis difficult.  My Biggest Mistake of the Day (BMD) is that I lack any method for getting a general sense of the appropriate relationship between their currencies and my own.  While it was clear to me that lowering interest rates and implementing Quantitative Easing (QE) policies weakened the US Dollar, I did not pay sufficient attention to the amount of weakening.  At some extreme, the US Dollar is too "strong," meaning that distortions are too significant to be sustainable.  The opposite is also true.

While precision is impossible, a general sense can be developed by looking at historical relationship and factors - something I have not done.  Given that I have some investments with exposure to the aforementioned currencies, it seems important to start to fill up the "currencies" folder.

Back At It - Wrong Framework Again!

My commitment to publish my Biggest Mistake of the Day (BMD) has fallen under the weight of a volatile month.  Whether or not the Chinese said it, it certainly might be a curse to "live in interesting times"  - at least in terms of keeping a blogging promise.

I have been reviewing my analysis of British Petroleum (BP).  BP is a major vertically integrated oil and gas company.  Several different functions of the oil and gas business, such as "upstream" exploration and production, "midstream" transportation and "downstream" refining and marketing are consolidated under one roof. Each of these functions has characteristics that are so different that many companies, such as ConocoPhillips (COP), have split them into separate businesses.

Typically the most valuable part of a vertically integrated oil and gas company are the reserves.  The nature of reserves is to discover them, develop them and extract them.  The end result is no asset.  This is an unusual structure.  Most of the time, companies have non-depleting assets that are designed to generate recurring revenues.  Here is where the challenge is to use the correct framework.

It is tempting, in the case of an exploration and production (E&P) business, to study its revenues, its expense structure and its cash flows and attempt some type of valuation based on those metrics.  Many Wall Street analysts resort to this - or even just use the dividend yield to value it.  Value Line, an investment service, uses a multiple of "cash flow" by which it means net profits (stated variously) added to depreciation. This is certainly an easy way to come to a conclusion, but it is hardly "fundamental" analysis. 

Even the accounting profession struggles with an approach. Accounting has to use a framework which is designed for a conventional business - one whose assets generate recurring revenues. As a result, the balance sheet and income statement presentation provides little insight into the understanding and valuation of an E&P business.

However, over time, accounting has created supplemental reports that provide useful information.  The critical starting point is to gain a sense of the value of the "proved developed reserves."  These are the reserves which are basically ready to produce oil and gas because all of the "get ready" expenses have been spent.  By studying the "proved developed reserves" and the changes in them from year to year, an analysis can arrive at the value of the reserves and gain insight into the value-adding or value-destroying nature of the activities that create them.