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Arete’s Observations 9/11/2020

By David Robertson | September 11, 2020

Market observations

‘Downbeat’ US executives dump most stock in a month since 2015

“US executives sold $6.7bn of stock in their own companies last month [August], cashing in on a record-breaking market rally with the biggest burst of selling in five years.”

“Chief executives have been much more downbeat in their outlooks than investors.”

CEOs are normally optimistic about the companies they run. After all, that’s partly what they get paid to do. When they sell, then, it rarely bodes well for the stock. And, by the way, they know better than anyone else how the company is performing. This particular bout of selling meaningfully contradicts the market optimism at the end of the summer.

Economy

The US is having a Wile E Coyote moment

“More than 29m Americans are still collecting some form of unemployment aid, yet federal and state unemployment benefits fell by around $60bn last month compared with July, according to research from Evercore ISI.”

“Consumption will also be damped by evictions. The Cares Act provided rental assistance and a temporary moratorium on evictions that expired in late July. Last week the government issued a new eviction moratorium but without funding for rental assistance, so that tenants unable to cover rent will face a massive balloon payment or eviction at the end of the year. This hardly gives them new financial breathing space.”

The main message of this story is that many millions of Americans are still struggling economically. This important fact seems to get overlooked in many stories and represents a major hurdle to returning to any sense of normalcy.

My greatest concern is not that nothing will get done. There will be new policy measures and at least some of them will be directed at the challenges highlighted. As Gary Shilling pointed out in his latest letter, he knows there will be more federal spending, it’s just a matter of “how much and who gets it.”

Arete's, Arete’s Observations 9/11/2020

I worry instead that whatever new policy measures are introduced in the fall and thereafter will only be ameliorative in nature and not corrective. The downside is that millions of people will be left on economic life support on a semi-permanent basis.

And economic life support will be needed. One of the simplest metrics of economic hardship is hunger. The graphs shows a striking increase in the percentage of households with children that sometimes or often go hungry. No need for caveats or hedonic adjustments here.

Credit

It is common for companies to reduce debt when entering a recession. After all, with diminishing prospects for revenue growth and profitability, that debt becomes harder to support. Even relatively small deviations from expectations can cause existential dilemmas.

Arete's, Arete’s Observations 9/11/2020

This recession stands in stark contrast to the historical cyclical pattern. Instead of reducing debt going into a downturn, companies are massively increasing debt. This is being done more through capital markets than bank debt, but nonetheless speaks to bizarre and fragile financial foundations.

Companies

A GE whodunnit

“For decades GE managers had an over-exalted sense of their own abilities, which led to narcissism, hubris and the bending, if not breaking, of accounting rules to hit their profit targets. This eclipsed any strategic vision they may have had.”

“A third common problem is stockmarket mythmaking. Ms Comstock’s approach to digging GE out of a hole was to, as she put it, “pick a simple story…and tell it again, and again”.

GE makes an interesting case study. The stock reached a peak in 2000 when its operations were arguably most impenetrable to outside analysis. It’s many failures along the way are instructive for investors and analysts.

The common thread that seems to run through the pantheon of failures at GE was the perpetuation of “success theatre.” This is a fairly common problem that often manifests itself in the form of managing to metrics rather than business logic. Once the practice gets institutionalized, the company ends up with a corps of managers whose main expertise lies in circumventing rules. I strongly suspect the lessons from GE also apply to many of the big tech companies today.

Fresh starts

When: The Scientific Secrets of Perfect Timing by Daniel H. Pink

“First, they [temporal landmarks] allowed people to open ‘new mental accounts’ in the same way that a business closes the books at the end of one fiscal year and opens a fresh ledger for the new year. This new period offers a chance to start again by relegating our old selves to the past. It disconnects us from that past self’s mistakes and imperfections, and leaves us confident about our new, superior selves.”

“The second purpose of these time markers is to shake us out of the tree so we can glimpse the forest. ‘Temporal landmarks interrupt attention to day-to-day minutiae, causing people to take a big picture view of their lives and thus focus on achieving their goals’.”

Dan Pink does a nice job in this book of highlighting how important timing is in our lives – and how we often do not pay sufficient heed to this reality. One phenomenon of timing I observe recurring across many different dimensions is that of the “fresh start”. As Pink describes, fresh starts allow us to separate from the past and start anew and also to disrupt daily routines in a way that provides perspective.

Although the coronavirus pandemic has caused a great deal of hardship, a silver lining is that it also provides a landmark of sorts from which to make a fresh start. What is the right tradeoff between commuting to work and working from home? What are the best living conditions for one’s family? While many of us are contemplating tradeoffs in our personal lives, the same exercise is being conducted across other domains as well.

