Limits to (Financial) Growth

Is bigger always better?

Photo: Emma Degerstedt. Source: Wikipedia

In America we like to think big: bigger companies have broader product lines; big cities offer more job opportunities and cultural events; bigger markets are more diversified. We brag about having the world’s biggest economy, the world’s biggest highway system, and several towns in the Midwest claim to have the world’s biggest ball of twine—over 8 feet across and 25 feet around.

But in business, big companies can run into problems. Big banks have regulatory issues. “Too-big-to-fail” means that once a financial corporation becomes so large that it’s embedded into most of the economy, a society can’t afford to let it fail if management makes bad decisions. That’s what we re-learned during the Financial Crisis: a bank run almost created a second Great Depression. So our biggest banks are facing special scrutiny.

Size creates sales challenges. Once you’ve saturated your home market and applied all the efficiencies you can, you need to branch out into new regions. But global diversification can create cross-cultural issues. When United Airlines opened a new hub in Hong Kong, they celebrated by handing out white carnations. But to many locals, the white flowers represented bad luck or even death. United quickly switched to red carnations, but the damage was done.

Bigger companies face bureaucratic complexity. The physical challenge of sourcing large amounts materials, building a millions of products, and delivering them to customers requires an intricate minuet of inventories, manufacturing, and finance. Everything has to be just in the right place at just the right time. A storm or a financial hiccup can disrupt the supply chain and lead to lost sales.

For these and other reasons, there’s a “size effect” in the stock market. Smaller companies tend to do better, over time, than large companies. Since 1993 the S&P Small Cap index has grown by 10.7% per year, while the S&P 500 has only returned 9.1%. Small stocks don’t outperform large stocks every year, and they tend to be more volatile. But over time, investing in small companies adds value relative to owning their larger cousins.

Small Cap vs. Large Cap. Source: Bloomberg

That’s why companies do spin-offs and divestments. Downsizing allows them to focus on their core competencies. In personnel management, we sometimes see a “Peter Principle” at work, where competent employees are promoted until they no longer perform well—they rise to the level of their incompetence. The same thing can happen to corporations: they grow until they can’t.

Henry David Thoreau observed 160 years ago: “Our life is frittered away by detail. Simplify, simplify, simplify! I say, let your affairs be as two or three, and not a hundred or a thousand.” The same might be said of companies. Sometimes the best way to grow is to shrink.

Douglas R. Tengdin, CFA

Chief Investment Officer

[tag size effect, Thoreau, Peter Principle]

Limits to (Trade) Growth

Why is global trade under attack?

Public Domain. Source: NOAA

Global trade has generated an unprecedented level of prosperity. From Foxconn-built iPhones to Novo-Nordisk-designed insulin therapies to Airbus and Boeing and Embraer competing to build and sell airliners, global companies competing in a global marketplace produce an incredibly broad range of goods at reasonable prices.

Trade works because a larger market allows for more specialization, and more specialization enables people to be more productive. Workers can be more focused and more innovative. New ideas generate new products that can be replicated millions or even billions of times in a few years. Companies can go from just a few programmers to multi-billion dollar businesses in just a few years. So why is everyone suddenly suspicious of increased trade?

From Brexit to Trump to the Italian constitutional referendum, opponents of increased trade have used static analysis to make their case. When cheap goods enter a marketplace, domestic producers have to change the way they do things. Wages may fall. The same thing can happen when immigration increases. In the short run, immigrants use public services and may displace local workers.

Indeed, there was a close correlation between how exposed British regions were to Chinese imports and how they voted on Brexit. The less an area was impacted by imports, the less likely they were to vote to leave the European Union. And although correlation doesn’t equal causation, Italian economic growth essentially stopped when that country adopted the Euro in 1999. It has been in decline ever since. No wonder their citizens are suspicious of the elites.

Italy Real GDP since 1970, Source: Bloomberg, IMF. Log scale.

Political turmoil often follows a period of lackluster economic performance. People don’t want to become worse off, and they expect their leaders to have some solutions. Global trade is supposed to make us all better off. But when the facts don’t seem fit the theory’s rosy promises, it’s reasonable to want to try something else.

Douglas R. Tengdin, CFA

Chief Investment Officer

Limits to (Revenue) Growth

Do businesses always have to grow?

