Value Redefined?

Historically, a "value" manager was in a category that adhered to a numerical basis for the valuation of an investment. This process was typically balance sheet-driven in which assets were purchased for less than their valuation. The positive estimate between the value received and the price paid constituted a "margin of safety." The results were driven by downside protection and some percentage of upside capture.

In contrast, a "growth" manager was in a category that followed structural disciplines in which indicators of growth were identified. This indicators might vary from gaining market share from cost or disruptive technology all the way to simply price movements. The results were driven by capturing the gains of expansion followed by a quick exit if any signs of maturity or decline set in.

Seasonally, value and growth managers alternated leadership with the best in each category generating superior results to market averages. However, for the past ten years (excepting the past two quarters), "growth" has trounced "value." While many pundits argue for a "reversion to the mean," I think that something else may be at work. 

Generally speaking, an investment does well if there is scarcity of supply relative to demand. After the vigorous efforts to restore markets damaged by the Great Recession of 2008-9, capital became abundant. Rates were low. This trend accelerated during the Great Infection of 2020. With government fiscal spending and central bank monetary support strongly committed, this abundance of capital could thwart the "reversion to the mean" thesis.

Business cycles are characterized by cycles in profits. When profits sink, unproductive assets drop in value, capacity is closed and capital is withdrawn. Later when profits recover, capital flows back into assets, capacity is expanded and assets increase in value. Critical to this cycle is scarcity of capital. If capital is abundant, then as profits drop, capital is not withdrawn and capacity is not closed, but instead continues to compete at lower levels of profitability. As a result of capital abundance, industries may experience prolonged competition and a decreased ability to cyclically get to "the good old days."

If this is so, then "value" managers may still capture results numerically, but need to focus on income statement items in which reasonable assumptions of growth are secured by some durable competitive advantage. Durable competitive advantages offset the impact of capital abundance. By discounting future earnings of such companies at today's lowered rates, value managers may discover a "margin of safety" through growing earnings rather than recovering assets. Such an approach may not yield the same combination of downside protection and upside capture, but it may generate superior results due to owning assets less subject to commoditization.

The Eyes of the Market

The eyes of the market are focused on inflation. This is appropriate, given that a sustainable dynamic of inflation would completely change the current dynamics of our economy. The reasoning is simple. If the Federal Reserve removed inflation under Paul Volker's leadership in the early 80s by tightening rates and shrinking the Fed's balance sheet, why wouldn't the opposite actions do the opposite? With the Fed's balance sheet ballooning to nearly $8 trillion shouldn't we be concerned that a view of benign inflation is simply a form of "fighting the Fed"?

This reasoning process is sound but fails to take into account the asymmetrical impact that Fed support has. This impact has been called "pushing on a string," articulating the powerful nature of a string to restrain but its limitations to support. Fed policy is difficult to disentangle from the other powerful force of fiscal policy. To use a model of disentangling, look at the current situation in Europe.

The ECB’s benchmark deposit rate sits at minus 50 basis points, with the seventh anniversary of sub-zero borrowing costs coming up next month, while total assets on the ECB balance sheet were €7.6 trillion ($9.3 trillion) as of last week, equivalent to 57% of pre-pandemic nominal GDP in 2019.  That compares to $7.9 trillion in assets held by the Federal Reserve, equivalent to 37% of 2019 output. Here is a situation of more significant central bank support that is not muddied by the aggressive fiscal stimulus in the US.

Of course, inflation could rise on a sustainable level, but the Fed's role will not be key. The Fed's actions have provided liquidity to the markets as well as a valuation lift. Every asset owner has received a "stimulus check" in the form of this support. Clearly the Fed will withdraw this support at a future date, but not until other forces have successfully driven sustainable inflation. So far those forces seem temporary.

Ignorance as Value-Added

John Bogle described the biggest cost of investing - an investor's reactivity causing selling at lows and buying at highs. This cost is well over 2% per year - a cost that towers over other investment costs. Is there a way to avoid these costs? Apparently so.

