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

Hewitt Associates ,

AdminisStaff , and

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.

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.

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.

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

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.