Saturday, December 26, 2009

Investment Outlook 2010 - Inflation Resistant Stocks

2009 was an eventful year as the financial crisis played itself out, and the stock market plunged in March as panic set in. Investors who bought during panic are now enjoying a nice lift as the S&P 500 looks set to close the year at about 1100, a large rebound from its March lows of around 700.

However what is remarkable is that even during the lows in March, stocks were never truly cheap by historical standards, nor were they really cheap from a Discounted Earnings perspective. (See the October 2008 post for my view of stock valuation). Value fund managers like John Hussman have alluded to this, and investment managers like Jeremy Grantham have placed the S&P 500's fair value at around 900. Whichever the case, today's 1,100 level puts stock squarely in over-priced territory.

I believe the odds are that the overall market will become cheaper over the next few years, simply because history suggests that after bouts of overvaluation, investors tend to allow markets to spend many years in undervalued territory. Assets prices are determined by what people are willing to pay for them, and human psychology has not changed over the last thousand years. There is no reason to believe that this time is any different. But this doesn't mean that prices will fall to once a century lows, because the democratization of investing and the raised awareness of stocks since the 1960s.

There are many ways the market can revert to cheaper levels, for example: (a) the market trades sideways over the next few years between 700 and 1000 while earnings continue to grow, or (b) another correction occurs in 2010, possibly triggered by a financial panic or the realization that slow economic growth is here to stay.

The future is inherently unpredictable

Of course one knows for sure if these outcomes are going to play out. Both markets and the economy are complex systems which are hard to predict. They also rely on individual decisions made by human beings that are driven by their own psychology and life experience, and reactions to each other. This makes it difficult (or some would say impossible) to use economic data points to predict the behavior of the economy.

For example, the huge increase in the quantity of money engineered by the Fed over the last year should be cause for inflation in the near future. But if individuals simply choose not to spend, then inflation isn't going to appear. Likewise, the large unfunded government obligations (Medicare, Social Security etc) suggest that either US interest rates should rise or inflation should kick in as government runs the printing presses. But this may not happen if individual investors continue to have faith in the ability of the US government to meet its obligations and continue funding the government's debt. While some would consider this living on borrowed time, the reality is that this "borrowed time" can last for decades and span the bulk of an investor's investing life. In the long run the fundamentals reassert themselves, but the long run could be a meaningless abstraction for an individual's investment lifespan. An investor whose analysis is fundamentally correct could suffer poor returns over his life, while someone riding momentum (or the popular thinking) could ride to riches.

Of course we can't abandon all hope and take a fatalistic view of things. It would be impossible to make any investment decisions if that were to happen. We need to make bets that will play out over the next 5-10 years. Some bets will go wrong and some will work out, and the name of the investing game is simply to have more bets go right than wrong over an investment lifetime. We need to form investment views based on the best data we have, and long term historical averages are one data point in any viewpoint.

The Investing Environment in 2010 and beyond

So what does this mean for us in 2010? It means we must be cognizant that today's investment landscape is marked by 4 key parameters that are likely to define our investing horizon:

(1) The probability that inflation is going to accelerate is high. The key drivers are the large unfunded government liabilities, and the large amount of money injected into the financial system by the Fed. The former will tempt the government to run the printing presses and inflate its way out of its debt hole, while the latter is a huge reservoir of money held back only by people's unwillingness to spend, much like Hoover Dam holds back the Colorado River. When the mood changes, the money will flood out into the economy.

(2) Economic growth is probably going to be low for a few years. The following suggest this:
  • (a) Realignment of economic structure. It is going to take some time to work through the mis-allocation of resources caused by the credit bubble. The structure of economic activity has to be realigned to stop the production of un-needed goods (like excess housing). People need to be re-skilled, and the debts taken on to purchase unproductive assets need to be cleared.

  • (b) Reduction in credit. Banks need to work through their bad assets which will reduce the amount of lending. Credit is the grease that keeps the economic engine running, and its reduction will probably reduce the quantity of economic activity.

  • (c) Demographic changes. Many economically significant countries (the US, China and large parts of Europe) have gone into full scale demographic decline. The aging of baby boomers and China's one child policy mean that going forward, the ratio of retired people to working adults is going to increase. This means both that (1) the structure of economic production will need to change to meet the needs of more older folks, and (2) the amount of production that can take place is going to grow slower or shrink, as there are fewer people of working age to carry out economic activity.

  • (d) Oil and energy. The probability is increasing that real energy costs are going to rise. Fewer easy to extract energy sources means that our EROEI is going to go up. More economic activity has to be generated to produce the same amount of output. The structure of the economy has to change to meet this challenge, either by restructuring our chain of production (which can be analyzed from a biophysical economics / thermoeconomics standpoint) and/or new technologies are going to be invented and the energy architecture of our economy changed.

In short, the probability is that we are headed into a world of low economic growth accompanied by inflation, much like the 1970s. Back then, equities performed terribly, while commodity prices and interest rates rose (i.e. bond prices declined). The question is will history repeat itself in the coming years?

All things considered, increased inflation and slower economic growth is likely to reduce the real earnings of companies and their valuation multiples. Warren Buffett's 1977 article on inflation explains this mechanism very clearly. The gist is that in most cases, companies have not been able to increase their ROEs in times of inflation. This means that they are rarely able to increase earnings beyond their historical average ROE of 12%. This reduces real earnings if inflation increases beyond a dormant 2-4%, and investors penalize company valuations accordingly.

The general remedy for investors is to own companies that have high ROEs. Such companies have room to increase their earnings during inflationary periods by retaining more earnings. However it is important to realize that this ability to increase their earnings in the face of inflation will, all things being equal, not increase their PE valuations. The higher earnings growth rate will likely be countered by the increased discount rate investors require on the future earnings stream.

How investors can profit in this environment

Fundamentally investors profit in three distinct ways:
  1. Capital / Asset preferences. Investors can profit by riding the price rise wave as other investors start converting their capital into a particular asset class. For example, from the early 80s up to 2000, people converted their capital into equities, driving a secular rise in market PE ratios. Investors who caught this wave made a good amount of money. The challenge is to see which assets investors might want to convert their capital into, and then jump in front of that train and ride the asset revaluation uptrend. It is important to distinguish between fundamental price revaluations and asset price bubbles. The difference between the two is the price relative to the underlying economic value generated by the asset. (i.e. the "pe ratio")

  2. Assets that grow economic value add. Investors can also profit by owning assets that continue to increase the amount of real economic value generated over the years. In other words, owning profitable businesses that have a growth path ahead of them.

  3. Betting on events. Another way investors profit is by spotting mis-priced bets. This does require a fair degree of understanding of the environment and parameters underlying the bet, and an appreciation for managing bets. Example of such bets include betting on the weather (which is what P&C insurance underwriters do), and betting on the direction of interest rates.

In the environment that we have for 2010 and beyond, we are likely the face the following parameters for each of these categories of profit-making opportunities:

(A) Capital / Asset preferences
Although there are similarities in the economic backdrop between now and the 1970s, the key difference is that in the 1970s, government was perceived to be functioning better than businesses. Businesses could not keep up with inflation and in some cases were seen as the cause of inflation, whereas the government was seen as an entity that had heft and was attempting to fix problems. It is debatable whether government fixed or created more problems, but the key is that the perception was that government was more a positive force relative to businesses. The backdrop of the cold war and the competing economic philosophies probably had a big influence on this perception. In contrast, the government today is thought of as being in trouble. There is pervasive awareness of the government's debt and under-funded obligations. In contrast, businesses are perceived in a better light, influenced in large part by the positive view of business and capitalism in general from the 1980s onwards, especially after the cold war ended. This makes it probable that investors will not abandon equities en-masse in exchange for government bonds or cash. Their attractiveness is likely to be muted as the people grow more wary of the risk of government default (explicit or implicit via inflation).

Real estate, which would ordinarily be a good inflation hedge, is unlikely to reclaim its role as a store of value because there is a dramatic oversupply of housing stock / commercial space built during the bubble years.

Commodities, another traditional inflation hedge, also face demand softness as the major economies slow down. Unless there is a supply constriction or intensive speculative activity, it is probable that commodity prices will not rise dramatically. (Though it should be noted that prior to 2005, commodities were hitting their lowest prices in decades. So some upwards movement in price, as has happened recently, is to be expected to get back in line with economic fundamentals.)

On the whole, it is probably that no asset class is going to be fundamentally more attractive than the others. Hence it it probable that we will not see a dramatic reallocation of capital between asset classes. (There may be a dramatic reallocation of capital between geographies, but that is a separate discussion.) The soft economy, oversupply of real estate, and "not-cheap" equities also makes it likely that the returns on capital will mediocre for investors in the coming years.

(B) Businesses with growing real economic value add.
One of the perennial investing opportunities is to buy companies whose real economic value add continues to grow over the long term. In other words, companies with sustainable competitive advantages that are taking business away from their competitors and/or riding a mega-trend brought about by changes in fashion, demographics or technology. There are a few key mega-trends that will continue into the next decade or so, which we should pay attention to:

  1. Globalization and Economic Development through the adoption of capitalism:

    (a) Developing countries are improving their incomes and standard of living, potentially benefiting consumer goods companies and infrastructure companies.