Business life cycle. Source: Aswath Damodoran

The short answer of course is no. There’s lots of businesses that have falling revenues. In fact, one classic way to turn around an unprofitable enterprise is to shrink it to profitability. There’s a life-cycle to most companies and industries: start-up, growth, maturity, and decline. It’s happened in technology (PCs), newspapers, transportation (trains), and other areas. It may be happening to brick-and-mortar retailers today.

But we don’t like to think about shrinking businesses. It seems unnatural to assume that a firm will see diminishing sales and declining margins. We lionize Steve Jobs, not Larry the Liquidator. CEOs that grow their companies get put on a pedestal, with books written by and about them. Leaders that preside over mature corporations don’t get as much attention.

That’s what can make value investing so tricky. The fair market value of a company in decline is a lot lower than one that’s early in its life cycle. Declining firms distribute more cash to shareholders as well, because there are fewer opportunities to deploy it profitably within the company. Taken in aggregate, value stocks are cheaper—but often, they are cheap for a reason. Blindly purchasing low PE stocks and high dividend yields can lead to disappointment—a “value trap.”

In sports, defense is just as important as offense. But people like to score goals more than they like preventing them. This cognitive bias can create opportunities. Declining firms aren’t worthless. When irrational gloom sets in, investors can profit—if they’re careful. As always, valuation—and values—matter.

Douglas R. Tengdin, CFA

Chief Investment Officer

Sustainably Stronger

What makes some businesses stronger than others?

Photo source: Morguefile

Business analysts look for “moats”—competitive advantages that one company has over another, even when they’re in the same industry. Like the way brand-loyalty supports iconic consumer companies like Coke or Colgate. But those kinds of moats are rare. Usually, a smart product or business idea gets copied and commoditized. Those won’t give you a sustainable advantage.

But there are some things that the competition isn’t always willing to do. Strategies or habits that—once adopted—make a firm able to adapt to new circumstances and develop new opportunities.

The most important is the ability to connect with customers. At the end of the day, the customers own the business. Coke or Pepsi or Microsoft or Pfizer wouldn’t exist if no one bought their products. And empathizing with folks who use—and struggle with—the products every day gives you market intelligence that doesn’t always show up in surveys. How many times do you think Delta’s CEO has been bumped from a flight or had his bags lost?

Just as important is the ability to try new things—and abandon them when they don’t work. The world is changing, but we don’t always know which way it’s going. So we have to experiment: like Amazon’s Fire phone or Google’s glasses. Jeff Bezos notes, if you double the number of experiments you try every year, you’ll double your inventiveness. Seeing product development as a set of scouting expeditions means you’ll always have a portfolio of new initiatives—a “skunk works”—where many fail. But failure just means there’s a different path to success.

Finally, there’s patience. Rewards sit on a spectrum: small, transient wins in the short run; big, revolutionary changes in the long run. Vanguard started the first indexed mutual fund in 1976 with $11 million. The company now has over $1 trillion in assets under management. For years, indexing was called a fad, a marketing gimmick, even un-American. But by being patient, Vanguard has fundamentally changed the money management industry. Waiting longer gives you time to correct initial errors, and to get past the chaos and randomness that characterize the initial phase of any new project.

It’s not enough to be smarter than the competition or to work harder. The world is full of smart, hard-working people, and what used to be called intelligence is now automated. But firms that understand what their customers struggle with and search for innovative solutions will have a powerful advantage. That’s not a moat. It’s a runway.

Source: US Navy

Douglas R. Tengdin, CFA

Chief Investment Officer

Swimming Upstream

What are we missing?

Great Barracuda. Photo: Clark Anderson/Aquaimages. Source: Wikipedia

There’s a story about two young fish swimming upstream who meet an older fish heading downstream. The old fish nods at them as he goes by and says, “Morning boys. How’s the water?” The two young fish swim on a bit. Eventually one of them looks over at his friend and asks, “What’s water?”

Sometimes the most obvious, important realities are the ones that are the hardest to see. Most of what we observe comes from inside us—from how we think about the world, what mental categories we use. It takes a lot of energy for a fish to think about what it’s swimming in.

So how’s our water?

