Sunday, December 26, 2010

Investment Outlook 2011

2010 in review

The US stock market spent the better part of 2010 in mildly overvalued territory. As of December 2010, the S&P is hovering around 1200, and the overall market capitalization is around USD 14.2 trillion. The market capitalization ratio is around 100%. As we've seen in our post in October 2008, the fair value of the US market is around 70-80% of GDP, which in todays terms corresponds to the S&P at 960. (A good place to get an update of the market valuation is here at GuruFocus:

History also suggests that market values will correct towards fair value, often overshooting in the process. But there is no guarantee that the past will repeat itself, and we must be careful not to drive forwards while using only the rear view mirror to guide us. The nature of the market and investor participation prior to the 1960s is different in some fundamental ways from today's market. Nonetheless, my bet is that the market is still overwhelmingly driven by human mob psychology, and that is something that has not changed throughout human history.

Market mob psychology has historically demonstrated the ability to allow:
- the market to fall to 50% of GDP. This would imply the probable lowest the S&P may fall to is approx 600. That's a 50% drop from here.
- the market to rise to 150% of GDP; this occurred very briefly during the 1999 dot com mania, and was an unprecedented all-time valuation high for the market. This would imply the S&P at being 1800, which is a 50% rise from here.

Wildly overvalued markets are often challenging for value investors, because almost all stocks can be overpriced. Similarly undervalued markets present a feast for value investors as the majority of stocks drop to fire-sale prices. Mildly overvalued or undervalued markets would typically present fewer investing opportunities, as individual stocks and assets become cheap because of poor investor sentiment arising from events such as bad press and unexpected (transient) earnings surprises.

However the market in 2010 did not manifest many such opportunities, because it demonstrated an interesting characteristic: a very high level of correlation across all stocks. This has commonly been referred to as the "risk-on, risk-off" behavior of investors. All stocks move up and down in unison, and individual stock picking thus becomes a very challenging task as every stock pick becomes a bet on the overall market movement. There are fewer opportunities to practice investing, the art of buying undervalued stocks whose prices then go up as their value gets realized in the market. One of the few opportunities that came up were the few times when high quality blue chip companies were trading at fair value.

Looking forward : 2011

The economic environment is 2011 is likely to continue to be subdued as we continue working through the mis-allocation of resources during the bubbles between 2000 and 2008. The high levels of obligations to retirees and government employees (manifested as debt and unfunded obligations) will likely be a drag on the economy, as either (1) working people adjust to reduce their standard of living to make good on these promises made by the government to other sectors of society by transferring the results of their production to these other sectors, or (2) society adjusts to inflation which comes from monetizing the debt to break those promises made. The drag on the economy comes from the psychological effect on people who discover that their plans based on past promises or projections now have to be changed. As they feel poorer and/or find less rewards in production, they may reduce their level of economic activity (production and consumption).

But does the underlying economy really matter for investors? Stock prices will go up if everyone gets whipped up into a frenzy, whether or not the underlying economy is sound. How it matters is that the degree of activity in the underlying political economy can increase or decrease the probability that investor psychology will be triggered in one direction or the other.

What is 2011 likely to present to us: what are the known risks this coming year?
  1. The risk of people recognizing that massive central bank money printing will lead to inflation.

  2. The risk of people recognizing that private and sovereign debt will default explicitly or implicitly via inflation, either way leading to inflation or increasing yields; because of the large amounts of debt.

  3. The likelihood that economic growth continues to be slow, as we work through the continuing economic readjustment from the housing and financial asset bubble.
The underlying longer term trends, that we have observed earlier, continue to play out:
  1. reduction in availability of low cost resources (energy, commodities)

  2. demographic trends: aging in the vast majority of developed countries, and China

How investor and mass psychology plays out over the coming year is uncertain, though the triggers for a market correction seem to be there.

Investing Playbook

Given the underlying economic landscape, and what seems to be latent triggers for a change in investor psychology leading to a fall in equity prices, we look towards investing in companies which have strong business positions and growth ahead of them. Their downturn resistant earnings streams should support their stock prices to some degree, and even driving a growth in prices once correction-psychology stabilizes. The key is to buy at fair prices, as it is highly unlikely that companies seen as low-risk, durable and world-leading will sell for cheap prices for too long, irrespective of how much the market corrects. It is unlikely for example, that WMT would go for less than 10 times earnings for any prolonged period of time. A study of the bear market in the 1970s would suggest this belief.