    (b) Countries across the world continue to mature their financial systems to allow savings to be channeled into investments in a rule based manner. In most developing countries, large conglomerates thrive at the expense of free competition from smaller/upstart players. In some cases this is due to political connections, but often also because it is difficult for small companies to raise capital to compete. This tends to allow established companies to continue dominating simply because they have access to capital. Maturing financial systems removes the opacity and fund raising obstacles in these countries, and provides growth opportunities for financial services companies.

  2. Electronification of payments; Payments are increasingly becoming electronic, benefiting credit card companies, to the detriment of check and cash handling companies.

  3. The Internet; The information revolution continues unabated, and is continuing to remake the landscape for media companies. It also continues to allow e-commerce companies like Amazon, and information companies like Google to thrive and grow.

  4. Globalization and uniformity of lifestyles. The living experience of people across the globe is becoming increasingly uniform. The information revolution and the way our lives are shaped by universal technologies account for this. A successful concept in one country stands a much better chance of working across the globe today: witness the pervasiveness of Starbucks, mall culture, supermarkets, FMCG products, and so on. Travel to any country in the world today, and you will find a stunning similarity in the consumer experience. Of course local differences have not disappeared completely. Tastes in food and fashion still differ from country to country. For example, Cadbury type chocolate has carried less well in United States, and Hershey type chocolates have found it tough going in many foreign markets. In today's world, a middle class professional in one country is likely to have more in common with a middle class professional in another country, than with his fellow citizens in a different socio-economic strata.

  5. Demographic wave of change - Many countries are aging. This demographic change is made worse in countries like the US by the government's crushing debt and under funded pension and medical benefits plans.
For investors, the key is to invest in companies with sustainable competitive advantages and to find companies with growth possibilities (by riding megatrends or by taking share from competitors).

(C) Betting on Events.
In many areas, the way a large number of events work out is predictable once a sample size is large enough. The insurance industry is founded on this basis. Underwriters make bets on the number of bank robberies in a country, the mortality rate of the population, and so on. P&C insurers even make bets on the weather, for example whether a hurricane is likely to strike an area in a given year.

Sometimes the odds on such bets are good relative to the price of the bet. These mis-priced bets afford an investor the chance to make some money, provided a large enough number of these events can be bet on. The trick is usually finding a large number of mis-priced bets. If you only have one or two instances of the event to bet on, then the law of large numbers that makes the outcome predictable isn't working for you, and you'd be taking a gamble more than an qualified bet.

Another opportunity for betting is when a single event is so extreme that it is an outlier event. In such cases, you only need one event to bet on, because the probability of the bet working out your way is relatively high. Betting on an outlier event is like betting on the movement of a basketball player when he is at the edge of the court. It's a reasonably good bet that he is going to move away from the edge. The number of movement possibilities is reduced, making a bet easier to set up. In contrast, betting on the basketball player's movements when he is in the middle of the court is more like betting on the basis of large numbers. You may know that over a season he is statistically going to move to the right 53% of the time. But it's much less predictable where he is going to go when he is in the middle of the court at a particular time in a particular game.

One key type of outlier event is asset prices, because asset prices tend to revert to a certain mean PE ratio over time. However it is important to be aware that asset price outliers can persist for a very long time. Stocks were at generational lows for more than two decades around the 40s and 50s. Similarly. between 1980 and today, stock prices have generally been raising their average PE value beyond what people in earlier generations would have considered sensible. Asset prices are determined by what other people are willing to pay for it, and people can keep prices up or down for much longer than an individual's investment horizon. So sometimes, it can pay to play outlier event as it continues its way up or down.

The only gradients which as a rule of thumb are better avoided are those that rise incredibly quickly. It is the fact that a collective mania has taken place that drives the speed of the ascent, and it is because the human condition makes collective manias tend to dissipate as quickly as they come, that makes these outliers revert to mean quickly. In other words, they are bubbles waiting to pop. Slowly growing bubbles are more like a cultural conscious that both inflates and deflates slowly, sometimes almost imperceptibly.

Unfortunately there are not many outliers in today's environment. Stock prices are neither cheap nor excessively expensive. The economy's direction is likely to go either way. The huge worldwide government intervention in economies has dampened the natural correction that should have taken place. Instead of a near certain shrinking of economic activity and recessionary consumer psychology, we now have an middle of the road situation where future economic growth or contraction become equally likely possibilities. This makes it difficult to find outlier bets in asset prices.

The only data point that I have seen that is now approaching outlier status is the interest rate. Interest rates are near zero, and they cannot go below that. Though as Japan has shown in practice, they can remain at zero for a very long time.

However, we must beware of "false outliers". A very good example is the government debt, which by all accounts is at a record percentage of the GDP in many developed countries. Government debt is not at an outlier, contrary to common belief. The debt can continue to grow as long as there are people willing to fund it (buy government bonds). New debt can be issued to pay off old debt, and the merry go round goes on as long as people allow it to. As long as people believe the borrower's best days are ahead of it, the circus can continue. The takeaway is that we need to carefully distinguish a true outlier (which has mean reverting tendencies) to record breaking feats, whose records can continue to be broken in successive years.

Investment Themes for 2010

Given this backdrop, what are our investment themes for 2010?
They are:

(1) Look for inflation beating companies. Returns on all asset classes are likely to be muted in the coming years. We will be looking for inflation hedges, with inflation beating companies being prime candidates.

(2) Prepare for asset price declines. The probability is that the equity markets will become cheaper in the near to medium term. So avoid chasing market momentum, and be especially careful of panic buying.

(3) Take outlier bets when the opportunity arises. We can opportunistically bet on outliers when the odds are in our favor. The closest one that is visible on the horizon is interest rates.

Sunday, November 1, 2009

The Nature of Money (How money works) in the Economy

The role of money and its impact on the economy is often misunderstood. Many ideas about money today are based on a pre-1960s world-view where money was gold-based. They treat money as a secondary variable to underlying economic forces, equating it to the motor oil that lubricates the economic engine. This view is no longer accurate in today's fiat-money capitalist economies where free flowing capital takes on a life of its own and can drive changes in the underlying economy. This is a reality that a dogmatic Monetarist or Keynesian approach to looking at the economy would miss.

In this post, I describe (my view of) the interrelationship between money, capital and the underlying economy, and how it investors can use this to form a macro-framework for their investment theses.

What is Money / How does something become money

Money is any item that can be offered to induce another person to do work for you, or give you something that he has worked for. In other words, money is the means by which we induce each other to economic activity. It does this in two ways: (1) It functions as a medium of exchange, as a means to induce each other to economic activity, and (2) as a store of value - when stored aside, it represents the ability to induce future economic activity when desired.

In other words, anything that has the following properties can become money: (a) it can be owned, (b) it can be exchanged, and (c) is desired by at least some group of people, is a form of money. In other words, money is more than just the paper currency which we are familiar with. Government issued currency is universal money because it is accepted by everyone, because everyone is willing to work (i.e. carry out economic activity) to get it. Other money, such as rewards points and physical assets like houses, are only accepted by smaller groups because not everyone is willing to be induced to work for it.

The types of items that can be used as money largely depends on society's legal and financial framework. A framework that allows assets such as houses, to have its ownership rights passed between individuals, to be subdivided, and to have agreements on the asset enforced, allow those items to take on the role of money among people who value the item. In countries without reliable property rights and contract enforcement, money tends to be restricted to physical things that can be carried around.

It is important to realize that money is not just the currency. In today's economy, there are broadly 2 types of money:
  1. Central bank issued currency - what we colloquially refer to as money or currency.

  2. Tangible items that are manufactured or extracted from nature - gold, silver, diamonds, seashells, land, houses, cars, antique art, companies etc.

In any economy, people will choose between different types of money to use to store wealth and for buying and selling. The choice of which type of money to convert a person's wealth to depends on a myriad of factors: the expectation that a money type will increase or decrease in its ability to induce others to work, the acceptability of the money to people whose work is required by the holder of the money, and the durability of that money.

The value of a unit of money is the amount of work that it can induce others to perform to get it. In other words, the value of a unit of money depends on the value your intended counterpart places on the money, which depends on what utility he can get out of the money. This utility typically falls into two categories: (1) the amount of work he can induce others to do in exchange for it, and (2) the natural utility produced by the item serving as money. Currency money's value is entirely dependent on the former, except in the case of collectors who may value paper currency strictly for its physical design. For most types of assets (tangible item money), both come into play. Though the utility of the item usually imposes a "floor" on the value of the money. For example, a house has as a minimum utility, the shelter and living condition it provides.