Large institutional investors have often proved themselves the worst in terms of reactivity, confirming Warren Buffett's comment that an IQ of over 120 is a wasted asset in investing. These large scale investors have been pouring money into private equity and venture capital. When zombie funds and survivorship bias and cash flow returns are calculated appropriately, private equity and venture capital returns do not exceed those of public markets. So what's the benefit?

Ask any money manager if she or he would be happy to pay for a statement that would revalue assets no more than one time a year and they would gladly sign up. Client investors read statements and invariably react the opposite of their best interest - inclined to buy high and sell low. Perhaps a product could be created that would allow static valuations of the portfolio with a liquidity option. The latest example of ignorance bearing fruit? SPACs.

Super Powers: Inevitable Conflict for AAFG?

Headlines about regulations affecting the business models of Amazon, Apple, Facebook and Google (AAFG) do not really concern me. History is devoid of government intervention truly damaging the fortunes of a successful business enterprise. The fall of a company like IBM was not fundamentally affected by the government's breaking it into smaller components. Rather, it was the company's focus on hardware rather than software. Companies are damaged either by their own arrogance or the innovations of others.

As the radio station owner declares in Brother where art thou, "Competition is bad for business," the challenges for great businesses often lie in competition. As a result, businesses spend great energies maintaining their positioning and thwarting the efforts of others. The laws around anti-trust are designed to prohibit activities that hurt competition and, thus, negatively affect consumers. The result is a set of laws designed with a standard of damage to consumers.

Today's monopolists have no problem with this standards. In fact, scale and aggregation of supply and demand allow for an increase in the quality of the product for consumers. In the past, oil companies like Standard Oil or phone companies like AT&T were broken up because the increased fragmentation led to lower pricing and thus increased benefits for consumers. But in the frictionless world of the internet, this structure is turned upside down as the consumers benefit at the expense of intermediaries and suppliers. If consumers are not hurt, should a restructuring occur?

Twenty years ago, the same issue came up for the explosive retailing force of Walmart. Competitors and labor unions complained about shutting down small towns as well as low wages. However, no real action occurred because the benefit to the consumers was compelling as Walmart increased the purchasing power of low and middle income Americans who were already struggling with the wage impact of globalization. Of course, Walmart was not welcome into major cities, but wealthier consumers were not Walmart's natural target. 

Today AAFG face the same issue. The services provided by each company are continuously increasing in quality and or appeal. In the case of Facebook and Google, the services are free. For that reason, antitrust issues will be difficult to apply in any way that does not simply further entrench them. In addition, taxes to supply "neutral" news services can be applied, but again this does not disrupt. So I spend my nights thinking about what could.

Lately I've been reflecting on the dominance that England, France and Germany had in the late nineteenth century. The three together dominated in science, math, industry, travel, leisure and on about any other standard relative to the rest of the world.  Yet, they managed to take the next fifty years completely self-destructing from a fear that somehow each would be displaced by the others. Each country, like the AAFG companies, brought unique cultural and structural advantages, but were not content to exploit those. Fear brought them to attempt the destruction of the others, only to destroy themselves.

As I read about the various attempts of each of the AAFG to outcompete the others, I watch closely for signs that might resemble early 1914 when the superpowers of that time thought their conflicts would be brief and insignificant. The current challenges of once almighty Intel are a lesson in the rapidity of a downfall.

Future Role for Banks Shrinking?

Historically the role of the banks was essentially to transmit the impulses of the central banking system. In that transmitting capacity, banks ran the risk of insolvency if and when the central bank decided to "tighten" money supply either through higher reserve requirements or higher interest rates or tightened lending standards. A conservative bank culture typically allowed the bank to survive a periodic tightening and expand during other periods. At the end of the day, it was a good job with a franchise on the money creation powers of an expanding economy. A good bank culture allowed a profitable ride on a rising economy with little loss of market share.

However, as the bond market revved up with the support of credit rating agencies such as Moody's and Standard and Poor's, the banks began the journey towards being disintermediated. Market share was diminished in the form of moving from the net interest spreads on large loans to investment banking fees to underwrite bonds. Gradually the outlines of a "bypass" of the middleman of banks occurred in the largest segments. This large debt market bypass was completed as the Federal Reserve, under the demands of the Covid-related lockdowns, purchased these bonds. 