Other more transient, or in-the-moment approaches are likely to be tricky this year. The recent erratic risk-on risk-off nature of market psychology makes it difficult to make money by playing transient shifts in changing asset preferences. It also makes it difficult to make the traditional value investing play of buying assets below their fair prices, in the hope of markets recognizing their true value.

The one shift in preference that seems a possibly good bet is the shift away from debt instruments. Rising recognition of sovereign default would likely trigger a shift away from bonds and resulting in rising yields. This has been expected for several years, and it is still anybody's guess whether this will happen this year. But when it does, it is likely the shift will be swift and decisive, providing an opportunity to place a bet on the continuance of this shift after it has started.

Sunday, October 24, 2010

Consumer food companies: profitability, debt burden, revenue diversity

Here's a cheat sheet for the profitability, revenue diversity, and debt burden metrics for several of the world's leading consumer foods companies:

Blend of reported numbers and estimates for FY 2009 / 2010 (USD millions)

Revenue 7,676 5,298 107,618 49,000 10,500 14,796 12,575
% from US 81% 86% ? 25% ? 44% 82% 68%
% from International 19% 14% ? 75% ? 66% 18% 32%
Operating Income, before interest expense (margin) 1,348 (17.56%) 761 (14.36%) 14,970 (13.91%) 5,814 (12.3%) 1,559 (14.8%) 2,861 (19.3%) 2,001 (15.9%)
% from US 89% ~90% ? 25% ? 53% 92% 86%
% from International 11% ~10% ? 75% ? 47% 8% 14%
Net Income (margin) 844 (10.99%) 436 (8.23%) 11,793 (10.96%) 2,376 (4.85%) 864 (8.2%) 1,535 (10.3%) 1,208 (9.61%)

Cash flow

Operating cash flow (before paying interest expense) 1,169 1,155 18,728 ? 1,557 2,581 1,938
Interest expense (as a % of revenue) 112 (1.46%) 90 (1.70%) 794 (0.74%) 2,126 (4.34%) 295 (2.81%) 400 (2.70%) 295 (2.35%)
Operating cash flow (after paying interest expense) 1,057 1,065 17,934 ? 1,262 2,181 1,643

Debt burden

Total debt (does not include liabilities such as accounts receivables, leases etc) 2,780 1,542 ~23,404 30,030 4,500 5,375 4,836
Debt to operating income ratio 2.06 2.02 1.56 5.17 2.88 1.87 2.41
Debt to operating cash flow (bef int) ratio 2.38 1.36 1.25 ? 2.89 2.08 2.50
Interest expense as % of operating income 8.3% 11.83% 5.3% 36.57% 18.92% 13.98% 14.74%
Estimated interest rate incurred on debt (guesstimate; does not consider different debt maturities) 4.03% 5.83% 3.39% 7.08% 6.56% 7.44% 6.10%

Saturday, September 11, 2010

ADP Investment Thesis / Stock Analysis

ADP is in the business of handling human resource and payroll processing operations for its customers. It is part of the data processing or back room operations outsourcing industry. This industry has been around for some time, and cuts across many industries and business functions. For example: Public listed companies outsource their shareholder and investor relations services to companies like ComputerShare; Financial institutions outsource their banking and payments back room operations to firms like BR, FISV, JKHY, and FIS; and many companies outsource their accounting and back office functions to service providers like WNS and Genpact. Companies can even outsource their payments processing to service providers like TSYS.

ADP's business and competition

ADP handles three main types of business operations: (1) the processing of company payrolls, (2) hiring employees and attaching them to customer companies (the business of being a Professional Employer Organization), and (3) the handling of core business processes of auto dealers.

ADP's 2010 revenue was approximately USD 9b, and its closest competitor PayChex had 2010 revenue of approximately USD 2b. There are a number of other competitors, though none close in size to ADP, such as
ReyRey (Dealership software)

The economics of the outsourcing business

The value proposition of business operations outsourcing is that the outsourcer is somehow able to carry out the outsourced operation better than the company can. This implies two things:
  1. that the process is not a competitive differentiator. Otherwise, the firm would cede its economic position over time.