Money is created and destroyed in two ways:
  1. It is manufactured. Tangible item money, such as gold or houses, is created when the items are extracted from the ground or manufactured. Fiat currency money can be created simply by the Federal Reserve creating money out of thin air and depositing into the accounts that banks maintain with the Federal Reserve (In practice, it usually does this in exchange for some non-monetary collateral, such as securities, that the bank pledges to the federal reserve). Alternatively the Federal Reserve can simply buy up Treasury issued bonds. Similarly, the Federal Reserve can create money by giving foreigners dollars in exchange for foreign currency.

  2. IOUs of the money that arise from borrowing/lending are treated like the underlying money. Money is created when the borrower issues IOUs which can function the same way as the underlying money, meaning it can (a) be exchanged for goods and services (i.e. to directly induce others to work) and/or (b) if it can be used as a store of value. This relies on people trusting that they can call in the IOU anytime. For example, if the IOUs can be exchanged for goods and services, then it is effectively a form of money. The total amount of money that is circulating in the economy then becomes the money that was borrowed (and presumably spent, inducing others to work for it), and the IOUs which are being passed around in exchange for economic activity. If a borrower's IOUs cannot be traded for goods and services, then money is not created because the IOU is unable to induce economic activity. The amount of currency that can induce economic activity will not have changed. The money that used to be in the hands of the lender has been transfered to the hands of the borrower.

    For example, if I borrow 20 apples from you and give you an IOU, and you can trade this IOU to another person for some services, then there are 40"apples" running around in the economy that can induce work. (The 20 physical apples I borrowed, and the IOU for 20 apples which you are using). This is the primary mechanism by which fiat money is created, and is also known as the money multiplier effect. The fiat money case is special because fractional reserve banking allows the IOUs (e.g. loan agreements by borrowers) to be treated exactly like cash, allowing the deposits to appear to still be there. (In effect, the IOUs are the deposits in the bank, and accounting rules allow them to be treated as cash, not IOUs). Changes in bank reserve requirements also create or destroy money by affecting the amount of lending/borrowing that can be done.

It is important to understand the nature of money
because it affects the underlying economy

It is important to understand the characteristics of money, because changes in people's preference for storing wealth, or in using one money over another can affect the underlying economy. Interest rates, asset yields, capital appreciation expectations are not just a reflection of the state of the economy; they can actually drive changes in the underlying economy.

(1) Central Bank Currency Money

By virtue of its universal acceptance, central bank issued currency is backed not by the productiveness of one asset (e.g. a house can induce people to work for it only insofar as the living condition it provides) but rather its value is backed by the productive capacity of the entire population / economy.

Because it is universally accepted, it has the special role of being the form of money that we use to measure the value of economic activity. For example, it is difficult to measure the value of a house in Vermont in terms of bottles of apple cider, simply because the people who love apple cider may not be interested in that Vermont house. But it is easier to say a house in Vermont is worth 1 million dollars, which is perhaps equivalent to the services of a doctor to perform 10 surgical operations, or 5 years of legal services, because everyone is willing to be induced by central bank currency because it is ultimately acceptable to the government for tax payments. Without universal currency, we would be back tot he world of barter trade, where the value of a good has to be expressed in the form of another good.

Because central bank currency is universal currency, and because we measure value with it, it alone serves as the measure by which economic decisions are made. Hence things that affect currency money can affect the underlying function of the economy. It affects how we decide to allocate society's resources, and affects decisions on if and how to create productive capacity in the economy.

The value of currency money is preserved if new dollars are created only when new productive capacity is created in the economy, and destroyed when productive capacity is reduced. Changes in the ambient velocity of money, arising from habits and economic structure, need to be factored into the overall money supply estimation. This means that the value of currency money depends on how its creation is handled:

  1. Currency Money created through borrowing/lending. The value of money depends on the ability of economic actors to use borrowed money to create productive capacity. When money is lent to finance the creation of productive capacity, if the productive capacity is successfully created, then the loan can be repaid using the income from the productive capacity. This is also why the banking system should only lend money on the basis of income of the borrowers, or the income that the asset being financed can generate. The banking system should never lend money on the basis of the market value of the asset being financed. The guardians of this are (1) the lending decisions of the banking system and (2) any borrower who can issue tradeable IOUs which can be used as a store of value and medium of exchange. Money has the primary functions of being a store of value, and a derived function as a medium of exchange. Money is created through: debt borrowing / credit extension, provided the borrower's debt is tradeable and hence can be both a store of value and a medium of exchange. The corollary is that the monetary base at all times is seen both as savings and as debt, which means that debt will grow in line with the economy. What is important is that it does not grow as a % of the economy.

    Money is destroyed when borrowers cannot repay their loans, because the loans are written off and shareholder's equity is lost (effectively shareholder's funds are transferred to depositors to keep them whole). The money in shareholder's equity is destroyed to compensate for the money that was given to the borrower, which the borrower was not able to use to create productive capacity. (Had productive capacity been created, income would have been generated to repay the loan). However, at the banking system level, this has the effect of reducing the banking system's ability to lend, because of reserve requirements. Hence to a certain extent, bad lending decisions affect the economy as a whole. Premium based federal deposit insurance (such as the one run by the FDIC) makes this mechanism work by transferring equity from sound banks to those that have made bad lending decisions. However, deposit insurance in the form of government guarantees and actions to prop up a banking system that made bad lending decisions by printing money and putting money onto the banking system's balance sheets (i.e. "investing in them") will debase the currency, because it prevents the money destruction needed to reflect the fact that the earlier lending (money supply increase) did not increase productive capacity.

    Sidebar: Non-fractional reserve deposit taking institutions generally do not create money. They may offer loans (funded by shareholder equity) which allow an asset owner to monetize an asset for a short while. This does no result in the direct creation of money in a big way. Take a pawnshop as an example. The pawnshop is essentially providing a "sell first with option to buy back later" arrangement for the borrower. The borrower "sells the item" to the pawnshop, with the option to buy it back within a certain time frame, failing which the pawnshop can sell the item to cover a non-redemption. The entire flow of money is simply a set of transfer payments (transfer of ownership of currency money) in the economy. This doesn't mean such loans are not helpful to the economy. They can increase the ability of economic actors to increase production, by allowing asset owners to more easily borrow money to invest in new business ventures (i.e. another channel for savers to get their money into the hands of people who can create productive capacity).

  2. Currency Money created by Central Bank domestically. The value of the money depends on the ability of the Federal Reserve to exercise good judgment, and only create new money when economic productive capacity has increased (and vice versa). This is why qualitative judgement, the interpretation of economic statistics to discern the true productive capacity of the economy, and political independence are necessary for central banks.

    The biggest threat to preserving currency value in modern political economy is the issuance of debt by the government which is funded by the central bank printing money (i.e. the central bank buys the government's debt). If this borrowing is used to fund productive capacity in the economy, then the value of the currency will be preserved. However if the borrowing is used to fund consumption, wars, or other activities that do not increase productive capacity, then the money will be debased. If the central bank sterilizes the borrowed amount by destroying an equivalent amount of money, then the value of the currency can be preserved. Likewise, there is no problem if the government repays the loan from the central bank through taxation, because the process will transfer money out of the economy and back into the central bank to offset the initial issue. In other words, money is taken off the market and destroyed. The problem is when the government does not repay, and the central bank does not sterilize (possibly because it wants to avoid reducing the money supply available to the economy).

  3. Currency Money created by Central Bank through foreign currency operations. The value of money also depends on the judgment of the Central Bank to manage the money supply when it accepts foreign currencies from foreign companies and creates new dollars to give to them. Foreign companies then use it to buy goods and services from the domestic economy. (i.e. a net basis, more foreigners want to buy the country's products, leading to a trade surplus). When there is a trade surplus, new domestic currency has been created out of thin air, and foreign currency reserves have increased. Hence trade surplus countries by definition, have a glut of currency money in their economy which the financial system needs to channel into productive capacity creation. For the trade surplus country's currency to hold its value, either the private sector needs to be using it to induce the creation of productive capacity, or the central bank needs to sterilize the additional money (for example through reserve ratio adjustments, or by issuing bonds and borrowing money from citizens in exchange for non-tradeable IOUs).

    In contrast, the country with the trade deficit now has fewer dollars in its domestic economy. There is no actual change in the quantity of domestic currency (provided it was private companies that sold domestic currency to the foreign central bank). The only that has changed is the ownership of some domestic currency has changed from being locally owner to being owned by foreigners.
    By virtue of the fact that the trade between the two countries took place, it means that the trade surplus country's central bank (or private sector) was willing to take foreign currency in exchange for products produced domestically. In other words, the trade surplus country has demand for the trade deficit's country's currency money as a means of storing value. When there is a net trade deficit/surplus between two countries, what has happened is that on a net basis, the one whose products are in demand is trading with the one whose currency is in demand as a store of wealth.

