The Challenge of Patience

We live in an impatient world.

Photo: Mariordo. Source: Wikipedia

After running our phones down to 1%, we plug them in and expect them to be fully charged in a few minutes. We get frustrated when a webpage takes longer than three seconds to load. We would rather use the microwave than wait for the oven to pre-heat. And if youre going too slow in the left lane well were probably not friends any more.

Our culture lionizes speed: the instant celebrity, fast cars and faster planes, microsecond response times. We prefer fast food to sit-down meals, and ready-to-eat entrees to grocery shopping. We continually feel the pressure to get more done in less time. Learning to be more patient is the last thing on our minds.

But patience plays a critical role for investors. When youre patient, you play a different game than the Street analysts who focus on time horizons measured in months, not years. When youre patient, you give a business time for its fundamentals to assert themselves. Operating earnings, dividends, and a strong balance dont spring up overnight, but theyre far superior than financial engineering. And patience gives you the gift of compounding the magic that can turn a $500-per-month 401(k) contribution into a million-dollar nest egg, if its left to grow in the market at 8%.

The value of patient compounding

Theres a cycle to investing, and to life, that embodies evanescence, or the transitory nature of all things. Those that are full become empty, and the empty become full. The Japanese called this muj, Buddists call it impermanence, and in Latin the phrase is Sic transit gloria mundi thus passes the glory of the world. The grass withers and the flower fades. If you chase the latest hot investment trend, youre like the cat that chases its prey up a tree, onto smaller and smaller branches. Eventually, the branches cant bear the weight, and the cat comes tumbling down.

Patience isnt just about waiting. Its about keeping a good attitude while youre waiting. Just remember: slow food is more nourishing than fast food. And sustainable, profitable firms make better investments than femto-second coin-flips.

Douglas R. Tengdin, CFA

The Ethics of Nudging

Is it ethical to nudge people?

Photo: Polar Cruises. Source: Wikipedia

“Nudging” is all the rage. A nudge is structuring someone’s choice so they make the “right” decision. For example, putting fruit at eye-level in a cafeteria is a “nudge” towards healthy eating. Banning junk food and sugary sodas is not. That’s coercion. Participating in Social Security – at least paying into it – isn’t a nudge, it’s part of our Federal tax system. But the default settings on a 401(k) plan are nudges. You can opt out or have your investments all go into cash if you want, but it takes a little effort on your part. Most people just fall into the defaults.

But is nudging a good idea? Is it right to guide someone in the “right” direction? I see three major issues. First, does nudging interfere with our choices? That depends on the how the choice is structured. If we just have to check a box to opt out of a default, that doesn’t seem burdensome. But if we have to fill out three forms in triplicate, that’s too much.

Second, is nudging too convenient? Does it make it too easy for us to go along with the default option and never make up our minds? In that way, nudging could infantilize us. Again, it depends on how the nudge is structured. If the choice is clear, and the default is clear, it’s hard to argue with changing what the default is.

Finally, does nudging make us better off? That’s a hard question, because we can’t really say what “better” means for everyone. Going back to retirement savings, it may be good for me to save more for retirement – if I can spare the money right now, and if I’m going to be around to collect. But I’m the best judge of my own savings, not some bureaucrat in Washington or Brussels. Nudges can be very effective, even when all the choices are clearly disclosed. The best we can say is that nudging may be pragmatically useful for achieving policy goals that we – through our representatives – have somehow settled upon before.

Any time economists and policy wonks start to talk about “choice architecture” and their ideas of the “right” policy outcomes, I get suspicious. Who put them in charge? But we have to have defaults: something has to be at eye-level in the cafeteria. If the choices are presented honestly and fairly, nudges shouldn’t be a problem. Just don’t nudge us into morally fraught questions – like organ donation or family issues. In those areas, everyone has to take their own choices seriously.

Hypermarket. Photo: Lyza Danger. Source: Wikipedia

For good or ill, nudging will always be with us. Salespeople and marketers nudge us towards what they’re selling all the time. I expect that when I go into a grocery store. We need to be careful, though, when public policy issues are the question. We might end up being nudged right off a cliff.

Douglas R. Tengdin, CFA

Buying Back the Future

Are stock buybacks a good idea?