  2. the process itself must be one subject to an economic effect (such as the "economies of scale", "economies of experience", or "the tragedy of the unregulated commons"), so that by operating the process for many companies, the outsourcer can deliver more value to each individual company than if the individual company were to do it itself. Otherwise, there is no value to outsourcing the business process, unless it is for accounting (expense vs capex, expense vs overhead) presentation or business strategy/focus reasons.

    If follows that if this is the case, then any company that does not subscribe to an outsourcer's services will be disadvantaged compared to similar companies that do use an outsourcer's services. When outsourcing truly adds value, then it almost tautologically creates a self reinforcing feedback loop. Companies who use the pooled services get benefits they otherwise could not obtain on their own, which leads to other companies also joining the pooled services so as not to be disadvantaged, which further leads to even more benefits to pooled members.
We can validate whether an outsourcer is truly creating economic value by reviewing the long term business record and retention ratios of the industry, covering at least 3 contract renewal periods. This will negate the artificial growth in cases where outsourcers do well in the short term (as companies try them out) but where the true long term benefit is elusive. An outsourcing industry and/or an outsourcer that grows and is profitable over the long term suggests evidence that: (1) the process it operates is not a competitive differentiator for its clients, and (2) there are factors that allow it to enjoy economic effects by pooling client operations.

In the case of human resource and payroll outsourcing, the long term record of ADP and PAYX (PayChex) suggests that the operations do indeed add value for their customers. The question for us then is whether this will persist into the future; whether future technology, laws, tastes and zeitgeist will allow the ecological niche that they occupy to continue to exist.

The ecological niche sustaining the PEO and HR payroll outsourcing industry

Over the course of history, changing tastes, technology, demographics, cultures and political economy allow conditions to arise that make room for new types of businesses. These ecological niches come and go over the epochs of history.

ADP's industry was made viable with the arrival of computers, which allow data processing to be subject to the economic effect of economies of scale. Because once a mainframe was purchased, the incremental cost of processing an additional unit of data is marginal. (As compared to pre-computing age, when this data processing was done by people) The high capital investments needed in mainframes, software and data processing technology magnified the economies of scale effect in this business.

The secondary force contributing to this industry's viability was that HR and payroll practices were becoming increasingly standardized across companies, and that for regulatory and other reasons, these processes were becoming increasingly burdensome to operate considering that they did not confer competitive advantage to the company.

This created the ecological niche for PEO and payroll processing companies. ADP and PAYX executed well, and are now the two dominant players in this industry. It is not uncommon for a few firms to dominate in industries that enjoy economies of scale or other economic effects that favor size and/or experience. (Conversely industries such as construction aggregate quarrying, cement manufacturing and flour milling, that do not allow for economies of scale or have products which are not cost effectively transportable, tend to be fragmented and have many small players. Michael Porter's book "Competitive Strategy" discusses this at some length)

Valuation and business prospects of ADP
(aka: How comfortable are we capitalizing the next 20 years of ADP's earnings; and what are those earnings going to look like?)

The need for payroll processing and operating HR processes is eternal. But the earnings quality, ability to earn supernormal profits, and the strength of ADP's business depends on:
(1) The sustainability of the ecological niche in its current form, and
(2) ADP's competitive position within this niche
(3) ADP's prospects for growth

Sustainability of the ecological niche: Whether this ecological niche will continue to exist in its current form depends on:
  1. Whether data processing will continue to be a high capital cost endeavor that enjoys economies of scale. As long as the capital investments needed to achieve the current operating costs that ADP is achieving is relatively high compared to each individual company's operating budget, then the ecological niche will continue to exist in its current form. There are 2 foreseeable threats to this:

    (a) The lower cost of computing, driven by the increasing maturity of distributed systems and middleware, as well as online Cloud Platforms like Amazon EC2 which make it easier for a competitor to start a hosted software/data processing operation without incurring huge upfront capital expenses. This could open the door to a more fragmented industry with many small players, which would erode the competitive advantage that ADP's size confers to it today.

