Is the sky the limit for Defense Stocks (LMT)?

For years, I have studied the stocks of defense contracting companies. These companies are technology companies who have an unusually favorable characteristic. In the case of most technology companies, research dollars are spent developing products that the company hopes will be met with consumer approval. As such, net incomes are often fully retained to fund future spending cycles. In the case of defense contracting companies, the research costs are to more effectively produce a product that has already been approved for purchase with the best consumer of all: the U.S. Government. This lower risk expenditure on R&D translates into an ability to pay out almost all of the net income to shareholders in the form of dividends and share repurchasing.

Over long periods of time, the defense contracting companies have experienced relatively slow growth and have merged in order to reduce the likelihood of being left out of the dance. The result has been a small group of companies, each with areas of specialization and all characterized by fairly low single digit revenue growth. For this reason, the rapid increases in market value over the past 10 years is astonishing. For example, Lockheed Martin (LMT), outside of the Sikorsky helicopter acquisition, has seen almost flat growth. Yet during the same period, the stock of LMT is up over 300%.

What gives here? It seems like there are four explanations. The first is based on the above mentioned characteristics. In a market that loves bonds, these companies have bond-like financial characteristics. Second, these companies do extremely well when the US Dollar is strong - as has been the case from 2013. Third, for whatever reason, margins have been allowed to expand. This may be due to an increased absence of bidding. Normally, the bidding and cost plus approaches have kept margins at 12% or less, but lately these have been allowed to expand. Fourth, there is a Trump bump - which is sensible due to a 20% increase in this year's budget combined with hawkish rhetoric.

There is some regret in all of this as we had come extremely close to a purchase of LMT about six years ago, but were dissuaded by their pension complexities and liabilities. Now it appears that LMT will be allowed to retain its corporate tax cut to put $6 billion towards an underfunded pension plan.

What makes the U.S. a natural "mass market?"

In reviewing the new 10k of Booking Holdings (BKNG), I noticed that the company outlined how the U.S. market is different than others - the U.S. has concentrated lodging in a narrow range of hotel chains, while offerings in other markets are much more diverse.

It is striking, giving the notion of American individuality, that diversity of products is so much greater in other countries. For example, Hershey's led the chocolate space for so long. The mediocre quality of its chocolate was arguably due to the extensive transportation and shelf life issues it faced. Why was that compelling as opposed to regional chocolatiers?

This same issue seems to arise in several consumer categories. Was it driven by the sizeable and easily navigated transportation infrastructure? Was it driven by the dominance of three television networks and the natural advantages that large scale companies had (big ad budgets, but lower per item ad costs)? Is it the convergence of the two?

The "millennials" have changed with greater diversity in preferences, but it's not difficult to see that this diversity may be the result of changed and fragmented viewing and listening patterns. If so, I would expect to see similar patterns continue to emerge in the lodging space - as Airbnb popularity seems to indicate.

Fed Getting It Wrong?

Recently, the Federal Reserve has announced that it would reverse Quantitative Easing (QE) while also raising interest rates. The market commentators have largely agreed that this is the first step in a return to normal interest rates at a higher level. It seems to me unlikely and, even more, I think it does indicate that the Fed is making a significant error. 

The typical Fed approach is to tighten money and raise interest rates when inflation rises due to an overheating economy and rising labor costs. In today's environment, the unemployment rates have dropped to low levels - levels that are normally accompanied by rising prices and labor wages. However, so far, inflation has been beneath the 2% target. Since there is no visible threat of inflation, why is the Fed tightening - with the inevitable slowing of the economy and shedding jobs? 

The basic arguments seem in two categories. The first is that tightening gives the ability to loosen in the event that another problem hits the economy - a kind of restocking "dry powder." The second is that the only way to have a normal cost of money is to create it by simply driving rates to the desired levels. Each argument, to me, is ridiculous. 

The first argument is flawed because the development of "dry powder" could be the exact cause of needing the "dry powder." It's like stealing a supply of ammunition to be utilized when the police arrive to arrest you for stealing ammunition. There must be a term for this, but let's just leave it at stupid. The second argument is flawed because the yield curve is not simply a fiat curve - even though the money is. The yield curve is made of complex elements that defy a demand. 

My preference would be to leave things as they are - a variation of "don't just do something, stand there!" I think that we are seeing several factors drive abnormally low inflation - high manufacturing productivity, developed country currency power relative to undeveloped country currency, the reduced friction from the internet, a maxed out leveraging of the consumer base and limits on major government spending. Given this combination, we can leave money loose and enjoy the benefits of low unemployment. Let the asset prices do the lifting for now!

Spin, Vbikes or Limelight?

An unusually temperate September in Dallas has allowed me to explore yet another asset class in the shared - asset economy made available by the power of the internet: bicycles. While it might seem that southern cities would be great venues for bicycle transit, they are infrequently seen. There are several reasons for this: 1) with low volumes, cars don't expect bikes and the resulting "blind spots" can be harmful to the riders' health, 2) with low volumes, there are few places where bicycling is easy, 3) bicycles can be stolen easily while parked outside, 4) bicyclists tend to be about exercise and not utility so the emphasis is whizzing by wearing tight spandex panties, not getting to work. All of this may change.

Thus far, I am excited about the prospects of this bicycle rental approach. It is easy to find a bike. The app shows clearly where they are and there are numerous choices within a block of places I go. Next, it is easy to rent. I just hold the phone over the image of a number and it identifies the bicycle and unlocks it. It is cheap to rent. It is a $1 per hour. Hard to beat that. Next, someone stealing the bicycle while I am gone is no longer an issue. When I lock the bicycle, I go off the rental and it is no longer my problem.

The only glitches that I am experiencing are likely to be ironed out or the service won't work. The first glitch is that many of the bicycles already need some kind of maintenance work. This has to be done or the prospect of unreliability will make this service an occasional fun idea, rather than part of a daily routine. Second, vbikes has no seat adjustment and somehow has concluded that 5 foot tall is the appropriate standard height. Third, weird technology things happen - such as when I locked the bicycle so that it kept charging me because it wasn't locked and yet I couldn't get another bicycle because the one I had was supposedly being used by me. I could give a few other examples, but there is no way to get help. The apps direct you to someone who may call in the next hour.

Progress not perfection!

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?