One big issue we ignore is the long-term deflationary trend. The internet is deflationary. As connectivity goes up, prices fall lower and lower. That’s because information can be multiplied for almost nothing. I stream “free” movies off of Amazon Prime because it is so convenient. Wikipedia and Wikimedia are free. Google makes searching for what I want easier than ever. And it’s really simple to compare prices.

The same can be said for global demographics. It’s a truism to say that the world is getting older—that falling birth rates and improved medical care are causing median ages to rise everywhere. But what does this mean? Older folks don’t need as much stuff as younger folks. They don’t need as much housing, they don’t go out as much, they don’t need as much education. Demand falls as populations age.

Source: UN, Wikipedia

It doesn’t matter whether Donald Trump pulls out of TPP or builds a wall, the near-zero-cost of information and aging global population will continue to drive down prices. There’s more supply and less demand. This means that it will be hard for inflation to take off in any sustained way.

This has profound implications for stocks, bonds, real estate, pensions, and all kinds of businesses. The ‘30s to the ‘70s were the age of rising inflation. The ‘80s to the ‘10s were a time of falling inflation. Will the next era be one of low-flation or deflation?

Douglas R. Tengdin, CFA

Chief Investment Officer

Rupee Rumble

What’s happening in India?

500 Indian Rupee note. Source: Wikipedia

Three weeks ago the Government of India declared that all of the current 500 and 1000 Rupee banknotes—the highest denominations—were no longer legal tender. At the same time, the Government issued new 500 and 2000 rupee notes. For reference, 1000 Rupees is worth about $15, and a loaf of bread costs about 25 Rupees. Prime Minister Narendra Modi announced the change in an unscheduled, live television address. In his speech, Modi said that demonetization was designed to crack down on corruption, counterfeiting, and tax-cheating.

Almost immediately, massive lines formed outside banks and ATMs across the country as people rushed to convert their current cash holdings to the new notes. Citizens were restricted to converting only 4,000 Rupees per day, and ATM withdrawals were limited to 2000 Rupees per day.

Photo: Biswarup Ganguly. Source: Wikimedia

The surprise announcement created a lot of confusion. ATMs quickly ran out of cash. Around 400,000 trucks became stranded on major highways across India because drivers did not have enough valid currency. Toll-plazas saw endless lines as plaza operators refused the old banknotes. The Indian stock market fell by almost 10%, while the price of gold in Rupees jumped by up to 30%. Some think this could derail India’s economy—currently growing 7%.

This isn’t the first time India has done this. In 1946, 1954, and 1978 the Government demonetized highly-denominated bank notes to try to hamper the underground economy. But it’s unclear how well this will work now. Much of the black market also operates via bullion, jewelry, and bitcoin. It’s possible that the latest demonetization will prove to be only a speed bump on illegal transactions.

India is a cash economy. Almost everyone keeps a few thousand Rupees in around as a nest egg. 500 and 1000 Rupee bank notes comprised about 85% of the outstanding currency. There will continue to be a lot of disruption as people adjust to the new regime. But India’s underground economy is estimated to be 50% of their GDP. If this brings a significant portion of that black money out into the open, Modi’s bold stroke just might be worth the trouble.

Douglas R. Tengdin, CFA

Chief Investment Officer

Smart Growth

What’s happening to demand for smart phones?

Photo: Alexandre Vanier. Source: Pixabay

Once, it seemed like smartphones would reach everywhere and do everything. But even Apple seems to be running out of room to grow. People will buy around 1.4 billion smartphones this year. That’s up less than 1% from 2015, when sales grew by over 10%. And it’s way down from the earlier part of the decade, when sales were growing by almost 50% per year.

Android phones are still growing. The free operating system is being used by several low-cost manufacturers in China and India—the places where smartphones are still growing. But Apple looks like it will post its first sales decline in 2016—over 10%. Apple’s 5-year revenue growth has fallen in the last two years from over 30% to just 10%.

Apple 5-year revenue growth. Quarterly data. Source: Bloomberg, Apple

I wrote yesterday that trees don’t grow straight to heaven. Five years ago it seemed that Apple would never stop growing—that there were four major asset classes: stocks, bonds, cash, and Apple. And the only correct decision to make regarding those shares was to buy them and never sell them. Obviously, that’s not the case anymore.

