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: http://www.gurufocus.com/stock-market-valuations.php)

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.

Analyzing eBay - How wide is eBay's moat?

eBay is often thought of as a business with a wide moat, because its core eBay site has a strong network effect and it has the largest number of users among its competitors. As with most network effect businesses or technologies, once a dominant player emerges, it is practically impossible to dislodge because of the value the network has to its users (the value created for its users grows polynomially as the number of users increases linearly). eBay was seen as the dominant franchise.

eBay started as a giant swap meet for people to buy and sell to each other. eBay was a venue for traders to meet and trade, much like a stock exchange. Such exchanges are economic entities that enjoy a tremendous network effect, and they are able to command economic rent. (The stock exchange analogy is conceptual only. In real life, there are large market makers participating in the U.S. stock exchanges each of which accounts for a large proportion of trading volume. This erodes the ability of the exchange to command economic rent, because the market makers can just link up among themselves to create a parallel exchange)

Because each participant in an exchange can potentially engage in two-way trade with all other participants, each additional participant increases the number of trading possibilities polynomially (think of it as a complete graph - such a graph has n(n-1)/2 edges). Traders, who value the number of trading possibilities available in an exchange, the value of the exchange grows tremendously as the number of participants increases. In practice, once a critical mass of participants is reached, the value of the exchange to all its participants probably grows at a rate far greater than the polynomial growth that the number of trading possibilities would suggest. In real life once a critical mass of traders is reached, benefits like economies of scale in trading volume and market liquidity kick in once a critical mass has been reached.

This economic characteristic makes it extremely difficult for smaller exchanges to compete with a larger dominant exchange. In fact, like all network effect entities, once a large exchange achieves a size beyond its competitor(s) by some amount, a tipping point is reached and competing exchanges will shrink rapidly as participants migrate to the dominant exchange. eBay was thought to be the dominant exchange and hence unassailable.

However it is probable that this assertion that eBay's site has a network effect is wrong. This is because eBay may actually be a marketplace and not an exchange. Exchanges have a network effect, while marketplaces do not.

There difference between the two lies in the trading patterns and behavior of its participants. In an exchange, all participants are traders that buy and sell from each other. In a marketplace, participants generally perform only one role: they are either buyers or sellers. Marketplaces are venues for two groups of people to meet, and for each group to derive benefit from the other group. The value of a marketplace to a participant is proportional to the number of participants that belong to the other group. For example, the value of a market to a seller is proportional to the number of buyers present, and the value of the market to a buyer is proportional to the number of sellers present.

Marketplaces do not have strong network effects because the value of the market only increases proportionally to increases in the number of participants. (Unlike an exchange, whose value increases disproportionately). However marketplaces do exhibit a self-reinforcing feedback loop effect. The more buyers there are, the more valuable the market venue is to sellers. This causes more sellers to come on board. The increased number of sellers in turn makes the market venue even more valuable to buyers, which causes more buyers to come on board. This in turn makes the market venue even more valuable to sellers, enticing more sellers to come on board, and so on. Examples of marketplaces are newspapers, shopping malls, and supermarkets/department stores that sell on consignment.

Newspapers (especially the classifieds section) are essentially a market venue for advertisers and readers. The more readers there are for a classifieds section, the more important it is for advertisers to advertise there. With more advertisers, readers will find the classifieds more valuable because of the increased ranges of products and services available. This brings in more readers, which in turn brings in more advertisers. (In a sense, the "news" in a newspaper is just a sideshow used to bring readers in - the real business of a newspaper is in being a market venue for readers and advertisers.)

Shopping malls operate on the same principle. The more people there are who visit a mall, the more valuable the mall is to shop owners. And the more shops there are, the more useful a mall is to customers.

Like exchanges, marketplaces tend to be "winner takes all" types of businesses. If an marketplace becomes much larger than its competitors, the business will eventually drain away from the smaller markeplaces and migrate to the larger marketplace. However, unlike in an exchange where it is practically impossible to dislodge a dominant player, it is relatively easier for a competitor to dislodge a dominant marketplace. How so?