At the same time, banks have increasingly standardized their loans to conform to be packaged into securitizations. This role, like that of the investment banking one above, does not necessarily require the powers to create currency to handle. Witness the proliferation of mortgage brokers. Again, as the Federal Reserve purchases these assets, the critical link of the bank becomes less critical. It appears to me that banks are increasingly losing market share in their primary function while the Fed's visibility and active role increases. 

The long term implications are such that banks need to reposition themselves. First Republic Bank is a particularly attractive model - driven by a financial planning know your customer lead and followed by lending and asset management. However, the lower end of the market is wide open and most critically to be determined by payment systems and technology. For this reason, payment processing companies have developed market capitalizations that dwarf those of banks.

Fed Lag Times

Yesterday marked a milestone as the wife of a friend of mine received the vaccine shot for Covid-19. With that milestone achieved, we move closer to the day of reckoning when the Federal Reserve starts to remove liquidity support and tighten. This will be an epic move.

The Fed's moves take about 6-18 months to show up in the economy. However, the responses in March were almost instantaneous as multiple approaches, both fiscal and monetary were implemented. In addition, market participants sharply changed with the visible engagement of the Fed.

With the market, especially in the technology sector (examples are too numerous to mention), experiencing unprecedented bubble characteristics, the Fed will have no choice but to remove support without impairing the real economy. To do this will require fiscal support to step up its pace. If the fiscal support does not show up, the Fed will have to wait.

The likely trajectory is that fiscal support does show up, however, both for small businesses and in the form of direct individual supports. This is reasonable as the Fed's actions have overwhelmingly been a "wealth effect" for the higher income and net worth segments of the economy. 

As this support shows up and the vaccine takes hold, likely pent up demand will drive a strong economic recovery. In the face of such strength, the Fed will have the opportunity to tighten while communicating that the Fed will be "measured" in its response. Given the Fed's typical lag time, the Fed can waste no time in implementing early actions - at the very least in the form of Quantitative Tightening to shrink its bloated balance sheet.

Beyond that initial point, the Fed must tighten until a blood-letting occurs in the technology sector - at the very least. Given the length of time it takes before the Fed begins its tightening journey and then the lag effect, 2021 could be a buoyant period. Beyond that though, bond buyers and Big Tech investors may have significant opportunities.

Bubblenomics

The Bubble is back. In a world of paper money, then Chairman of the Federal Reserve Alan Greenspan commented that part of his job was to make sure that paper money retained value as if it were gold. At that time, I took his comment to apply strictly to the framework of inflation. Yet since then, I have seen that his comments also referenced asset inflation or "bubbles." 

Although Chairman Greenspan claimed that he did not have the ability to spot bubbles, he did take action against the Tech Bubble of 1999. He consistently tightened money supply until short-term and long-term rates reached high levels despite a notable absence of inflation. What was he acting against if not the perception of a bubble?

Those actions contrast sharply with the current market. Despite similar bubbly valuations in a wide range of noticeably unprofitable companies such as Snowflake or Tesla, the Federal Reserve is forced to support liquidity and market euphoria. With political tension in rapid decline, people are able to turn their attention to the dramatic rise of the stock market and ask themselves, "does this make sense?"

I finally understand why the Fed always takes away the punch bowl when the party gets fun. It is not simply so that inflationary structures get built in. It is also to discourage speculation and gambling as activities that denigrate the fundamental concept of hard work as the way to build wealth. There is a moral structure built into the Fed's design. Further, the Fed has to be careful about how many "white elephants" get built with cheap capital combined with rosy projections. Those structures are sunk costs.

But as long as the Fed is required to support a Covid-impaired economy, it appears to me that the punch bowl is here to stay.  It will be taken away at the first opportunity. When that punch bowl removal happens or is perceived to be likely, the notion of a punch hangover will wreak havoc on valuations in these bubbly areas. Caveat investor.