    A corollary of this is that there is no self-correcting mechanism for trade surpluses/trade deficits in a fiat money economic systems. Trade deficits and surpluses were self correcting in a gold-standard monetary system, but are not self correcting with production backed country-level fiat-money systems. The demand for a nation's currency money can allow trade deficits to run continuously, until the demand for the currency tapers off. Hence, there is also no "natural equilibrium" exchange rate for currencies. The only trading bands that currency exchange rates will stay within are the the rates which cause Purchasing Power Parity disparities to become untenable. For example, the exchange rate at which foreigners can buy your products so much cheaper than elsewhere, is likely a rate below which the currency will not fall. Because if it did (and assuming you had the capacity to produce the products, and the product value add is largely domestic), the flood of exports from the domestic economy would create a much larger demand for your products than your currency, and reverse the direction of currency movement (and net trade flows).

(2) Tangible Items used as Money

What underlies the value of tangible item money
There are two components to the value of a tangible item that has monetary characteristics:
  1. Utility Value. If the tangible item produces some tangible value, then the value of the item can be thought of as a multiple of the tangible value. For example, a house provides living space and its location and condition contributes to a certain lifestyle. This "living value" places a lower bound on the amount of work that a person is willing to do in exchange for the house.

    The value of course also depends on the supply of the tangible item relative to the people's demand for it. For example, if there are more good houses than there are people in the population, then it is conceivable that many houses will be worth near nothing.

  2. What other people (whose work you want to induce) think of it value. The fundamental value of tangible item money lies in the minds of people. It depends on how much work a person is willing to do in exchange for getting the item. In other words, the value of the money lies simply in what other people think it's worth. If the item produces no tangible value, then it's value solely lies in what people think other people will give up for it. Sometimes what people think other people think the item is worth (how much work they will do for it) depends on the perceived scarcity of the item.

Most items have value from both counts. For example, antique art is largely "what other people will pay for it"value, but it also has enjoyment value. In most cases, the are outbound markers that mark the outer limits of how people will think of its worth, are based on the utility value, relative the supply and demand situation.

How Monetary Preferences (Asset inflation / Asset deflation) affect the economy

In a modern economy with specialization of labor, people make economic activity and resource allocation decisions with the objective of creating economic value, which is represented as money, so that they can use this wealth to induce a host of other people to perform economic activity that in combination will improve their lives. When people's perception of the value of a money changes, or when people's expectation of its future value changes, it affects their economic decisions. This is how monetary phenomena affects the economy's structure and the amount of economic activity on the existing economic structure.
  1. People switch from preferring to hold currency money to preferring to hold asset money (Asset price inflation) - causing resource misallocation, and long term devaluation of currency money. Capital and asset markets make its easy for people to trade one type of money for the other. People generally choose the type of money to hold based on their expectations of the value of that money over time. This comes from both inflation/deflation expectations, and also market psychology. A market where asset prices are constantly rising can induce market mob psychology, and build in asset price growth expectations. An economy where faith in currency money or government has deteriorated can build expectations that currency money will not be able to hold its value over time. Often these decisions are expressed in daily parlance as the need to invest for capital preservation, of to invest for capital growth and returns, or simply a place to squirrel away one's retirement savings.

    When more people start preferring to hold asset money, the price of asset money in terms of currency money rises. People holding currency money are more and more willing to give up more of their currency money for smaller and smaller amounts of asset money. People trade money with one another, exchanging ownership of money. In the short run, the total amount of currency money and asset money in the economy stays constant. But there are more and larger transfers of ownership of currency money between parties reflecting the increasing prices of asset money being traded for. In the medium term, our propensity to make economic decisions based on currency money indications of value means that economic decisions will be made to create more the assets being used as money (for example houses or gold). This can create a misallocation of resources if the economy fundamentally does not need so much of those items. For example, the rising housing prices may suggest strong demand for houses, which could cause overbuilding because the underlying population may not be big enough to need all the newly built houses. (If you think houses are always useful, have a look at cities like Buffalo, Detroit or parts of Germany where the population is thinning out). This misallocation of resources fundamentally means the loans taken out to build the houses (money created) did not go to creating productive capacity (living space) that was actually needed by the people in the economy. This means the currency money has the potential to be devalued, if money is created to "write-off" the bad loans. It also presents the likelihood that economic activity will be constrained as the banking sector reduces its lending owing to capital destruction caused by loan writeoffs.

    Rising asset prices can also affect individuals' perceived financial savings. They perceive they have more wealth, and so save less income each month. The result is that economic savings (actual saving of monthly income) declines, which reduces the economy's capital formation and future productive capacity.
    A key force that tends to prick asset price bubbles is that as prices and trading volume go up, there comes a point where the transfers of ownership of currency money between asset buyers and sellers becomes so large that there are simply not enough people who own enough currency money left to trade at the prices being asked for. In other words, as asset prices go up, the herd of people who can buy and sell starts to thin out. Market crashes occur when everyone tries to sell at once - there simply isn't enough underlying money to transfer between parties to match the volume of all the shares, even if there are willing buyers in theory. For example, if market capitalization is 15 trillion, and money supply in cash accounts is only 5 trillion, then if all stock holders want to sell at one shot, there simply isn't enough money to transfer to them to buy it. So a price crash occurs. Corollary: The corollary is that as asset prices increase and trading volume increases, the velocity of money increases while the quantity stays constant, until there simply isn't enough money anymore. The duration of this phase can be extended if buyers start taking out loans (debt=credit) to buy the assets, then overall money supply increases. But this only lasts until the maximum debt-to-income ratio is reached, then the bubble will also pop. Unless it kicks into 3rd gear, when people start lending on the basis of asset prices instead of income. This can last a long time. But fundamentally is inflationary because the dollars are now not backed by productive capacity.

    This is one reason why it is useful to watch trading volume in market, once the market capitalization starts getting close to or exceeds the M1/M2 money supply, to see if an asset price bubble is running out of steam. Naturally bubbles can be given a boost if banks start lending to buyers on the basis of expected prices of assets instead of the income of borrowers. This boosts the asset price bubble, and also makes its aftermath worse, as the amount of misallocation of resources becomes much higher and a much larger amount of money destruction is needed to preserve the value of the currency money.

  2. People switch from preferring to hold asset currency money to preferring to hold currency money (Asset price deflation) - causing asset price deflation and reduction in gross capital formation in the economy. Conversely, when people have expectations that asset prices (measured in currency money) are falling, they may start preferring to hold currency money instead of asset money. As more people are willing to give up their ownership of asset money in exchange for currency money that the other way around, the prices of assets will drop. The ownership of both currency and asset money changes hands, with transfers of currency money ownership becoming smaller and smaller in quantity.There is no natural stop to this downward cycle, as eventually the ownership transfers of currency money drops to a negligible level. In the short run, no currency money or assets are destroyed, unless the asset price bubble also involved banks lending on the basis of rising asset prices, and the inability of borrowers to repay loans leads to a destruction of currency money.
    However, in the long run, continuing expectations that asset prices will continue dropping will lead to a reduction in investments in creating assets. People can continue to save their income whilst the economy as a whole reduces its borrowing. In economic terms, economic savings still equals economic investment. However, the economic investment can take place out of the country owing to financial flows. It manifests as monetary savings that continue to increase, but not translate into monetary borrowing. Instead, monetary savings is held in currency money of foreign countries. (This is a probably what is happening in Japan today)

    This can reduce the economy's productive capacity, insofar as these assets are capital goods. People may also stop borrowing money to create capital assets, thus preventing money supply growth, which could induce consumption good price deflation. The only natural force that can stop this cycle is if the population is fundamentally growing and the legal and financial framework allows these people to demand and work for more consumption goods. This can manifest itself in rising consumption goods prices, which in turn, will make the return on assets higher and induce economic investment in capital assets, breaking the asset deflation. (Japan's difficulty is that its population is in decline)

This misallocation of resources caused by changing monetary preferences is probably a part of the economic tempo, caused by the way people relate to money (as a store of value and medium of exchange) and the nature of the way human psychology responds to markets. The way the human mind works in a market environment has not changed over the last 5,000 years. This makes it probable that this economic misallocation behavior occurs like a harmonic wave, with peaks and troughs that occur in each generation whose lives are shaped by large shared experiences.

The takeaway for investors

The takeaway for investors is that economic statistics can mean very little when making macro level analysis of foreign country investments. Trade deficits or negative net international investment positions can persist for extended periods of time. Asset price levels in each country can also change beyond what appears to be levels that can be supported by national income.

The underlying zeitgeist and expectations of people play a large role in sustaining asset price directions, which can in turn affect the underlying economy in ways that support the nominal price increases. To a certain extent, profiting from "secular" changes general asset price levels depends on the ability to identify turning points in the zeitgeist and the expectations harmonic wave.

The key idea is that Money is alive. Changing expectations of its value and changing preferences for different types of money, will drive economic activity in different directions. This is especially relevant in today's world of free capital markets, and improving legal frameworks that allow more and more assets to become capitalized and take on the role of money. In scientific parlance, money is no longer just the dependent variable in the economy. It is often the independent variable in the economic system.