For a small exchange to dislodge a larger exchange, it essentially has to convince a large number of participants to move from the large exchange to its smaller exchange. In fact, to beat the larger exchange, it literally has get enough people to move over so that it becomes the larger exchange. In other words, the strategy for a smaller exchange to beat a larger exchange is to become the larger exchange. This is going to be difficult, because participants of the larger exchange derive higher value simply because it is the larger exchange. It is difficult to come up with a proposition to get them to switch over.

However, for a small marketplace to dislodge a larger marketplace, it only needs to convince one group of participants to move over. Once it has done this, it can count on the self-reinforcing feedback loop to draw in the other group of participants. The participants know this too, and they may be willing to bet that the market owner will be able to convince their group peers to move over. For example. they may believe that the market owner has the clout/salesman ship to bring over lots of their group peers. The hurdle to overtaking a large competitor is lower than in the case of exchanges.


Signs suggest that eBay is a marketplace, not an exchange.

Although I have no figures to back this up, it looks probable to me that the bulk of today's eBay users are not traders. Rather they are divided into two groups of users: buyers and sellers. It appears that more and more of the trading on eBay is between people who specialize in selling (such as the eBay Power Sellers) and people who visit eBay only to buy/hunt for bargains (i.e. buyers).

If this is true, it would explain why eBay is trying to move away from its "flea market, swap-meet auctions" format to a more commercial "buy it now" format with fixed prices and store fronts. This look-and-feel transition, if true, signals that the underlying economics of eBay have changed. This change of format is not simply a cosmetic matter, or a matter of catering to the changing zeitgeist (which is what retail and fashion businesses have to do to stay relevant to their customers). (Even if the underlying economics are exchange in nature, eBay's current moves towards a marketplace business model means that the underlying economics will eventually become marketplace economics)


The competitive landscape - Amazon Marketplace.

If indeed eBay is being used as a marketplace, then it susceptible to competition from Amazon, in particular the Amazon Marketplace which was launched in 2001.

While eBay does seem to be orders of magnitude larger than Amazon (2007: eBay Gross Merchandise Volume of USD 59.3b, compared to Amazon Revenue of USD 14.8b), Amazon does have very strong mindshare with buyers as the "defacto place to buy things online". Amazon's mindshare with the general public will make it possible for them to convince large numbers of buyers to move over. Likewise, their fulfillment capability could also convince large numbers of sellers onboard. This could then precipitate the self-reinforcing feedback loop which could grow their marketplace significantly and threaten eBay's position.

Strategically, the only two Amazon capabilities that eBay cannot counter, is (1) the fulfillment feature for sellers, which can attract sellers on board, and (2) Amazon's mainline store, which can be used to offer loss leaders and coordinated merchandising to bring in buyers. These are two very strong competitive tools that Amazon has in its fight against eBay. eBay's competitive advantage over Amazon (as of now) is its larger size.

This competition is shaping up as a contest between a large bazaar of vendors selling to customers (eBay) and a huge shopping mall with an anchor tenant (Amazon).

The two may be able to co-exist, but only if (a) the e-commerce market is large enough and both players to maintain size parity with each other; otherwise tipping point economics will take over and only one will survive, or (b) each specializes in a different product range, or (c) each specializes in a different type of buyer/seller; for example eBay goes for traders/swap-meet, while Amazon goes for conventional buyers and sellers. Because the online ecommerce market is still growing and its ultimate size and form is unknown, the growth and competitive parameters of both Amazon and eBay is tricky to quantify.


eBay's other businesses - PayPal, Skype and online Classifieds (Gumtree, Kijiji)

While eBay's other businesses are strong, they are still small relative to eBay's overall business.

Nonetheless, they have strong competitive positions, and eBay may end up as a conglomerate with a collection of strong online businesses. Betting on them is a venture capitalist's game, not the game of an investor looking to invest in a running business. I'll take a look at eBay's other businesses sometime, possibly in another post.

Bank stocks - The Business of Banking, and Investing in Banks

We have recently seen many big-name banks declaring huge losses and raising capital from investors. They look like they are tip-toeing through a credit minefield, and stepping on a mine every few weeks as their portfolio of loans and assets deteriorate and new credit exposures surface. Is this the nature of the banking industry? Are banks just one of those lousy businesses that investors should stay away from?

Not in my opinion.

At its core, the business of banking is the business of (1) attracting customers and (2) managing risks.