Future of work: how managers are harnessing employees’ hidden skills

“’I haven’t seen anything tremendously creative or innovative,’ he says.”

“We moved from the adrenalin phase, to the real estate phase — ‘maybe we don’t need that office any more’ — to the adulatory phase: ‘Now we have a return plan!’”

“Most companies are still missing a big opportunity to ‘fundamentally re-examine what the employer-worker relationship, or the worker-worker relationship is going to be’.  The risk, he says, is that ‘companies haven’t considered the second-order effects’ of some of the consequences of widespread remote working, including how to integrate the people they hire and how to maintain a corporate culture.”

These comments from Laszlo Bock, head of Humu and former head of personnel at Google, captures both the risk and opportunity from pandemic related disruptions to the work environment. Many managers have simply flipped on their emergency switch and aggressively reacted. However, there is also a terrific opportunity to make a fresh start in determining what the “worker-worker relationship is going to be”.

Politics

Republican party battles over its post-Trumpian soul

“Politicians are not known for decency or decorum, but typically they wait for a leader’s defeat before diving into the scrum for a successor. Not this time. Even before US President Donald Trump gets his chance at a second term, a battle has begun over where the Republican Party may turn after.”

“Genuinely conservative Republicans envision a different post-Trump future. They draw lessons from his political success but focus on the challenges that caused it. They ask: What has gone wrong with the market, and what role can policymakers play in fixing it? Their task is to apply conservative principles to contemporary conditions.”

One interesting point from this article is that the tepid support for Trump echoes the tepid support for Hilary Clinton in the 2016 election. The lack of enthusiastic support from notables in the same party sends a message in itself.

A second point is the glimmer of a fresh start among certain Republicans. Although the author acknowledges ideological reform in the Republican party would be an uphill battle, it is interesting to watch the movement gain legs before the election.

Technology

Battle lines drawn as Australia takes on Big Tech over paying for news

“’I must say in 10 years of fighting Google, in seeking a fair share of value, [the Australian proposal] is the best I have seen so far,’ said Thomas Höppner, a partner at law firm Hausfeld, who filed the original antitrust complaint for publishers against Google in 2009. ‘It’s brilliant. They’ve learned the lessons from Europe. And it will have precedent character [for the rest of the world]’.”

“The stakes are high on both sides. If Google and Facebook withdrew local services it would inevitably lead to a drop in traffic to Australian news websites and affect other businesses. But blocking access to news on their platforms in the country would be complex and fraught with legal risk for the US groups …”

One of the recurring themes in regard to big tech companies is unfair advantage. This particular story addresses news and publishing which have been used, but not compensated for, by Google. The key point for me is the imminent prospect of a compromise that makes sense.

If an agreement can be reached, there is a good chance its effects will be far-reaching. For one, the model can be applied to other countries around the world. For another, it can create a level playing field to support industries such as publishing which have been undermined by parasitic activities. Finally, there are several other fronts where the tenets of shared value may help define the boundaries of peaceful coexistence. If an agreement is not reached, the legal battles will persist.

Google’s problems are bigger than just the antitrust case

“Google employees were allowed to spend 20% of their time working on what they thought would most benefit the firm, even if that often led to them working 120%.”

“Where Mr Brin and Mr Page were technologists and Mr Schmidt a technologist-manager, the new team are simply managers.”

As an analyst it is always interesting to get a glimpse into how a company actually operates. For Google, the 20% “free” time sounded almost too good to be true. It was. In addition, apparently, “Leaking, particularly to the press, was a sackable offence.” In sum, the characterization of Google’s culture has more than a hint of John Grisham’s The Firm.

It is also interesting to watch how a company evolves over time. The change in leadership from technologists to “simply managers” is one that has precedents and is not a trivial one. Such changes can fundamentally change the culture and priorities of a company.

Monetary policy

Grant’s Interest Rate Observer, 9/4/20

“Omissions featured heavily among the highlights of the Jackson Hole message. Powell admitted no error and conceded no policy trade-offs. He said nothing about the mischief-making properties of ground-hugging interest rates—how they facilitate overborrowing, incite speculation, misallocate capital, entrench in cumbent businesses, prolong the lives of marginal businesses (a.k.a., zombies) and contribute to the ever more familiar ‘episodes of financial instability’ that wind up curtailing expansions.”

It seems like some kind of state of denial. Powell delivers his Jackson Hole presentation. He outlines policies and provides right-sounding explanations. Reporters dutifully highlight key changes and frame the narrative. Investors give polite applause (figuratively) and the show goes on.