How General Inflation and Deflation affect the economy

General inflation and deflation are monetary phenomena caused by changes in money supply relative to underlying production. They affect both consumption good prices and asset prices, and tend to have different effects in the economy.
  1. General inflation. Inflation happens when there is a general increase in prices of all goods and services across the board. (This is different from spikes in prices for certain goods caused by supply and demand imbalances). Orthodox economic thought says that this happens when

    (a) the quantity of money increases - caused by animal spirits driving people to borrow to the full extent, thus increasing money supply through the money multiplier effect and through central bank printing money into the banking system, and/or

    (b) the velocity of money increases - this happens when animal spirits drives people to trade more frequently, increasing the number of times a dollar changes hands. This could also be because people expect inflation to accelerate, and so opt to use their currency money as a medium of exchange to buy assets instead of as a store of value.

  2. General Deflation. Deflation happens when the reverse occurs.
Inflation and deflation, especially when they are unpredictable, cause damage to the economic system because it makes it difficult for people to make economic decisions. Inflation makes it difficult to invest in creating productive capacity, since the cost of production and the prices which produce can fetch over the life of the production (factory etc) become hard to predict. Inflation also makes it better to be a borrower than a lender, since debts are denominated in nominal sums, and inflation makes it cheaper to pay back future dollars. This can accelerate the borrowing in the economy, which further increases money supply. This can lead to spiraling inflation. It should be pointed out though, that countries like Brazil have managed to grow their economies even with sustained levels of inflation. The key though is that inflation rates while high, they were felt to be predictable.

The takeaway for investors in cases of inflation is that a company's financials need to be examined relative to the general inflation level. Through the early 2000's for example, many Brazilian companies showed 10-20% annual growth in revenue. This was considerably less impressive than it appeared, because much of the gain was purely inflation driven.

Deflation on the other hand, damages the economy by inducing consumption hold-backs, which reduces economic activity. It also increases the burden of borrowers over time, and can lead to social instability because of the stresses it creates in society. For investors, the impact is that deflation can reduce overall economic activity, and affect the general business climate.

Saturday, September 19, 2009

Update on bank investment thesis: WFC, USB, Lloyds TSB

The banking sector is undergoing a tremendous amount of stress and change, with parameters that fall beyond our earlier investment thesis for banks WFC and USB and Lloyds TSB (UK). It is necessary to reconsider the investment thesis for banks, and incorporate these latest data points.

Broadly the following macro changes have to be factored into the investment thesis:
  1. The macro environment is turning out much worse than expected. This will drive losses and loan defaults are likely to increase to outlier levels unless some form of government guarantee or intervention takes place. The chart of loan resets (below) suggest that more pain is to come as the wave of Alt A and Prime loan resets hit.

  2. The probability of the macro ecosystem changing is rising: regulators and/or the market may make it difficult for banks to sell their loans. If this persists, then banks will likely have lower ROAs because they will have to hold loans on the balance sheet. This could lead to a fundamental downward revaluation of bank equities.

For WFC and Lloyds TSB specifically, their investment merits need to be re-evaluated. WFC's acquisition of Wachovia and Lloyds TSB's acquisition of HBOS has created a great amount of uncertainty:
  1. How much bad assets are there sitting on the acquired bank's books? WFC and Lloyds TSB have good credit underwriting and a good loan book; it can only be hoped that their acquisitions have equally good loan portfolios.

  2. Both WFC and Lloyds TSB have a good business model, and are able to price their products at a premium. HBOS on the other hand, has traditionally relied on low prices to win business. Wachovia is in the middle of the road, not relying on low prices, but not able to command premium prices either. This suggests that the customer bases of acquirer and acquiree are very different, and that their business models are also very different. Whether these can be integrated is a large unknown.
Monthly Mortgage Rate Resets Chart:

Sunday, August 23, 2009

Consumer Staples Stocks - Long term outlook for the FMCG industry, and what it means for investors

FMCG businesses like P&G, Unilever, and Colgate-Palmolive are often seen as reliable long term investments, because their products are seen as daily necessities and are perceived to have strong brands with economic moats. The major FMCG companies' decades long track record of steady earnings growth reinforces this image.

However the last century's structural factors that allowed FMCG companies to evolve their economic niche are changing rapidly. Changes in technology, lifestyles, and the business landscape have brought the FMCG industry to an inflexion point in its evolution. The playbook that gave FMCG companies their past success is gradually becoming outdated. As investors, we need to critically analyze this; we cannot blithely project their future earnings by extrapolating from their past successes.

The value proposition of FMCG

The FMCG business was made possible by the technological advances of the industrial age, mass production, cheap transportation, and chemical and materials technology. FMCG companies leveraged these advances to create affordable products that improved people's lives, products which gradually came to be considered essential for daily living like shavers, toothpaste, detergents, shampoos, and so on. They created this value for consumers by:
  1. Bringing new chemical and materials technologies to daily life. FMCG companies translated technological advances into new products that improved lives. Shampoos, better soaps and detergents, powders for washing machines, sanitary products, cheaper and safer food, and so on, brought technological advances to bear on improving daily living. This is similar to how Google, Amazon and eBay are today improving our lives by creating services based on advances in information technology.

  2. Using mass production and cheap transportation to make their products affordable. FMCG companies applied mass manufacturing to achieve low unit production costs and make their products affordable. The dropping costs of transportation allowed centralized manufacturing to serve ever more distant markets, further increasing the economies of scale in mass production.

How the leading FMCG companies succeeded up to today

The leading FMCG companies succeeded by (1) identifying and manufacturing products that people wanted to buy, and (2) providing a compelling reason for retailers to stock those products.
  1. Creating products that people want to buy. There are 2 ways for a FMCG company to have a product range that people are willing to pay for:

    (a) A company can manufacture products that are already in the market, at more attractive prices. This is the low cost executor strategy, to produce only goods which meet well identified needs, and use a low cost of manufacturing as a competitive weapon. For example, if it has been established that consumers are willing to buy margarine, then simply manufacture margarine on a large scale so that you can sell it to consumers cheaper than your competitors. Companies like Unilever excel at this strategy.

    (b) A company can innovate and develop new products (or features/solutions) that improve people's lives. This requires a large investment in market research and technical innovation, to identify hitherto unserved needs and use technology to create new products to serve those needs. P&G is an example of a company that has succeeded with this strategy. It has (a) mature market research and product testing capabilities, and (b) extensive expertise in chemical and materials technology. Such companies can typically charge a premium for their products, provided the differentiated value is communicated to, and perceived by, consumers.

  2. Providing a compelling reason for retailers to stock their products. FMCG companies rely exclusively on retailers as the channel to the consumers, and getting retailers to stock their products is key to their success. There are 2 ways they can do this:

    (a) allowing the retailer to earn more money by selling those products than other products. This was done either by (1) providing innovative products that consumers are willing to pay more for, and/or (2) providing products that people want at a price lower than what the retailer can find elsewhere or by manufacturing it on its own. Their adoption of mass manufacturing and increasing volumes achieved the latter, as FMCG companies gradually evolved to become many times bigger than individual retailers.

    (b) by making customers ask for their products by name, so that a retailer can't afford not to stock the product. FMCG companies needed to communicate with consumers to tell them why they should ask for a particular product. To do this, they developed brands, which are fundamentally a signaling mechanism to tell consumers something about their products. When managed properly, brands were very effective in the pre-information age, when information was scarcer, less accessible, and where consumers could not easily share information.

Changes in the world between the 20th century and the 21st century that affect the FMCG industry

The year 2000 roughly marks the watershed between 2 eras in the evolution of the FMCG industry. Several things have changed between the 2 eras:
  1. Some retailers are now as big, or bigger than many FMCG companies, nullifying the FMCG companies' economies of scale advantage. Prior to the 1990s, retailers were much smaller than FMCG companies. This meant that FMCG companies were much larger than retailers, and hence FMCG company produced products would inevitably have a cost advantage to private label / store manufactured products. However the size and scale of retailers today allow them to commission private label manufacturing for products (whose technology is available to private label manufacturers) on a scale as large as the major FMCG manufacturers.

  2. It is harder for FMCG companies to sustain a technological edge and build brand value, because chemical and materials technology have moved to the upper end of the technology innovation S-curve. The last century was a period when chemical, materials and industrial technology were starting to evolve rapidly, and new industrial technologies brought us innovations like the washing machine, rice cooker, and other home appliances. During this time, well managed brands that communicated capability were a source of competitive advantage. It was also difficult for competitors and upstarts to manufacture the products because technology know-how was not widespread. They did not have the know-how (e.g. advanced detergents, shampoos etc) or scale to manufacture effectively.

    However, technology progress in chemical, materials and personal/household technology is now entering the upper end of the S-curve. While technology advances continue at a rapid pace, fewer of these advances are "paradigm changing". People are no longer experiencing "shock and awe" at new products coming onto the market, and are generally able to understand new FMCG products. There are also fewer radical advances in categories; for example, in many cases, the difference between a good detergent and a cutting edge detergent is not dramatic. The result is that the value of brands deteriorates for capability driven brands, and makes it hard for consumers to differentiate one product from another. The widespread availability of manufacturing and technology know-how also makes it easier for upstart competitors to manufacture functionally near-equivalent products. The result is that many categories of FMCG goods are in danger of being commoditized.