Photo Viktor Hanacek. Source: Picjumbo

When companies generate extra cash, they can do four different things with it. They can invest in their own business, through capital expenditures, they can invest in another business, via mergers and acquisitions, they can pay dividends to shareholders, or they can buy back their own shares.

Investors tend to like dividends and buybacks. It puts money in their pockets, rather than sitting in the corporate treasury. When excess cash builds up, there’s always a risk that the company will do something foolish with it, like Microsoft buying Nokia – a dying cell phone maker – for over $4 billion. Now Microsoft had almost $80 billion in cash on its balance sheet, so what’s the big deal? But that cash belongs to investors, not management. The stock fell by almost 20% after the announcement.

But are buybacks any better? When companies pay dividends to investors, investors get cash in exchange for a more risky investment. The stock is just a little more levered, but investors now have that cash under their own control. When companies buy back their shares, the stock is more levered, and the remaining investors get … what? An increased ownership stake in a financially more risky company. Is that a good thing?

It’s good if the company continues to perform well. Over the past five years, Microsoft has purchased $43 billion of its own shares, even as revenues grew from $70 billion to $85 billion per year. IBM, by contrast, has bought $44 billion of its own shares, even while its revenues have fallen from $104 to $80 billion. The money IBM has poured into its own stock has disappeared – it’s gone to “money heaven.” Their market cap has decreased by over $50 billion during this time. If IBM manages to turn things around, their buybacks will seem smart. But if revenues keep declining, IBM could end up like Dell – spending over $40 billion for a company that eventually went private for $14 billion. What a waste!

Dell share price. Source: Bloomberg

Big hedge funds love buybacks. They provide liquidity for their positions so they don’t move the market so much when they sell their stakes. But for the remaining shareholders, buybacks are like a call option. If the business prospers, that additional leverage can be a turbocharger the company’s returns. If not, well …

Since 2010, over $3 trillion of corporate cash has gone into buybacks in the US stock market. Time will tell if those call options expire worthless.

Douglas R. Tengdin, CFA

Risk, Reward, and Valuations

Risks, Rewards, and Valuation

Is the stock market risky?

Photo Rhett Sutphin. Source: Wikipedia

Of course it is. Anyone who went through the Financial Crisis or dot-com crash or Long Term Capital crisis or ’87 crash has experienced the gut-wrenching feeling of having significanlty less in savings than they had just a few months before. Nobody likes that feeling.

And the longer you hold onto stocks, the more likely you are to experience a bear market. These can be caused by wars, recessions, panics, and bad policies coming out of Washington. The world seems like an especially risky place right now, with untested political leadership confronting missile tests in North Korea, terrorist threats around the world, intelligence failures, and a stalled domestic agenda.

So why are market valuations so high?

Source: Bloomberg

The expected price-earnings ratio for the S&P 500 – computed by comparing the market’s current market-cap divided by aggregate expected earnings – is 18.5x, above its long-term average. Why – with all the risks that we’re currently facing – is the stock market making new highs?

One reason is earnings. Company earnings are hitting records. Corporate titans like JP Morgan and Johnson & Johnson and Google have never had so much money hit their bottom lines. So S&P 500 earnings are making records, and are expected to grow even more. And all the cash sitting on corporate balance sheets means that these firms have a lot of financial flexibility.

But an even bigger reason is the bond market. With inflation low and stable, bond yields are low and stable, too. Financial assets are ruled by interest rates. It’s one of the first lessons in finance: a financial asset is worth the sum of its future cash flows, discounted to present value by the appropriate interest rate. If interest rates are low, financial assets are worth more.

Does this make stocks especially risky right now?

The short answer is no. Stocks can crash when valuations are rising or when they are falling. They can crash when valuations are high or when they are low. The PE ratio is a poor predictor of market direction, but it’s a decent indicator of long-term returns. High valuations in the early ‘60s were followed by modest returns over the next 20 years; low valuations in the late ‘70s facilitated strong double-digit returns through the ‘90s.

Nothing in life is certain. If we look hard enough or deep enough, though, we can discern some of the broader trends. Equities may be risky, but no riskier than average, it seems. The race isn’t always to the swift, nor the battle to the strong. But that’s probably the way to bet.

Douglas R. Tengdin, CFA

Making Stuff Happen

Where have all the manufacturing jobs gone?