Credit Risk Management
Banks, both investment banks and commercial banks, borrow money from one group of people and lend it to another group of people. They make money when the people they lend to are credit worthy, and lose money when they make bad loans or buy bad assets. It's as simple as that. From the perspective of the banking system, the whole system is sound as long as all banks make sound credit risk assessments. If the system as a whole makes a lot of un-creditworthy loans, then the inevitable result is a contractionary monetary base as loans are written off, and money is destroyed via the bank multiplier effect. This is one key reason why governments are loathe to let large banks fail, because a rapidly shrinking money supply would be disastrous for the economy as a whole. I believe this is why the Federal Reserve has maintained a loose monetary policy throughout the credit crisis. Some commentators contend that this stokes the fires of inflation and I have to agree. But I don't see any other choice.

Commercial banks also have to manage the risk of using short term funds (deposits, debt) to fund long term loans. This is a problem that all banks face, and a good bank should be able to manage this risk to an acceptable level. If we look at it from the perspective of the banking system then this risk becomes a non-issue, as long as bank depository institutions continue to be the only institutions allowed to take deposits and make loans. At the system level, all deposits (short and long term) have to remain within the system, and will continue to fund the issuance of loans (short and long term) which are also completely held within the banking system.

Why banks are good investments
The banking system as a whole channels all the money supply in the economy, so the profits from the banking system will generally grow in line with the growth of the money supply. And since the money supply tends to grow in line with economic growth, the profits from the banking system are a core-inflation protected stream of earnings that grow at the pace of economic growth. In a broad based economy with sound fundamentals, buying a share of the banking system is an excellent way to preserve your wealth. The best lowest risk banks, assuming that not all banks are run identically, would be excellent investments.

Risks and Attracting Customers
Unfortunately, it is difficult to figure out whether a bank is managing its risks well. It is very easy for a bank to make loans to un-creditworthy customers, and it is very difficult for someone reading a bank's financials to know when this has happened. An un-creditworthy customer may be able to pay his/her installments for a few years before finally defaulting on the loan. It's not something you can see coming just by looking at the financials. Assessing a bank's credit risk profile is an art. Among other things, we need to look at the bank's business model, operating culture, and compensation incentives. The price of credit is also an integral part of assessing a bank's credit risk profile. A bank can be financially sound if it makes loans to less creditworthy customers, as long as it charges a higher interest rate for each loan. Netted over a large base of customers, the higher interest rates can make up for the higher number of loan defaults. But it is generally difficult to know whether a bank has adequately priced for the risks that it is undertaking, because loan default typically only show up after a loan has aged for a while. Because of this, it is also easy for a bank to underprice its loans to gain market share, without showing signs of distress in the initial few quarters.

Good banks also need to be able to attract customers. But banking is the business of supplying money, which is the ultimate commodity product. A dollar bill from one bank is as good as a dollar bill from another bank. This doesn't mean that banks can't differentiate themselves using clever retailing, marketing, better service and so on. But it does suggest that, as with all commodity businesses, customers will be willing to switch to a competitor if the competitor's price is low enough. Because banks (1) are such highly leveraged businesses, and (2) it is easy for competitors to underprice their product, a bank can easily become susceptible to a loss if irrationally aggressive competitors attract their customers away with unrealistically low prices. The corollary of this is that a sound bank is one that has customers who don't see it as a commodity provider. Identifying a sound bank means knowing which banks have such customers.

Investing in Banks
Investing in individual banks is not for the uninformed. A bank's high level of leverage means that small errors of judgment by the bank can send the bank into a downward spiral. Flighty customers, underpriced risks, bad credit risk management can precipitate a deadly run on the bank.

The premise that regulator will not let a bank fail, and hence a bank is a failsafe investment, is a false one. I think it is true that bank regulators are loathe to let the bigger banks fail, but this only means that they will protect the assets and liabilities of the bank. They will have to let the shareholders be wiped out, in order to prevent moral hazard from creeping in. The experience of failed banks like Northern Rock and Continental Illinois support this observation.

I believe sound banks are an excellent investment, and the recent downturn in the stock market presents a good opportunity to buy into good banks at a good price. The trick is to pick out the good banks from the bad, before the market cottons on.