  3. The mindset and norms of people brought up in the Information Age reduces the value of brands. The generation that grew up in the information age is culturally different from the generations before. Compared to the past, when information was harder to come by, people are now used to looking for information on product attributes and sharing product reviews. Information is freely available and the new generation is mentally predisposed to looking for information. The value of brands as a signaling mechanism is reduced. For example, observe how the online jeweler Blue Nile has been able to build a large customer base relatively quickly. In the past, it would have been unthinkable for consumers to buy thousand dollar pieces of jewelery over the phone, much less over the Internet. High value purchases of such hard-to-assess products would only be done at trusted jewelry stores.

    It is also difficult to command a mass audience because of the decline in attention to mass media, and the change in people's attitudes to consuming information. The old formula for building brands through mass communications will no longer work.

    It is an open question if it is possible to build billion dollar brands in this new environment. In the annals of history, it is entirely possible that brands will be seen as an artifact of the industrial age, when information was consumed as a one-way feed through mass media.

Types of brands, their characteristics, and
how the changes described diminish their value

The FMCG companies used mass communications to market their brands, to induce an respondent conditioning response in consumers. So that for example, if a consumer thought of "cleaning power" he/she would automatically reach for a box of Tide. In some cases where the product delivers an assessable and keenly felt capability or experience, operant conditioning also kicks in. Fundamentally, there are several types of brands:
  1. Brands that serve as a Quality / Safety signal - the quality guarantee of a product. For example, Lea and Perrins Worcestershire sauce - the distinctive icon imprinted on the label combined with a past experience of the product, serves to communicate its taste and ingredient quality. This was particularly important in the era when there were many manufacturers and the market had many products of differing base levels of quality. For example, the Heinz brand conveyed an image of safe food made with good ingredients. The value of this type of brand decreases once all products presented in a market are of comparable quality or meet certain universally demanded specifications. It also decreases when people have the ability and predilection to exchange notes about the quality of a product. For example, an Auto Company may be known for making low quality vehicles, but with Auto review sites today, it is possible for consumers to identify the occasional high-quality car model from this manufacturer. The value of building a brand like Toyota that conveys quality gradually begins to diminish.

  2. Brands that serve as an Experience signal - the promise of a particular experience. For example, the Cadbury label conveys the promise that the chocolate bar insde the wrapper will have the same taste, or type of taste, that you expect from Cadbury products. The value of this type of brand erodes when people are able and have the predilection to exchange notes/reviews on a product. For example, the Hilton and other hotel brands used to serve as a signal of a certain experience. Smaller hotels who had no brands were at a disadvantage. Even if they provided better service than the big luxury chains, it was impossible for them to be well known for it. But this has changed in the new Internet age. With review sites like Trip Advisor, even small hotels without such brands can become known for their quality of service.

  3. Brands that serve as a Capability signal - a description of a new feature brought about by new technology. This is particularly useful when people are trying to adapt to something new. For example, when washing machines were first introduced, people relied on washing powder brands because they were unfamiliar with the difference between the various types of detergents. The value of this type of brand erodes once people are familiar with the technology, or are able to assess the product's capability, and have the predilection to exchange notes on the product or technology. Brand products whose capability cannot be easily assessed, such as the "beautifying power of a facial cream" or the "germ killing properties of a cleaning liquid", tend to retain their value better, since consumers cannot assess the product's capability and need to "trust" that the product is doing what its brand says it's supposed to do.

  4. Brands that signal an Identity or Message - For example, some brands like Harley Davidson are designed as an identity which people can take on. As social animals most humans want to belong to a group, and need to communicate their status or position to members of their community. Brands such as Harley Davidson provide for this. Other brands such as See's candies or Godiva chocolates are partly designed to indicate a message of "I bought something exclusive and expensive for you". The value of such brands is largely determined by how well they are managed, and the relevance of the message within the context of the zeitgeist of the day.

Perhaps brands in this new age of information will only have value for products that are:
  • (i) Edge of Consciousness (Mental shortcut). Low-priced and/or where it doesn't make sense to go spend so much time looking for information. In other words, products that exist at the edge of our decision-making consciousness. Brands are particularly useful in this area if the market is full of bad products/"lemons", because the value of a brand as a mental shortcut in decision making is enhanced.

  • (ii) Extreme Risk Aversion (Risk-reward ratio of trying new products is not good) Where there is extreme risk aversion, for either evolved, physiological, psychological or cultural reasons. For example, any product that comes into contact with the mucosa of the human body. In this category are products for whom the impact of a bad product far outweigh the potential benefits that come from trying a "better product".

  • (iii) Operant Conditioning. Where the brand is a signal of an experience which is part of a consumer operant conditioning, where the signal and the experience reinforce each other (typically where the brand is a signal of an experience which the consumer craves, and experiencing the product causes the consumer to react to future encounters with the signal).

  • (iv) Quality / Capability cannot be objectively assessed. For example, in cosmetics or nutritional products such as health foods and vitamin supplements, where the quality and effectiveness of the product is largely subjective. (This is not to say that such products cannot be assessed in clinical trials; rather within the context of an individual's assessment of the product effectiveness for him/herself, the assessent is subjective)

  • (v) Signal of a message or identity. For example, luxury brands which indicate exclusivity and the wealth of the owner. This taps into a primal human need to identify with a group and/or show-off. It also applies to expensive gift brands, where there is a need for a person to signal the importance with which he considers the gift receiver. This ties to a fundamental need of social animals like humans, and is unlikely to go away. These brands only need to stay in touch with the zeitgeist, to make sure that they are not "out of date".

Why the existing FMCG playbook won't work so well
in the next few decades

The confluence of these forces results in a world where (1) the cost advantage enjoyed by FMCG companies from economies of scale are now available to retailers too, (2) the value of brands is deteriorating as consumers are prone to searching for and sharing information, (3) the rate at which FMCG companies can introduce new product capabilities is slowing down, because chemical-materials technology has entered the upper end of the S-curve.

In this environment, it is easier for upstart competitors (local FMCG players, or retailer private labels) to surface. Just as a hypothetical example, consider yourself a next generation consumer walking into a large retailer: When you see a product on the shelf, what makes you decide to buy it /a competitive product? It's probably a combination of:
  1. the product proposition, communicated by its packaging and price, and whether it meets a need you have
  2. its shelf position
  3. its performance / technical ability, and your past experience with it (if any)
  4. what you've heard about it before
In the past, 1 and 4 would have be signaled by brands and brand marketing; and 3 would have been something that few companies could duplicate easily. Large FMCG companies had the advantage.

However, in today's world, 3 is easy for private label or upstart competitors to match. 4 is now becoming the domain of new communications technologies, and no longer communicated by brands. 1 & 2 are firmly in the retailer's court - they can confer the advantage here to house brands. In other words, retailers now have the upper hand.


The major FMCG companies won't disappear overnight because of consumer inertia. But long term investors need to reassess their long term prospects.

For investment analysis purposes, there are various wildcard scenarios that are also worth thinking about:
  1. The end of cheap transportation / rising oil prices. Global supply chains may be disrupted. End of cheap transport may make it uneconomical to manufacture at central location for the world, for lower value-to-weight goods. This would remove the economies of scale of large FMCG companies, and make it economical for local competitors to pop up because they can nullify the cost advantage of the big companies.

Sunday, July 19, 2009

Analyzing Retail Stocks - Economics of the business, and what it means for investors

In this post, I describe the nature of retailing and the key factors that affect a retailer's health. It broadly forms the base of the investment thought process for investments in retailers.

The nature of the retail business
and the fundamental drivers of success

The retail business is a tough one, and very few retailers succeed in building enduring businesses. The retail landscape has changed tremendously over the last few decades. Fast food restaurants have replaced Automats, and big box retailers have risen to prominence at the expense of high-street/city center retailers. Retailers have to adapt to changes in fashion, lifestyles and consumers tastes. Large established retailers that fail to adapt can fall swiftly; witness how bellwethers like Sears, K-Mart and Circuit City have gone from boom to bust in a matter of years.

Retailers are fundamentally in the business of distribution. They create value by getting products to consumers, in a manner accessible to them when they need it. For a retailer to be successful, it needs to:

1. Stock products that customers intrinsically want. Retailers are rarely able to generate intrinsic demand for a product. The intrinsic demand for a product is determined by a combination of product marketing, consumer lifestyles and the prevailing zeitgeist. What retailers do is to meet that demand by making the products available to consumers. Retailer merchandising and presentation play an important role in stimulating the desire to purchase a product, but they only work if the customer has a fundamental need/demand for the product. For example, it's unlikely a retailer will succeed in selling chicken feed in New York city, no matter how creatively the product is merchandised.

