Deferral of Gratification: the "Real" Deal

The only logical reason for deferring gratification and not spending all of our income is either the hope of increasing our spending power or the fear of not having enough to maintain it. In order to logically defer spending, we need to find a place for our funds with "real" earnings.

Warren Buffett discussed this in Berkshire Hathaway's 1980 annual report stating, "If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real (my emphasis) income from your investment, no matter how much it appreciated in dollars." (I wish all annual reports were so easy to read.)

At least two factors need to be understood before engaging in the act of faith of deferring gratification. First, the place in which funds are stored need to have returns that keep up with inflation. For example, the $9.5 trillion of savings held in U.S. banks (from St. Louis Federal Reserve numbers) represent a significant likely loss of purchasing power with average interest paid under 0.5% while inflation exceeds 1.7%.

Second, Buffett's example shows that taxes must also be considered and today's low rates become even lower with taxes. Historically savers have done better. From 1925 until now, U.S. Treasury Bills (a proxy for savings) have yielded 3.3% while inflation has averaged 2.9%. For 94 years, savers generally increased purchasing power. However, by taking a tax rate even as low as 20%, the saver loses purchasing power. That's the "real" deal.

ESG: Doing Good by Doing Well?

A recent study reported that the market value of U.S. companies qualifying as Environmental, Social and Governance (ESG) companies made up 26% of the $46 trillion managed by professional investors. I had long been a skeptic of ESG investing due to its initial exclusion of industries such as defense and alcohol. However, ESG has evolved and now includes all legal industries, looking for best practices within industries. The results have been powerful:

1) ESG companies have outperformed non-ESG companies by 3% per year over the past five years, and
2) 90% of bankruptcies (15 of 17) from 2005-2015 in the S&P500 could have been avoided by not purchasing companies with low ESG scores.

In reviewing financial statements, I have lightly scanned the "ESG" portion of their reports. However, I am beginning to form respect for these ESG components. For me, they represent the likelihood that those companies have their act together. If a company can not only compete in today's global economy, but can also find ways to improve their impact in the world, it may be highlighting the degree to which such companies are either competing favorably or being managed effectively enough to move down the "to-do" list.

Pension Plans: Rear-View Investing

In the 1978 Annual Report of Berkshire Hathaway (BRK), Warren Buffett wrote,"pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities - breaking the record low figure set in 1974 and tied in 1977." At the same time, Chairman Buffett was aggressively purchasing equities for BRK. But with flawlessly poor timing, the pension managers stumbled badly on their investing responsibilities as equites have generated superior results since those three years.

Those observations came to mind as a recent headline from the WSJ read, "Public Pension Plans Continue to Shift Into U.S. Stocks: 47% of plans’ assets were in U.S. stocks in third quarter, the most since 2007." The article had this graph illustrating pension allocations:

This graph illustrates that pension managers have hardly improved on their timing in the past 40 years. They continue to underweight equities at low prices and lift allocations at higher prices. These timing missteps compound an even more fundamental error. Why would managers with the "longest of investment perspectives" heavily invest in fixed income assets? With investment thinking like this, it is little wonder that pension plans are looking for a government bailout.

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!