    (b) The structure of the economy changes and the number of SMEs/SMBs decreases meaningfully compared to the number of large enterprises. Large enterprises are more likely to be able to afford the capital investments needed to run their own operations at a scale where they would enjoy economies of scale.

  2. Whether the cost of processing payroll/HR is going to get more complicated and the penalties for lapses more severe. In other words, will there be increasingly complex rules and laws to obey, with increasing costs / penalties for compliance failures or errors in processing. If the rules for HR and payroll processing become simpler, with few penalties / business costs for processing them wrongly, then the cost-benefit of outsourcing this work to a dedicated service provider will become less attractive.
The major megatrends that we know of today, namely (1) the adoption of
Internet technology and the Internet generation mindset, (2) increasing
Oil and Energy prices, (3)
Aging demographics, and (4)
China and India joining the world economy, are unlikely to affect this ecological niche.

Sustainability of its competitive position: ADP's competitive position in the current ecological niche is excellent.In an industry which enjoys economies of scale/experience, being the largest player allows you to operate at the lowest cost and offer the best prices to your customers. And price is likely to be one of the primary deciding factors for ADP's customers, since the processes being outsourced are relatively standardized and not a source of competitive advantage. In this regard, being almost 4 times larger than its next nearest competitor PAYX, ADP has a wide competitive moat.

Where is the growth going to come from: By most estimates, the vast majority of businesses in the United States (and the world) have not yet outsourced their payroll and HR operations. This leaves enormous room for growth, whether or not the macro economy does well.

What can go wrong / How ADP can screw it up

Assuming ecological niche remains as it is, the one thing that could torpedo ADP's earnings stream is if ADP messes up. The fundamental business value that ADP provides is that of cost-effectively handling business processes for businesses. In most cases, it is probable that the most competitive player is the one with lowest cost, and best record of risk mitigation.

The forseeable ways which ADP could stumble and cede business to competitors are:
  1. ADP loses customer data or otherwise fails to deliver its services properly, causing a flight of confidence to other service providers, or
  2. ADP fails to keep up changes in HR / payroll regulations or new business process needs, and allows a competitor to grow by servicing the new requirements, or
  3. ADP's management forgets its source of competitive advantage and allows its cost position or pricing to gradually drip upwards, creating room for a competitor to sneak it and steal its customers.

Monday, June 28, 2010

Is a rights issue good for shareholders / Should I participate in a rights issue?

One way that companies raise capital is by issuing shares through a rights offering. Some shareholders see rights issues as a "gift" from the company, because the exercise price is usually below the market price of the shares in the market. They view a rights issue as the company giving them a special "by invitation only" opportunity to buy shares a discount to its market price. Others see a rights issue as a sign that the company's investment merits are deteriorating because the company is either being forced to adopt a lower-debt funding structure that reduces the shareholder's return on equity, and/or is becoming more capital intensive.

This post explains how both perspectives can be valid depending on the conditions surrounding the way the market views the company.

Case Study: an example of a rights issue and how it affects shareholders

Here's a simple, but representative, example that illustrates the mechanics behind a rights issue:

You buy one (1) share of a company with the following financial structure:
Total shares issued: 1,000
Shareholder's equity: $2,000 ($2 per share)
Earnings: $1,000 ($1 per share; ROE=50%)
Market price: $10 per share (PE ratio of 10; PB ratio of 5)

The next day, the company makes a 1:1 rights offer with an exercise price of $5 per new share. This gives the company the following financial structure immediately after the offer is exercised:
Total shares issued: 2,000
Shareholder's equity: $7,000 ($3.50 per share)
Earnings: $1,000 ($0.50 per share; ROE=14.3%)

Does it make sense for you as a shareholder to participate in the rights offer? If your primary concern is in maintaining your voting power, then you need to subscribe to the rights issue in order not to have your stake diluted. Otherwise you will end up owning a smaller percentage of the company.

However if your primary concern is the value of your stock holdings, then it depends on how the market values the company: whether the market values the company as a multiple of its earnings, or as a multiple of its book value.
  • If the market values the company as a multiple of its book value, then a rights issues is beneficial to an existing shareholder only if the exercise price of the rights shares are above the Shareholder's equity per share of the original shares.

