Warren Buffet's Berkshire Hathaway annual shareholder letter is always a great read for both investors and non-investors. The manner in which he writes his letters in plain English so that people can better understand them is a true skill.
One of my favorite Buffet quotes is "it is always morning in America." So what does this mean? Those familiar with the musical Anne might be able to relate to "the sun will come out tomorrow." The point of both quotes is that despite the gloom and doom and no matter how bad things may appear to be, America has had a strong track record of recovering from her lows and pushing into new highs.
“American GDP per capita is now about $56,000. As I mentioned last year that – in real terms – is a staggering six times the amount in 1930, the year I was born, a leap far beyond the wildest dreams of my parents or their contemporaries. U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue: America’s economic magic remains alive and well.”
“Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious…. Congress will be the battlefield; money and votes will be the weapons. Lobbying will remain a growth industry.”
“For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs. America’s social security promises will be honored and perhaps made more generous. And, yes, America’s kids will live far better than their parents did.”
“I told you how our partners at Kraft Heinz root out inefficiencies, thereby increasing output per hour of employment. That kind of improvement has been the secret sauce of America’s remarkable gains in living standards since the nation’s founding in 1776. Unfortunately, the label of “secret” is appropriate: Too few Americans fully grasp the linkage between productivity and prosperity.”
“The productivity gains…that have been achieved in America – have delivered awesome benefits to society. That’s the reason our citizens, as a whole, have enjoyed – and will continue to enjoy – major gains in the goods and services they receive. To this thought there are offsets. First, the productivity gains achieved in recent years have largely benefitted the wealthy. Second, productivity gains frequently cause upheaval: Both capital and labor can pay a terrible price when innovation or new efficiencies upend their worlds.”
“A long-employed worker faces a different equation. When innovation and the market system interact to produce efficiencies, many workers may be rendered unnecessary, their talents obsolete. Some can find decent employment elsewhere; for others, that is not an option.”
“When low-cost competition drove shoe production to Asia, our once-prosperous Dexter operation folded, putting 1,600 employees in a small Maine town out of work. Many were past the point in life at which they could learn another trade. We lost our entire investment, which we could afford, but many workers lost a livelihood they could not replace. The same scenario unfolded in slow-motion at our original New England textile operation, which struggled for 20 years before expiring. Many older workers at our New Bedford plant, as a poignant example, spoke Portuguese and knew little, if any, English. They had no Plan B.”
“The solution, rather, is a variety of safety nets aimed at providing a decent life for those who are willing to work but find their specific talents judged of small value because of market forces. (I personally favor a reformed and expanded Earned Income Tax Credit that would try to make sure America works for those willing to work.) The price of achieving ever-increasing prosperity for the great majority of Americans should not be penury for the unfortunate.”
Last week I wrote about why people may believe that things are not better within the U.S. I hope that readers will be able to tie the message from that article to these highlighted pieces from Buffet’s annual letter. Despite America's trials and tribulations, I too like Warren Buffet would never bet against the U.S. or its people.
A new feature below (from which I have copied from some very successful financial writers i.e. Barry Ritholtz and Ben Carlson) is to list several articles that I believe readers would have an interest in. While I would love to opine on many of the subjects covered in these great pieces, there is simply not the time.
Enjoy the reading and if you or someone that you know of would be interested in learning more, or is concerned with their current portfolio and what to expect in 2016, I would welcome the opportunity to arrange a meeting or a phone call.
What I Am Reading this Week
Keeping Anxious Thoughts at Bay (Harvard Business Review)
The US economy is getting better, but US workers are getting worse (Business Insider)
Ted Williams, Baseball’s First Quant (The Big Picture)
Harvard Studied People For 75 Years & Found That Happiness Comes From One Thing… (TED)
While the economy may have improved since the Great Recession, there appears to be an increase in uncertainty. A sea change of sorts has been overtaking the American Dream if you will. Once upon a time it was merely a high school education that one needed to secure their spot within the middle class of America. From there the road to a secure middle income life required a college degree but largely without the massive amounts of debt that today's generation is currently being saddled with.
But today there are still those that are stuck between these diverging roads to the middle class of America. One of the reasons why so many people are caught in this economic transition is the rapid change within some industries.
It was only a few decades ago where you could walk into any number of U.S. manufacturing locations and see people manually doing the work that robots are currently doing today. What took the work of say 6 people to operate a manufacturing line now takes only a few. However, the skill sets of the people remaining doing the work has changed drastically.
Rather than doing the physical work that robots or other machines are performing today, the manufacturing worker of today needs to know how to repair the robot and how to make it run more efficiently.
