Buffett LEEves the newspaper business

In 2006, I blogged extensively about the newspaper business decline. By then, newspaper stocks had dropped precipitously from 2004. I read and discussed it extensively. Comments ranged from a former newspaper editor - "what would people read in the toilet?" to my children - "you mean people actually pay for old news?" The best comment came from Warren Buffett who, like myself, grew up delivering newspapers. He said, "if there were no newspapers, would they need to be invented?" With his epiphany, I closed out my newspaper research process and saved myself much agony.

I was surprised that he continued to purchase newspapers as their prices dropped even further. Unable to resist a bargain, a fan of newspapers and aided with a flush balance sheet, I imagine that Chairman Buffett was unable to contain himself - despite the profound insight he shared. Further, once in a business, rarely does he give up. But he did on Tuesday.

Lee Enterprises (LEE) announced that it had purchased 40 newspapers from Berkshire Hathaway (BRK) for $140 million - all of it financed by BRK. In addition, BRK was financing another $400 million for LEE (all of LEE's debt) at 9% for 25 years with no fees or performance contracts. This structure is extraordinary - akin to selling something "to someone for part of whatever he can make on it." It does express that 1) in Buffett's opinion, there is little value to the local newspaper model and 2) Buffett stands behind his commitment to do all he can to help local news by selecting high grade people to find a new sustainable model.

Perhaps LEE can innovate to create an app or a Google or Facebook based revenue stream. It's unclear and the markets did not really respond. LEE traded at $40 per share in 2004, $31 in 2006 and is now at $2. The P/E is exceptionally low and the support is there, despite high leverage. Clearly there is a model for digitally important local news, but who will find it?

Private-Equity Companies - Own The GP?

Alternative investments are an expanding universe and include categories such as hedge funds and private-equity (PE) funds with PE funds expanding seven-fold since 2002. Over the last five years ending June 2019, hedge funds have done much worse than the S&P 500 (5.5% vs. 10.7%) while private-equity funds have done much better (14.4% vs 10.7%). In some ways, this is sensible as hedge funds are theoretically structured for downside protection while private-equity funds are structured for upside gains and the past five years have been expansive.

As a result of these gains, pensions are flocking into PE funds. Currently, PE funds have over $1.5 trillion in cash to invest along with the likely contribution of an additional $500 billion this year. Institutions are lining up. Much of the dramatic reduction in publicly traded stocks (down 50% over the last 20 years) can be attributed to PE activity, as well as M&A and share repurchasing. As Jim Grant, of the eponymous Grant's Interest Rate Observer says, "On Wall Street, success begets failure. Take a good idea, emulate it and embellish it, drive it into the ground like a tomato stake. Voilà: It's a bad idea." The Achilles heel of PE funds is their leverage. PE funds increase equity returns by levering up. In a slowing economy, PE results would be challenged, as would their bonds. (The location of ownership of these bonds is important.)

But PE funds may continue their winning ways. If that is true, why not invest in the general partners who are collecting these handsome 2% plus 20% fees? For example, Blackstone, Apollo Global and Carlyle all seem to be on the more generous side of these investments. Why wouldn't the institutions simply buy the publicly-traded general partnership interests? Is the avoidance of market to market that extreme by institutional investors?

"Disaggregated Business Model": Cisco (CSCO)

For years, Cisco (CSCO) dominated the internet routing business, earning the moniker "the plumber of the internet." At the height of the "tech bubble," CSCO's stock hit a price of $77 - a price it has not come close to since - and was one of the most valuable businesses in the world. Since then, CSCO has continued to thrive, but its market cap has never recovered. Why?

For years, CSCO has sold its networking solutions as an integrated system. Such systems set themselves up for what Clayton Christiansen defined as the "innovator's dilemma." What does that mean? That means that some businesses set up their business profitability based on a margin driven by the "value-added" of integrating components. The nature of capitalism is to disaggregate these components and commoditize them. Often this occurs by a lower-cost modular innovation, such as connected microcomputers replacing mainframes.

Based on Christiansen's framework, CSCO was a prime candidate for commoditization. By 2014, the largest companies in networking, such as telecommunications and Big Tech companies, had moved forward into software-defined networking (SDN). SDN allowed companies to use lower cost hardware and then design software to meet their specific requirements. The result was a lower cost, higher quality outcome. CSCO protested that their security was better. But the large purchasers increasingly pursued SDN.

Last week's WSJ reported the inevitable modularization as it announced that CSCO would now allow customers to purchase the chips alone. Given that this was going to occur, it may be that CSCO has finally accepted the inevitable because either 1) it is better to stop losing market share and accept lower margins or 2) it is now in a prepared position with vastly superior chips that allow for a reorganization of value into one of the components - the chip. It will be fascinating to see which way this develops.

Moral Hazards of Capitalism

For the upcoming generation of Americans, capitalism does not hold the same cachet as it did for prior generations. A recent survey showed that capitalism as a preferred economic system had dropped from 68% to 49%, despite the clear implosion of "socialist" Venezuela to the south. I believe that the drop in support is caused by an increasing income and wealth gap. In the 1980s, the average CEO made nearly thirty times the average worker. At the present, the spread has moved to nearly three hundred times!

A generational pushback on this seems entirely appropriate. In fact, it is unfortunate that it takes a new set of eyes to identify the unfairness. While it is true that such discrepancies regularly exist between professional sports figures, the assessment of the CEOs performance is a different issue. In professional sports, there is no factor such as the Federal Reserve, to make everyone's score better. By dropping interest rates to support the economy, interest expense goes down and stock prices rise - driving stock options up and richly benefitting CEOs.

The mantra of paying for performance has become so sacred to my generation that little effort has been made to assess how that pay should occur. Warren Buffett recognized early on that stock options had a pernicious effect as they were not recognized in financial statements. Even after they were recognized, their usage had morphed into a necessary item for C-suite compensation packages. Boards and compensation consultants worked together to create highly inflationary C-suite compensation. There is little opposition in the form of money managers and this is only worsening with the prevalence of passively managed funds - and active managers like me who view attempts to control this compensation as futile and thus, unworthy of efforts.

It is unclear to me what the solution could be - short of simply outlawing these complex instruments as a form of executive compensation. That is a radical solution, but surely better than a continuing to damage capitalism's powerful force for lifting standards of living for all.

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.