  • If the market values the company as a multiple of its earnings, then a rights issue is beneficial to an existing shareholder only if the company can employ the additional capital at an ROE similar or greater than the ROE enjoyed on the company's existing shareholder's equity.

Here's why:

(A) Companies that are valued by their PE ratio.

In the best case scenario, the capital raised can be used with a ROE of 50% (the original ROE achieved by the company), then the company will end up earning $3,500 or $1.75 a share, and can be valued at $17.50 if the PE ratio remains at 10. If the company cannot put the new capital to such productive use, then the price of the shares should be lower because the earnings are lower.

Assuming this best case scenario, how then would a shareholder fare? A shareholder which bought 1 share originally at $10 (which he could have sold for $10), would have put in an additional $5 to subscribe to the second share. By contributing $5 out of his/her pocket, he now has 2 shares each worth $17.50, for a total of $35. The additional $5 contributed has resulted in a gain of $25. What has effectively happened is that the company has offered the opportunity to (1) invest $5 in a venture that has a ROE of 50%, and (2) benefit from the market's propensity to capitalize those additional earnings at a certain PE ratio. The shareholder has gain of $35-$10 - $5 = $20 ($35 of shares after the issue, $10 for the initial share purchase, and $5 for the rights exercise price)

Businesses that are lumpy step functions (like property developers) where there is a need for huge amounts of funds for each "project" can end up raising rights issues often. While they can try to keep retained earnings until they reach the critical mass needed for a project, many avoid doing this because during the interim years, the retained earnings just sitting there will be a drag on ROE and result in unhappy shareholders.

However in the worst case scenario, the company needs the additional funds just to continue operating as it is. Then the rights issue would be extremely bad for all shareholders. In this scenario, the company would continue earing $1,000, or $0.50 per share (since there are now 2,000 shares after the rights issue, instead of the the original 1,000 shares). The fair value price of the share would then be $5, assuming the PE ratio of 10 is maintained.

An investor would then be worse off. He originally paid $10 for one share. Then had to to pay $5 for the rights issue. In effect, he paid $15 for 2 shares, and the 2 shares are now worth $10 in total. A loss of $5 for the shareholder. In reality, if the ROE of the business dropped, the fair value of the company in PE ratio terms would also drop, which would further reduce the value of the shares. This is a simple mathematical relationship in the Discounted (Extractable) Future Earnings model for valuing any asset.

So in summary, whether or not you are financially better off depends on the ROE at which the company can employ the new capital being raised:
  • (a) if the company is raising funds for a new venture, then the funds raised had better earn returns that justify the current share price.

  • (b) if the company is raising funds to continue operations, because it cannot access debt, then your ROE is dropping and the fundamental investment merits of the company have changed.

(B) Companies that are valued based on their book value.
The amount of gain for a non-participating shareholder depends largely on how much higher the rights exercise price is to the book value per share of the original shares.

In the best case scenario where shares are issued at a price higher than current book value per share, you would have benefited even if you had not participated in the rights offering. Let's see how this works: your original share would now be worth $17.50 each and you would have a gain of $7.50. What has effectively happened is that you've gotten a free ride, because the rights shares buyers are effectively subsidizing you. Buying the shares on the open market, you paid $10 each share which had $2 of underlying shareholder equity, without actually injecting any equity into the company. Whereas the "buyers of the new rights shares" are injecting $5 for every new rights share they are being given. This $5 they have injected will increase the value of your "original shares". In other words, there is new additional shareholder's equity for your shares, that is being paid for by the new buyers.

But if the company has issued the rights at an exercise price of $2 (the book value of the original shares prior to the rights issue), the company would have $4,000 in shareholder's equity. There would be no gain for you in book value per share terms. So the market value of your stock holdings would be unchanged.

In the worst case scenario, the company has issued the rights at an exercise price of $1 (below the book value of the original shares prior to the rights issue), the company would have $3,000 in shareholders' equity. The book value per share would have dropped to $1.50 per share, and the market value of your existing shares would be diminished. In this case, it pays to subscribe to the rights, since the premium of the market value of your new shares over their exercise price would counter the loss in market value of your current shares. Whether or not this completely compensates for the drop in value of your existing shares depends on how far below the book value the new shares are issued at.