This brings me back to the current political scene. Opposite the message of “hope” that President Obama ran on in 2008, The current batch of Presidential candidates seem to be running on the message of “fear.” The politicians try to stress upon the structural challenges that have occurred within America and the long-term economic uncertainty that it has brought to so many Americans caught within these transitory cycles.
The popularity of anti-establishment candidates such as Donald Trump and Bernie Sanders can flame the political fires of Americans who feel left behind and disenfranchised by the rebound in the American economy that has helped to create a larger divide between those that have and those that have not.
Professor Scott Galloway of the NYU Stern School of Business has stated that it has never been easier to become a billionaire in the U.S. while it has never been harder to become a millionaire. How is this so?
Think of the millennial software tycoons who have built companies such as Facebook, Pandora, Uber, or any other software that you likely use on a daily basis. These innovative disrupters are also the same people who help to fuel the great divide. Consider Facebook, they employee a fraction of the people that say Ford Motor employees but with having a market valuation of 6 times Ford. Many of those people working at Ford could not work at Facebook. Thus this is one of the factors that have driven the structural changes.
However, what we continue to need is more innovation and not less. We need more disrupters who will create the companies that generate jobs that stay in America that will help to continue to support a middle class that most nations can only dream of.
The economy as a whole is much better today than it was 7 years ago. However, that does not mean that all individuals are much better today than they were 7 years ago. The structural changes that occur within every generation does not bring every American along no matter how hard it tries.
Although there will always be challenges, what America needs now is a message about solutions to those challenges and not a message of fear that most politicians seem to be giving out today.
In the 1960’s and 1970’s there were a group of companies favored by institutional investors characterized by consistent earnings growth and high P/E ratios named the Nifty 50. Within the past two decades the markets rode in on another grouping of big companies dubbed the “Four Horseman of Technology” which consisted of Amazon, Google (now Alphabet), Apple, and Facebook. Today we usher in the latest collection of momentum stocks termed “FANG” stocks, which represents Facebook, Amazon, Netflix, and Google.
According to research by Palo Capital, the “FANG” stocks were collectively up over 60% in 2015 while the remaining 496 stocks in the S&P in aggregate were down 4.8% for the 2015. Here were the current Price to Earnings (P/E) ratios for the group of “FANG” stocks as of January 8th;
- Facebook – 98.3
- Amazon – 875.9
- Netflix – 297.6
- Google – 33.7
For comparison purposes the overall S&P500 index supported a P/E of 19 for the same date.
So now for a couple of disclosures;
- We own shares in Facebook with the caveat that we bought at a much lower P/E
- We did own shares in Google but sold in mid-2015
- P/E ratios are only one relative valuation metric for which to calculate a company’s worth, these ratios do not tell the whole story of a company
So what is the one area that these four companies have in come? They are all growing their revenue at high speeds and that is what the U.S. equity market seemed to be paying attention to during 2015. Amazon for example had grown their revenues by 948% from 2005 to 2014 which averages out to be 28% per year. However, at times they barely recorded much income and although they threw off a large amount of cash from operations each year, their economic margin has been in decline since 2009.
This is not to say that Amazon isn’t a great company because it is. My family uses Amazon practically on a weekly basis. But at times even great companies such as Amazon can get ahead of themselves from a valuation standpoint. This same point could be made for the other three “FANG” stocks as well. Chances are, when the revenue growth begins to slow, the stock prices are likely to decline and potentially decline at a faster rate.
As we have previously communicated, I believe that the decline in revenue and earnings amongst most companies along with the decline of revenue and earnings estimates, are the drivers behind the decline in stocks that we have seen to begin 2016.
We have noted time and time again that there will always be headline risk within the financial markets. At this point in time there are concerns regarding;
- Economic slowdown in China,
- Federal Reserve raising interest rates,
- Continued disturbances within the Middle East, &
- North Korea testing a potential hydrogen bomb
While none of these areas of concern can be brushed aside and our decline in revenue is certainly not helping China, the decline is revenue and growth estimates is more concerning to us when it comes to company valuations.
We have now experienced an entire year with unusually low gasoline prices but where has the increase in consumer spending gone that the financial experts predicted? Spending on items such as healthcare, education, and experiences are the three main areas that have seen increased revenue growth. Have you been in an airport lately or paid a college tuition bill? Both of those industries have been able to push through price increases that most people cannot avoid.