Apple share price. Source: Bloomberg

But they’ve grown into a new problem: not enough customers. There are only 7 billion people in the world—and not all of them can afford iPhones. Unless phone makers do something radically new, smartphone sales growth will be limited by the growth of the global economy. It’s time to think different.

Douglas R. Tengdin, CFA

Chief Investment Officer

Investing Rationally?

What do investors want?

Photo: Simon Steinberger. Source: Pixabay

Fifty years ago analysts assumed that all investors should care about is getting high returns with low risk. People who traded a lot, or concentrated their portfolios, or did something other than what conventional finance recommended were labeled irrational.

But what we do seems rational to us at the time. A dress from Filene’s Basement may be just as functional as a $2,000 designer dress, but it may not be as beautiful, or it may not convey the right message those around us. Clothes have a utilitarian purpose, but they also serve our expressive and emotional needs.

The same thing happens when we invest. We want the same things from our investments that we want from the rest of life. We want to feel secure. We want to be true to our values. We want to believe that we can do better. And we don’t want someone taking advantage of us. Our finances should serve these larger objectives – toward the goal of our well-being.

That’s why a company that has no debt, strong management, and a high growth rate may not be a good investment for you if it keeps you up at night. At the same time, we need to know – not just believe – that diversification works: trees don’t grow straight to heaven, and what’s out-of-fashion eventually changes places with what’s in fashion. Investing is an ever-shifting kaleidoscope of fundamentals, trends, and economics.

Artist: Martha Sky Radford. Source: Wikipedia

Behavioral finance teaches us that how we invest can be just as important was what we invest in. Investors want what everyone wants: to feel good about their money.

Douglas R. Tengdin, CFA

Chief Investment Officer

Postmodern Portfolios

What’s the best way to hit your investment target?

Photo: Eddi Laumans. Source: Wikipedia

There’s a school of thought that says people are basically the same: apart from our individual quirks, we all want a little income and a little growth from our investments. So we should combine a balance of stock and bond funds together to have a low-cost, broadly-diversified portfolio.

There’s a lot to be said for this: it’s cheap and it gets people started on the investment process. And people usually get more conservative with their money as they age, so reducing risk by increasing the bond allocation isn’t unreasonable.

But this ignores some important issues. People aren’t all alike. Once you scratch under the surface, we all have very different hopes, dreams, fears, and constraints. And everyone brings a different set of resources to the table: financial, emotional, intellectual, and so on. Using a “cookie-cutter” approach with mutual funds and investment models neglects our unique assets.

Building an investment portfolio is a lot like building a house. We all need shelter, but no two living spaces are alike. Every structure may all have a foundation, walls, and a roof, but the similarities end there. Homes in southern California are very different from dwellings in New England, which is different than the Midwest. And like our homes, our investments need to fit our current lifestyle and future plans. It needs to use the materials at hand to provide resources for the future.

Investing, like all of life, is complex and multifaceted. Managing our money is as much an art as it is a science. Some generalizations may be useful, but at its core all finance is really personal finance

Douglas R. Tengdin, CFA

Chief Investment Officer

Thanks and Thanksgiving

What is Thanksgiving for?

Photo: Chef Sean Christopher. Source: Wikipedia

Oh, I know that millions will be full of turkey and stuffing and potatoes and football, but why do we make a national holiday out of it?

Part of it has to do with remembering our national legends, the self-image we have of pioneers carving out a life for themselves in the wilderness. We imagine ourselves having the initiative, ingenuity, and cooperation that enabled the early Pilgrims to come, learn, and grow in the New World.

Part of it is a celebration of family, both near and far. Thanksgiving is a time of gatherings and traditions. At a time of economic stress and political turmoil, family ties are more important than ever.

And simple pleasures have always been an important part of the holiday. Sports, basic food, and relationships: there’s little controversial or divisive about these icons.

From the moment that Abraham Lincoln declared a “National Day of Thanksgiving” during the Civil War, Americans have paused in November to count their blessings. Sometimes simplest pleasures are best, and the best things in life aren’t things. As we look back at a year of tumult and forward at an uncertain future, let’s give thanks for how far we’ve come, and for all the potential we see in one another.

Douglas R. Tengdin, CFA

Chief Investment Officer

Douglas Tengdin's Global Market Update