So in summary, whether you benefit depends on whether the shares are issued at an exercise price equals to the book value of the current shares, or if it is greater/less than it. If it is greater, than you may benefit even if you don't subscribe to the shares. If it is less, then you may need to subscribe to the shares just to minimize the losses in the market value of your existing shares.

Short-term trading opportunities when a rights issue occurs and trades on the secondary market

In the short term after a rights issue is announced, the immediate question that strikes many investors is: is there money being left on the table, when a company is selling new rights shares at less than its market price? Strictly speaking the answer is no, because the current share price is simply a reflection of the returns on the capital /book value already in the company. The rights issue will have changed this calculus, because the key question going forward is what is the ROE on the new capital / the new book value per share after the rights issue.

However this line of thought is sometimes the reason why the existing/new shares may continue trading at their prevailing prices. (In other words, the market can't figure out the "correct share price" after the rights-issue) This can create a short-term windfall for existing shareholders, because the rights may trade at over-valued prices. When this occurs, shareholders who subscribe to the rights can sell the rights. Likewise, the market may clear at a a too-low "post-rights-issue" price, and the rights trade at a unfairly low price. This creates a buying opportunity for new investors to take an ownership stake in the company at a discounted price to the market.

The key in both situations is that you must have a clear idea of how the market values the company over the long run, and whether the rights exercise price creates a beneficial or detrimental situation for you as an existing shareholder (see our earlier analysis). That will allow you to figure out the price that the shares would likely trade over the longer term after the rights-issue, and allow you to see if a mispricing has occurred which you can take advantage of. Of course, be aware that the mispricing may continue for quite a while, even after the rights issue exercies, because it takes a while for the company to actually deploy the capital and earn the return which you think it should be earning.

Saturday, May 1, 2010

Analysis of First Ship Lease Trust (Singapore)

At it's current price (SGD0.60), FSLT's attractiveness as an investment boils down to 2 questions:
  1. Is a price of SGD 362m (the market cap) a good price to pay for (a) ownership of the 23 ships that the trust owns, and (b) assuming responsibility for SGD 650m of bank debt.

  2. Will the trust management be able to manage well (ride the cyclical shipping demand / manage capital) to the benefit of unit holders.

Here's the thought process behind this:

First, assuming the management does not buy more vessels, and just continues running the existing ships until they are obsolete. Typically ships have a lifespan of 20-25 years, and the average age of the ships in the trust is about 5 years. So the question is: is SGD 362m a good price to pay for 23 ships with 20 years of life left, and taking on SGD 650m of debt that was originally taken on to buy the ships.

The answer probably depends on two things: (1) were the ships purchased at rock bottom prices? and (2) what's the probable lease income from the ships after the current lease term expires in 5-7 years time.

Ships are a commodity, and shipping rates are cyclical. Ships lessees tend to lease ships mainly by price, so having the cheapest ships is key. When the industry is in a funk and excess capacity abounds, ships that were purchased at high prices are effectively money losers for owners, as the lease rates may be even less than the cost of the loan taken to buy the ship. So the future level of distributions ("dividends") from this trust depends on whether the ships were purchased at a rock bottom price and/or the amount of loans outstanding.

The other thing is that because the ships will become obsolete after 20 years, the intrinsic value of the trust drops every year. So having a high dividend/distribution yield is critical for investors to counter this. At the end of 20 years, the intrinsic value of the trust is the scrap value of the ships minus any outstanding loans.

Of course, if the ships were purchased at a rock-bottom price, then the trust can sell the ships even during a down cycle and make some money to return to unit holders. The ships are carried on the books at SGD 1.18b, so a key variable is whether this is considered cheap in the maritime industry.

So the next question is, can the management counter this inherent drop in value by buying new ships? The answer is yes, and this leads us to the second angle.