And then you actually read the comments. You hypothesize what could have been said and should have been said. You consider all the things you would do (and not do) if the country’s monetary policy was your responsibility. And you come up with totally different answers. I don’t know when it is going to happen, but it seems like the Fed is set up for a huge fall in credibility.

Public to private equity in the United States: A long-term look

When people are eager to learn about investing they often flock to the writings of Warren Buffett, Howard Marks and other successful investors. I would put Michael Mauboussin right at the top of that list. I still refer to his collection of Consilient Observers from his days at CS First Boston in the early 2000s and his books Expectations Investing and The Success Equation should be required reading for anyone interested in markets and investing.

His latest piece provides an extensive overview of public and private markets. A lot has changed over the last 25 years and I highlighted some of the implications in a June 2019 blog post, “Stocks: One person’s treasure is another person’s trash”. Mauboussin’s work methodically describes the ecosystem and in doing so provides a wealth of useful information and insights. With all of this background, it is easier to understand the growth in private equity and venture capital.

Bumper year for IPOs is also a harbinger of long-lasting change

“The current system is ‘systematically broken and is robbing Silicon Valley founders, employees and investors of billions of dollars each year’.”

“Mr Mortara estimates that Spac listings and direct listing together could eventually account for a quarter to a third of all listings.” 

This FT story provides an interesting companion note to Mauboussin’s background on public and private markets. One highlight is the degree to which the IPO process is “systematically broken”. This has been true for a long time, but nonetheless the same basic system has remained intact.

More recent evidence suggests this is changing. There have been some successful experiments with direct listing, for example. In addition, although the increase in SPACs (special purpose acquisition companies) is at least partly opportunistic, it is also at least partly an effort to improve the process of a private company going public.

Implications for investment strategy

GOVERNMENT BONDS HAVE GIVEN US SO MUCH and A ROADMAP FOR NAVIGATING TODAY’S LOW INTEREST RATES

“All investing is about trade-offs. For almost all portfolios, those trade-offs have suddenly gotten worse because of what has happened to the yields on cash and government bonds.”

“In a world where historical performance is much less relevant for forward-looking expectations, it will require more thought and creativity than it once did.”

GMO is one of the more thoughtful asset managers and Ben Inker always shares useful insights in its quarterly letters. In highlighting the consequences of low rates, he touches on many of the same subjects I discussed in the June blog post, “It’s time to retire the 60/40 strategy”.

One of the most valuable aspects of Inker’s message, in my opinion, is his honest communication of difficult challenges. Yes, investing is all about tradeoffs. There are no silver bullets. Yes, those tradeoffs have gotten worse. And yes, historical performance is much less relevant for forward-looking expectations. These are hard truths and he does not dance around them like many would.

Reading through his commentary sparked another thought for me though. Inker talks of the importance of diversification for investors, which is true to a point. The purpose of combining bonds with stocks, however, has more to do with providing an insurance policy against big stock losses.

In this sense, one could argue that the value of that insurance policy is greater for the advisor than the investor. The investor actually sacrifices higher potential long-term returns by including bonds. The advisor benefits by avoiding the types of selloffs that may spook an investor and cause them to either liquidate investments or transfer to a different advisor. It will be interesting to watch if the diminished ability of bonds to offset portfolio return volatility results in higher client turnover.

60/40 Strategy Will Flop Fairly Soon, Paul McCulley Says

“This [the reason financial markets have done well over the last 40 years] is the result of a political victory by those who control capital over those who provide labor, he says. ‘Unambiguously, we’ve had 40 years of disinflation, and that’s because we’ve shifted power in our economy, both domestically and globally, from labor to capital’.”

“’I really hope that my old profession figures out a new paradigm,’ he said. ‘What’s worked the last 40 years should not work unless you want democracy to fail’.”

McCulley takes a different tack in discussing the consequences of low rates. Rather than focusing just on investment consequences, he puts things into a broader social perspective. He is absolutely right that power has shifted from labor to capital and he is also right to highlight the inherent conflict between democracy and many tenets of capitalism over the last 40 years.

My question is, why now? McCulley was right in the middle of things during most of those 40 years and made plenty of money riding that wave. I don’t remember him complaining quite so vociferously at the time about the damage being caused to democracy. He’s not the only one who helped stoke a financial system that undermined democracy and he’s not the only one who is virtue signaling at the end of his career. It’s still disappointing that more effort was not exerted to solve the problem at the time rather than complain about it after the damage is done.

Principles for Areté’s Observations

  1. All of the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.
  2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.
  3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.
  4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, Areté’s Takes are designed to show both sides of an argument and to express my opinion as to which side has the stronger case, and why.
  5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.

Comments

Please direct comments or feedback to drobertson@areteam.com.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization’s particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.


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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

2020/09/11
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