Retailers can either create their own items to stock (such as retailers like the Body Shop, or the general provisioners of the early 1900s who sold brand-less commodity items), or stock items made by other companies, as long the products are what people desire and fit into the position and mind share occupied by the retailer. FMCG companies add value for the retailer by supplying them with products that their customers want, at a lower cost and with less hassle than having to develop the products themselves. This symbiotry between FMCG companies and retailers has evolved over the years, since it started in the late 1800s when P&G, Colgate and other FMCG companies were founded.

Retailers need to adjust their merchandise mix over time as tastes and needs change over time. Products that are considered necessities today may become irrelevant in a decade, and products that people aspire to change over time. Many retailers fail because they do not keep up with lifestyle and zeitgeist changes.

2. Make it convenient for consumers to buy. Because people generally do not derive value from the buying process; they see it as something they have to go through to get to the value that products deliver (e.g. refreshment from a drink, the cleaning power of a soap, etc.). People tend to buy from the store that is the most convenient to buy from.

What about people who enjoy shopping? While it's true that they derive value from the shopping activity, the actual purchasing process is not something they would place much value on. Their shopping expeditions will generally be to places which are convenient, being both accessible and a one-stop destination for the merchandise being sought. So making it convenient for consumers to buy is key to successful retailing. To do this, retailers must:
  • (a) be accessible in the context of its customers' lifestyles. People will only visit stores that are conveniently accessible to them. The only exception is when a store sells something that a person has become addicted to or induces a strong physiological response, such as pornography and addictive items.

    For example, malls and big box stores fit the car-centric lifestyle of suburban shoppers in the U.S. Big box grocers find it harder to succeed in Japan because many people there do not drive, and also have small fridges which cannot store a week's worth of shopping. Instead, convenience stores scattered amidst the urban alleys are more suited to the Japanese lifestyle, because most Japanese consumers walk to subway stations on their way to and from work.

    The way people shop changes with changes in their lifestyle, which is typically driven by technological advances and changes in the zeitgeist. For example mail order used to be a convenient way to buy things, but is today rarely used as (1) people are more mobile and able to travel to stores easily, (2) modern logistics networks bring all kinds of goods to local stores, obviating the need to buy from a faraway mail-order retailer, and (3) the prevalence of Internet shopping, which has made mail order less relevant (though not extinct - for example, NBrown in the UK still runs a large home shopping operation)

  • (b) be a one-stop shop for the position that it has carved out in people's minds. Each retailer has a position in the customer's mind (for example, a store to buy "natural remedies" or "imported groceries" or "stuff at bargain prices"), and the merchandise mix in the store must support that position. When a customer walks into a store, he/she should be able to find all the items that he/she is looking for. A successful shopping trip reinforces the retailer's position in the customer's mind, while a wasted shopping trip makes it more likely that he will choose another store in future. No amount of positioning marketing will help if the store doesn't have the range of goods a customer looks for.

The economics of the retail business
and sources of competitive advantage

The economics of the retail business are similar to that of the distribution business. Both are a combination of a logistics network and a trading business (inventory management). Like distributors, retailers are price-takers when there are multiple competitors serving the same target customers. On the other extreme, a dominant retailer in a town enjoys a natural moat that gives it pricing power. This does not mean that a retailer's pricing power grows with size, rather there is a tipping point between the two extremes.
  • A retailer generally has no price-setting power when there is a competitor serving the same group of customers. (i.e. targeting the same customer profile, and present the same assortment of goods at the same locations/customer touch points). The economics of the distribution business are such that a customer faced with the choice of buying from 2 or more distributors will not be willing to pay much more for one distributor's services as opposed to another. Certainly some people may be willing to pay more to visit a cleaner/less crowded store, but the premium they are willing to pay is minimal. The players are price-takers, and the only sustainable competitive advantage is to be the lowest cost operator within its market. Having the lowest cost of operations and procurement allows the retailer to match all competitor price actions while remaining profitable.

  • However a retailer has price-setting power if no other retailer is serving the same group of customers. For example, if a grocery store is the only one that is accessible to the residents of a town, then the retailer can generally set the prices for its services. Likewise, the only store to sell specialty cheeses in a city can set the price for its services.

Size is a source of competitive advantage. All things being equal, the economics of retail are such that the value that a retailer brings to customers increases naturally in proportion to the size of its operations. The largest retailer will almost by definition (a) be the most accessible to customers with the best network of sites by virtue of the in-place nature of the business, and (b) have the widest range of goods. The economies of scale that exist in distribution means that the largest distributor is also likely to have the lowest unit costs, and thus able to offer the lowest prices in order to fend off competitors who try to compete on price.

The largest enjoys a positive feedback loop where its increasing size improves its competitive position, which in turn increases it size, and so on. Once a dominant position is achieved, the economics of distribution gives the retailer a structural competitive advantage and makes it very difficult for smaller competitors in the same category to compete.

This doesn't mean that no other retailer competitor will survive, because consumers don't just base their buying decisions on these factors; there will be people who prefer the competitor's store because of its color scheme, etc. (This applies less to distributors who sell to businesses, because business buyers tend to make economical decisions. Take for example, the different buying behavior between consumers and fleet-buyers when they buy cars. The former will be influenced by styling, while the latter will be driven by fuel efficiency and maintenance costs.)

Building an enduring long-term retail business
with a sustainable competitive advantage

The economics of the business means an enduring retail business is one that is able deliver value to its customer and achieve and retain dominance. This means that an enduring retailer is on that is able to:

(1) Constantly adjust its inventory to continuing stocking products that its customers want, and adjusting its mindshare position in its customers' minds accordingly. (or it could try selling products that are relatively insulated from fashion trends and quick changes in demand)

(2) Constantly adjust it store accessibility, to be accessible even when its customer's lifestyles change. (or it could be serving a consumer group whose lifestyle that isn't expected to change much)

(3) Achieve the lowest cost of operations. In the retail business, this means:
  • (a) Maximizing inventory turns. Moving inventory as quickly and efficiently as possible. Fast moving inventory also allows the retailer to reduce the capital intensity of the business, and increases the flexibility to quickly change stock when customer needs change. Conversely, slow moving inventory means that capital is tied up (and financing costs incurred), and also prevents the retailer from purchasing new stock to cater to seasonal or changing customer demands.

  • (b) Maximizing sales per square foot. A higher sales intensity increases capital efficiency and productivity. Per unit operating costs are also reduced through the efficiencies gained from selling more in a single location.

  • (c) Maximizing economies of scale. This is a business where there are economies of scale. A retailer that has higher purchasing volume will be able to extract more price concessions from its suppliers. Likewise, higher merchandise volume means that the retailers logistics and distribution infrastructure will be better utilized. For example, trucks will travel with full loads, and the fixed costs like warehouse management systems will be amortized a larger volume of merchandise.

Openings that an upstart competitor can exploit
to displace a dominant retailer

The competitive landscape of retail is like an open savannah, where the playing field is flat with few natural defensive positions. The factors of production, technology and merchandise used in retail are available to all competitors. Likewise consumers can switch retailers easily, and lifestyle and fashion changes affect all retailers. A competitive retail landscape is like a highly evolved Savannah ecosystem, where individual players have carved out their own survival space (value to customer, delivery model etc), and their incumbency is evidence of their competitive strength within a niche. In other words, they will likely have found the best way of utilizing existing factors production for a particular customer niche. The more competition the incumbents have defeated, the less likely it is that there are unexploited factors that the incumbent has overlooked.

In this landscape, competitors can establish a survival space only if one of the following openings exist:

(a) They ride a changing consumer wave or change in zeitgeist. In other words, exploit a changing customer profile which the incumbent isn't attuned to. For example, Sears used to be the dominant retailer in the United States, but the rise of suburbia, the auto-culture and changes in tastes allowed big-box stores and category killers to muscle in on Sears' dominance.

(b) They find some technology or operating technique which the incumbents have overlooked. This is difficult, but not impossible. Walmart did just that to K-mart, by exploiting the logistics efficiencies of building store in geographically contiguous fashion. It built out its network of stores in small towns by going into towns next to each other. This logistics efficiency allowed it to achieve lower costs that the incumbent discounter K-Mart, which had store that were situated in big cities hundreds of miles apart.

(c) The incumbent messes up. The dominant retailer may also mess up, for example, by allowing its store to be infested by rats. Dominant retailers can also the mistake of muddying its position and deviating from the formula that made it successful. For example, a retailer with the position of lowest-cost discounter may try to become an aspirational retailer that sells higher-end goods. Because of the Savannah like competitive landscape, deviating from a survival space means that a retailer is exposing itself to open competition from other players who have already found the competitive advantage in their survival space. The dominance in one survival space often does not translate to another survival space, and the retailer will be starting from zero in its competitor's stronghold. This doesn't mean that a grocery discounter will be unsuccessful selling discount electronics, because the competitive dynamics of both areas are similar. But a discount grocer trying to sell fashionable clothes is going to find it tough going, because the survival dynamics in each space are vastly different.