Because of the legal-financial structure of this type of trust, they generally do not retain their earnings. They more or less have to distribute all the cash coming in from leases/income streams. From an accounting standpoint, this means that the distribution is typically more than the accrued income shown on the income statement. This is because the reduction in equity caused by the depreciation expense can be distributed, unlike in normal companies where dividends are generally not to be distributed if there are no more retained earnings in the shareholder's equity. (In other words, the trust is a self-liquidating vehicle)

The implication is that anytime they want to buy new ships, they will need to either take on more loans or raise equity by issuing more units. Whether this is beneficial or detrimental to existing unit holders depends on (a) the price at which the new units were raised, relative to the Net Asset Value per unit of existing units, and (b) the returns on the capital raised - ie. whether they are able to buy good ships at cheap prices using the money raised. Both of these factors are very much determined by the decisions made by the trust management. (This is broadly true for companies too, any time new shares are issued, it can either be good or bad for existing shareholders, depending on the management's business acumen and decisions)

This variable depends entirely on the business acumen of the management team.

Sunday, April 4, 2010

How Demographics affects Equity Investors (and people saving/investing for retirement)

Some investment theses rely in part, on making a broad bet on the economic prospects of a country. (For example: buying an equity index fund) The economic prospects of a country are determined by two key factors: its resources and scheme of organization (its legal, cultural, financial and political framework), and its demographics. The former is understood and often acknowledged; the rule of law, respect for private property, and so on, are seen as essential to unleashing the economic instincts of human beings. However, the impact that a country's demographics have on its economic prospects is sometimes overlooked. Why? Because much of recent economic history has unfolded over an era when populations were growing in almost all the major countries. But this is now changing as many countries have crossed the tipping point and are now starting to age.

To see how demographics affects economics, we can examine the 2 extremes that population demographics can take: a growing population that is predominantly young and growing, and a shrinking population that is predominantly old and aging. (You can check up the population pyramid of most countries at this U.S. Census Site)

Growing Population

All things being equal, a country with a growing population will generally report positive economic growth. As the population grows, the population will create and consume more products and services to sustain itself as a given standard of living. So even if the economy does not grow on a per capita basis, investors betting on general economic growth will have the bet work out in their favor. Within the economy itself, we can expect to see real estate values grow in real terms, as the growing population has more productive output that it can cede to land owners to secure rights to the land. (This is assuming constrained land resources - if there's huge tracts of usable land adjacent to major cities that are already zoned for development, then its a different calculus). Investors in such an economy can protect the value of their savings by using it to either (a) buy a share of the profits of economic production (via equities) or (b) buying land. Since the dawn of the industrial age around 200 years ago, this has been the demographic pattern of most countries in the world.

However, we are now at a turning point in many countries, and populations are beginning to shrink. This portends a very different economic reality for investors. Countries like Japan, whose populations have peaked and are beginning to shrink, are giving us a preview of what is to come in Europe and other soon-to-be aging countries.

Inflection point between Growing and Declining Population

At the point when the population begins to turn from growth to decline, the economy will begin to have excess productive capacity because the capacity was built by a larger population to sustain itself. As the population declines, we can expect the productive capacity of the economy to exceed the needs of its shrinking population. There will literally be too many houses, machines, car, and equipment for the shrinking number of people. Because capital equipment tends to increase and decrease in step-function jumps, we can expect that the excess productive capacity will remain for a while. During this time, it is probable that businesses will try to cut prices in order to retain the nominal amount of business in a shrinking pie. The implication for shareholders is that they face a declining ROCE. The shrinking consumer needs will ultimately lead to reduced production needs, and reduce the number of workers needed, hence preventing wage inflation from pushing prices up. Deflation is the likely result during this inflection point period. This would suggest that investors would do best simply to hold on to cash during this time, since cash would increase in real value as prices continue to drop.

This deflationary trend will probably be hard to reverse using monetary policy:

1. The first monetary tool that central banks can use to induce inflation is to grow the money supply through credit growth. Unfortunately this is unlikely to cause inflation because credit is predominantly extended for capital stock creation, of which there is already too much of it relative to the shrinking consumption. If anything, it will probably exacerbate the deflationary trend for the reasons we've seen. (This monetary tool to induce inflation is probably more effective with a growing population, because the increased capital stock will eventually be utilized as the increasing population requires more products and services. The increasing population may temporarily freeze their consumption, thus making this monetary tool ineffective in the short run as the extra capital stock sits idle. But over time, the growing population will eventually start demanding more soap, food, electricity and other products which are produced by the capital stock. Once this kicks-in, the deflationary trend will probably be reversed.)