At TAMMA, I am continuing to focus on our processes that emphasizes quality over momentum. I am focused on finding companies that;
- Have low levels or zero debt; allows companies to ride out economic downturns and make strategic business decisions when other panic and assets go on sale
- Generate strong cash flows; while some companies can financially re-engineer their earnings per share, cash is one on the strongest indicators of a healthy company who can again withstand economics headwinds
- Can reasonably grow revenue; companies must have adequate catalysts that will keep customers coming back which could be a great product, customer service, or some other factor that makes them a must have
Although the data that I review doesn’t show signs of a meltdown that we had in 2008, when the financial markets turn down as we saw this first two weeks of 2016, most financial assets begin to move towards a correlation of 1. This means that there are very few places to protect your assets from a drop in prices other than to go to cash. And while we currently recommend having a healthy amount of cash on hand, we never recommend being all in or all out of the equity markets. Trying to time the markets have been proven to lead to lower returns in both the short and long run.
If you or someone that you know of would be interested in learning more, or is concerned with their current portfolio and what to expect in 2016, I would welcome the opportunity to arrange a meeting or a phone call.
Sometimes a picture can tell a thousand stories. However, I hope to use far less words and utilize only three pictures (graphs actually) in which to explain the story behind the price declines within the U.S. equity markets. Let’s begin with the two graphs below which from my viewpoint tells of the correlation between the drop in equity prices over the past 6 weeks and the continued deterioration in earnings per share estimates.
The first chart from Business Insider demonstrates how 2015 equity prices and Q4 earning per share estimates were moving apart during Q4 2015.
The second chart, compliments of The Earning Scout, shows the drastic slide by month beginning in July 2015 of Q4 earnings estimates.
According to these two charts, we could have seen going back to the early Fall of 2015 timeframe that something was amiss within the fundamentals of the biggest U.S. Companies and the prices that they were trading at. The right call at that time would have been to underweight equities and overweight cash or bonds which is precisely what we did at TAMMA Capital.
But what are the driving forces (or noise in my opinion) behind expert’s explanations of why equity prices have dropped so far this year? A decline in oil prices and an economic slowdown in China. Let’s take a closer look at each individually starting with oil to determine if either are a driving force or just market noise.
Decline in Oil Prices
- While consumers are benefiting greatly from the drop in oil prices (it is estimated that consumers are saving $80M per day) oil companies that spent big money in capital projects years ago to bring on new capacity and build new pipelines when oil was near or over $100 per barrel are definitely hurting right now. Economics would tell us that there are winners and losers in this game, but is this current situation a net positive or negative for the existing economy? I am not sure if anyone really knows the answer to this question. Regardless of the answer, my job as an asset manager is to determine who those winners and losers are and invest accordingly.
- With the graph below, you can see that as the price of crude oil began to drop, equity prices did not. The drop in oil prices were likely due to a decline in demand which also began showing up in U.S. companies revenue and earnings estimates. This chart is another illustration of how the correction of equity prices downward is beginning to catch up with the downward revision in both revenues and earnings per share.
Economic Slowdown in China
- The drop in crude oil prices probably has some direct correlation with the slowdown in the Chinese economy. However, as I have listened to reports from Bloomberg over the past few weeks, China has potentially begun to stock pile tankers full of crude oil in order to take advantage of this dramatic decline in crude oil prices. If this is indeed the case, this type of situation could give a false sense of what the actual price of a barrel of crude should be. If Chinese interaction such as this were occurring, it would make the price of crude oil artificially high.
- While the slowing China economy could be a reason why oil has fallen, it should not be having a material impact upon the U.S. economy. According to Howard Marks at Oaktree Capital, “China doesn't play a pivotal role in the U.S. economy (other than as a provider of finished goods). It is estimated to account for only 1% of the combined profits of the S&P 500 companies. Exports account for about 13% of U.S. GDP, and in the first eleven months of 2015 less than 8% of our exported goods went to China ($106 billion of goods, versus an annual GDP approaching $18 trillion – again, well below 1%)."
As we have noted in previous articles, we believe that there are several reasons as to why revenue and earnings estimates have slowed which include the following;
- Consumers are saving more, this could be for a variety of reasons which could include, paying down debt, increase retirement savings, or increase overall savings for emergency purposes. People may still be planning for an uptick in oil prices and have taken up alternative savings measures to take advantage of the drop in gasoline prices.
- Although the government CPI data shows little to no inflation, there are pockets of the economy that are increasing their prices. We see inflation in both the education and health care sectors. As we pointed out earlier there will always be winners and losers within the ever changing economic landscape.
So at the end of the day we are back to focusing on the continued deterioration of revenue and earnings estimates by U.S. companies. By understanding some of the underlying trends within the various sectors that make up the U.S. economy, we can carefully try to identify those potential winners while trying to avoid the potential losers.