What this means for Investors
who invest in retail companies

Investing in retailers involves a quantitative assessment of the retailer's cost position and dominance, and a qualitative assessment of whether its position, customer base, and accessibility to its customers are likely to continue relative to zeitgeist and technological changes. It basically means:
  1. identifying retailers that have established strong survival spaces, and

  2. constantly monitoring the landscape for evidence of competitive openings that may have been created, and

  3. constantly monitoring the changes in consumers' lifestyles and evidence that the retailer is keeping up with these changes

It is more than a simple spreadsheet exercise, unless we are planning to liquidate the retailer for its assets.

Sunday, June 7, 2009

Analyzing oil companies - The economics of the energy, commodity and materials business, and valuation traps

One school of thought is that investing in commodity-processing/resource-owning companies, such as oil majors like XOM, RDS, BP and CVX, and pulp and paper companies like Votorantim Celulose e Papel (NYSE ADR: VCP), is a good way to preserve wealth during periods of elevated inflation. The underlying hypothesis is that the price of commodities will rise in line with the general price level, allowing them to grow their profits in line with inflation.

However as with all investments, it is crucial not to overpay for a stream of earnings or you will end up with negative real returns. We'll look at one way of analyzing and valuing a commodity-processor/resource-owning company's earnings quality. We'll also see why in some cases we are better off buying commodities directly.

The economics of Commodity producing businesses
- they are price takers

Because their products are seen as commodities, customers have no particular reason to pay significantly more for a product from one company over another. In many cases, it is also relatively easy for customers to switch suppliers. This means that commodity sellers are price takers who cannot sell their product for more than the market-clearing price. The implication is that:

  1. The strongest company is the one with the lowest cost of production and cash reserves. One of the worst things that can happen to a commodity company is if the market price for the commodity drops below its cost of production, making it lose money every day it stays in business. (While hedging can ameliorate this, it is only a short term solution) So well-funded companies with the lowest cost of production will have the most sustainable competitive position; if prices drop, the lowest cost company will be able to run with the lowest losses until all other competitors go broke and withdraw capacity from the market, allowing prices to rise to a profitable level.

  2. They are vulnerable to price-irrational competitors. A competitor that decides to sell product below cost could drive the company out of business. This is a particular risk in "essential commodity industries, as governments may run loss-making state-owned competitors for political reasons. This is also a risk if the industry requires large amounts of fixed capital to operate, because ailing competitors may resort to flooding the market with product just to cover some part of their fixed costs (ie. manufacture as much as possible, as long as variable production costs are covered).

Durability of competitive position
- Factors affecting Earnings stream quality

Because they are price takers with an undifferentiated product, they have a durable earnings stream only when (a) the environment minimizes chances of prices falling below their operating costs, and (b) in the event that occurs, they are the best positioned to weather the down period until prices recover.

Industry reports and published financial statements can give you an indication of which companies are the most competitive, and have low production costs. The leading companies typically achieve their competitive position by (1) having economies of scale, (2) acquiring commodity reserves with lowest costs of production, and (3) applying operational efficiency and technology to minimize production and overhead costs. Unless there are disruptive events, it is likely that the leading companies will retain their competitive positions over the short term. However, the long-term durability of their earnings stream depends on 2 principal factors:

(1) The probability of price-irrational competitors emerging (such as government funded competitors). This depends on:
  1. the geo-political environment: For commodities that are considered strategic assets, there is always the possibility that interventionist governments may setup state-funded not-for-profit competitiors. States with resource reserves are especially good candidates for this. The probability of this happening is balanced by the existance of trade barriers and trade agreements which can prevent dumping of commodities into foreign markets.

  2. the cost structure of existing competitors. Competitors that are heavily in-debt and/or have high overheads may flood the market with product, just to cover some part of their fixed overhead costs/debt servicing. They can price product below true (fixed+variable) costs over the short run, just to meet cash flow needs.

(2) the probability that an upstart competitor can achieve lower costs of production. This depends on:
  1. The components of the cost of production. For example, the bulk of the cost of steel production lies in the cost of energy needed to run furnaces. So a competitor could achieve lower costs of production if it managed to find a cheaper source of power, for example by erecting a new dam for cheap hydroelectric power. You would need to analyze the probability of this happening to estimate the earnings quality of a commodity company. Likewise a pulp and paper company's costs could predominatly be in forestry costs, so a competitor who could open up cheap forestry landbanks (because of climate change or changes in government rules) could gain a competitive edge.

  2. Commodity re-cyclablity. Recyclable commodities like gold present the possiblity of a recycler finding a way (through technology, or finding an untapped source or cheap recycled gold) to produce re-cycled commodity at a lower price than extracting it out of the ground. For example in the gold market, it is conceivable that gold prices can fall below the cost of production of even the lowest cost miner, because there is a huge supply of gold which is already in the hands of consumers. Because gold is indestructible, there is always the possiblity that existing consumers may flood the market with their gold, and depress the market price of gold below it cost of extraction from the ground.

  3. Probability of changes in the company's competitive sphere. The "competitive sphere" is the range of competitors who can serve the customers that the company is serving, and it varies according to the nature of the commodity. For example, a perishable commodity like fresh milk has a local competitive sphere (as long as customers aren't open to ESL milk or UHT milk which can be supplied from thousands of miles away e.g. by Fonterra in New Zealand). Competitive spheres can change with technology. For example, natural gas used to be a local product which could only be transported along a pipeline to nearby consumers. However, with technology advances and the build up of LNG processing facilities worldwide, natural gas can now be converted into LNG and shipped anywhere across the world, making its competitive sphere a global one. The lowest cost producer in a particular region might find itself displaced from the lowest cost position when compared with producers across the globe.

  4. The Company's ability to keep acquiring lowest cost reserves. Resource owning companies constantly need to find new resource reserves to replenish reserves depleted by production. Otherwise the company will be operating in run-off mode, and will cease operations once its existing resource reserves are depleted. If the company is unable to find reserves with low extraction costs, or a competitor finds a motherlode of easy to extract reserves, then its future competitive position and earnings quality will deteriorate.

Valuing commodity/resource companies
- buying commodities, instead of resource companies, may be a lower risk way for investors to preserve wealth

To a long term owner looking at a company as an income producing asset, the valuation of any company is based on the present value of the expected stream of earnings which the owners can take out of the company. (We exclude earnings which need to be retained in the company, since they are needed to keep the goose alive to continue laying its golden eggs)

To arrive at a risk-weighted estimate for the future earnings stream, we need to combine all of the following:
  1. the earnings that will flow from its current commodity reserves

  2. the risks to those earnings, arising from changes to its competitive position (costs relative to its competitors) and the likelihood of non-economic competitors

  3. the ability of the company to continue adding to its resource reserves without changing its costs of production relative to its competitors

In the short run the company's earnings will likely grow in line with inflation (assuming it also drives commodity price rises), because the company's costs of production (reserve extraction costs and reserve acquisition costs) are based on yesterday's prices while revenue is based on today's inflated commodity prices.

However over the long run, the ability of resource companies to grow earnings in line with inflation is not a sure thing. In fact, their earnings behavior over the long term is likely to be no different from the average of a basket of companies across industries. Why? Because (a) as inflation sets in, their cost of acquiring reserves and the costs of extraction will also likely go up, and (b) like all companies, they face competitive risks to their earnings. And as we have seen, as commodity producers they can face more earnings risks than non-commodity producers.

So if you are looking to preserve the value of your wealth during inflationary periods, you may be better off investing directly in commodities, if you hold the view that commodity prices will rise in line with inflation. (which is the same premise in the "invest in resource companies" hypothesis)

Valuation traps and mistakes
- particular to commodity/resource companies

One mistake is to value a company by extrapolating its future earning stream from its recent earnings history. Commodity prices tend to be cyclical in nature, because of the oscillating boom-bust feedback loop that develops; increasing production causes prices to drop, which causes production capacity to be withdrawn, which causes prices to go up, and so on. These cycles can span many years, so you need to look at the 10-year earnings history (or longer) to get a feel for the company's earning power.

For resource-owning companies, this approach also ignores the fact that the company's reserves are not infinite and will run out at some point. Management will continue acquiring new resource reserves to keep the company viable as a going concern, and the new reserves' cost of production will determine the company's earnings quality down the road. For example, an oil company with low-cost reserves may have a high quality earnings stream today. But if it cannot replenish its reserves with equally low cost resources, it will gradually slip into a weaker competitive position and become more vulnerable to losses in future. This should reduce the valuation placed on the company.

Another valuation mistake is to take the enterprise value of a commodity company as = the amount of commodity reserves they have, multipled by the prevailing commodity price. (i.e. valuing the company in run-off mode, where the company will cease operations once its existing reserves are depleted). The problem with this approach is that it assumes that it is possible to extract and sell the entire reserves all at once. In practice annual production capacity is limited, so if you want to value the company as a run-off company, you need to base your value calculation on the NPV of each year's production, until all reserves are depleted. (It is not uncommon for resource companies to have only 10-20 years of resource reserves if production rates are maintained.) You may be surprised that the NPV value expressed as a PE ratio can be in the low single digits.