2. The second monetary tool is for the government to turn on the printing presses and grow the money stock through the government spending of printed money. This too is unlikely to induce inflation, because the surplus productive capacity of the economy would easily create the goods and services for the government to buy with its freshly printed money, without increasing the price level because supply capacity is abundant. If the economy has a high savings rate, then this extra money will probably go back into investments in capital stock, further reinforcing the deflationary trend.

Unfortunately, the tendency to over-invest in capital stock can be expected during the period when population gradually shifts from growth to decline, because people tend to extrapolate from the past when making decisions. In the past the population was growing, which required (and rewarded) a continuing increase capital stock. So businesses will likely persist in this behavior and over-invest in capital stock, until it finally sinks in over time that what worked in the past no longer applies because of the shift in demographic trends.

In such an environment, deflation will be sustained, and investors would do well to simply hold on to cash.

Declining Population

However once the country's economic participants adjust to the new reality of a shrinking population, and reduces its investment in capital stock as a proportion of GDP (i.e. reduces its savings), then a different set of economic forces come into play. The more normal level of capital stock relative to consumption will remove the incentive for businesses to cut prices because they are no longer operating under high fixed overheads. The systemic deflationary forces will then disappear.

Over time, the total overall economic production will continue to decline in line with the shrinking population's reduced need for material goods and services. Unless exports are an overwhelming proportion of the economy, the economy can be expected to shrink in line with the decline in population. (Technically speaking under today's economic terminology, such an economy would be considered to be in a prolonged recession.)

Investors would not profit by buying a share of the profits of economic output (by buying equities), since overall production and productive capacity will keep shrinking. In practice, equity investors will see this happening though shrinking corporate profits. (With the shrinking population, businesses will also have to get used to shrinking revenues as overall sales volume goes down.)

Investors would also do well not to buy land, since the shrinking population will have less economic production to cede for the finite land, and indeed, on a per capita basis, the increased available land per capita would also increase and further reduce the real value of land.

How about cash? Would investors (or people planning for retirement) in such an economy do well to hold cash over the long run? In all probability, no. In a declining population economy, both savers will likely earn negative real returns. The savings (either held as cash or in equities) generated by an earlier generation when the population was larger, will have less real value as the population declines. Why? There are 2 reasons:

  1. Because society requires less and less capital over time, and hence owners of capital (savers and equity owners) will find that their returns will drop. Conceptually what's happening is that at the earlier time, and forgone consumption of the larger population (i.e. savings) was basically work spent to build up capital stock in the form of buildings and machinery. As time passes and the population declines, the smaller population requires less buildings and machinery than what was built (through savings) of the larger population. So the capital stock built by the earlier generation will now be used to produce fewer products(profits) than what the earlier generation would have been able to get if the population stabilized at the earlier generation's level. In effect, the earlier generation will experience low nominal returns (negative real returns) on its savings.

  2. Inflation will also likely set in, as the total economic production drops and the money supply chases fewer and fewer goods. The central bank may forstall this effect over the short run by absorbing excess money through bond issuances, but over the long run, the inflationary trend is likely to persist.

NOTE: In a steady state economy, capital stock investments as a % of GDP should increase or decrease in line with population growth or decline. (This implies the same for savings, since in a clearing economy, Savings = Investment). The capital investments should be to get ready for the increasing or decreasing needs of a increasing or decreasing population.

Rule of Thumb for Equity Investors (wrt to Demographics)

On balance, investors would in general, do well to avoid investing in economies with declining populations. It is difficult to profit from holding scare resources like land, because as the population declines, the amount of production that the population can use to purchase the resources also declines. In such economies, the reducing need for capital also means that returns for capital owners will be poor. Persons in such economies who are saving for retirement will probably fare best if they hold on to inflation protected bonds. Unlike persons in growing population economies, their prospects for increasing real wealth through passive investing is lower, because there isn't a future generation of more people and more consumption which requires the capital they provide as investors.

This is an important realization, because recent economic history has been one founded on continuous population growth. A declining population presents a different economic environment.

Image by TerriersFan, via Wikimedia Commons, released under the GNU Free Documentation License Version 1.2