Old shoe factory, Columbus, OH. Photo: Nytend. Source: Wikipedia

Since 1989, manufacturing employment in the US has plunged by 6 million workers – over 30%. But this doesn’t mean the US has stopped making things. Employment has fallen, but output – after a setback during the recession – has continued to grow. In fact, the output of stuff made in the US – cars, engines, advanced machinery – is currently near an all-time high.

Source: St. Louis Fed

Is this good or bad? Employing people is good, but not if it’s unsustainable. US manufacturers have become far more efficient at what they do. Global supply chains now take rare earth metals from Africa to make advanced chips in Texas to apply to circuit boards in Taiwan to assemble iPhones in China. Different areas have different specialties. And our improving productivity adds to global prosperity.

To some extent, this has always been the case. When shoe factories couldn’t operate profitably in New England, they moved to the Southeast and Midwest. When inputs became too expensive there, the facilities moved somewhere else. But new manufacturers also started up, with processes that aren’t as labor-intensive. For the most part, the folks who lost their jobs found other work. But the transition can be tough!

I’ve worked in finance most of my life. I’ve been merged, downsized, laid off, right-sized, and seen lots of other issues. I’ve moved overseas and back again. It seems that banking and finance have many of same issues as manufacturing: pressures on profits, new technologies, and a workforce that constantly has to upgrade its skill-set or risk being left behind. Better skills and higher profitability should lead to higher wages. But it doesn’t always seem to work out that way.

In many ways, today’s job market is like riding a bicycle: you have to keep moving forward or you fall off.

Photo: Octavio Lopez. Source: Morguefile

Douglas R. Tengdin, CFA

Dancing With Giants

Will the big software giants eat the world?

Big Five market cap. Source: The Atlantic

Everyone is buzzing about the big five: Apple, Google, Microsoft, Amazon, and Facebook. Ten years ago, their combined market cap was just under $600 billion. Now it’s almost $3 trillion – a five-fold increase, or 16% per year. This was more than twice the general US market’s return, and three times to global market.

This, in a nutshell, is why active portfolio managers are struggling to keep up with passive indices today. The disciplines of conventional active management – diversification, rebalancing, emphasis on small and mid-cap names – run against concentrated, sector-specific, big-company growth.

But, as Shakespeare said, there is a tide in the affairs of men – and managers. It ebbs and floods, leading to times of feast or famine. We see various investment approaches go in and out of favor all the time. These are the salad days for passive indexing. Before this, dividend growth investing was all the rage. Before that, everyone was a value investor – or claimed to be. Prior to that, global thematic investing was the flavor-of-the-month.

There’s more than one way to skin a cat, and lots of ways to invest. Each approach has its strengths and weaknesses. It’s critical to stick to your discipline – to “dance with the one that brung ya’.” Don’t get discouraged and switch to a new style just because what you’re doing is temporarily out of favor. Chances are, the new model will start to under-perform just as you start to use it.

The most important thing to bring to the market is discipline. And an easy way to be undisciplined, is to change disciplines.

Douglas R. Tengdin, CFA

Drugs, Drones, and Hats

Can drones be used to smuggle drugs?

Photo DB. Source: Wikipedia

It sure looks like it. In 2015 guards rushed to break up a mob in an Ohio prison yard. When they reviewed a security tape, they saw that a drone had flown in and dropped a package containing tobacco, pot, and heroin, which the inmates were fighting over. Increasingly, drones are smuggling drugs, mobile phones, and even weapons into prisons at an alarming rate. Authorities are trying to respond, but this takes time. Prisons haven’t been built with security cameras looking up.

Using drones to smuggle drugs and other contraband is incredibly lucrative. Online cameras and improved navigation and control mean that the drones don’t have to just drop off their goods for whoever gets there first. They can fly right to an inmate’s window. The prisoners then reach out and grab the drone, pull it inside to take the contents, and toss the vehicle back outside in about 30 seconds. One prisoner referred it as Chinese take-out.

A British prison has installed a series of disruptors around its perimeter that jam the control and feedback signals. The system works against traditional operator-run drones, but won’t stop autonomous systems that aren’t radio controlled. And, of course, they won’t stop a tennis ball filled with drugs that’s throw or launched over the prison wall.

Tom Mix. Source: Bundesarchiv

There’s a continual black hat/white hat struggle with technology, where the tools that help us become more productive can also be abused by criminals and creeps. The problem isn’t the tech – it’s the folks who misuse it. Ever since the archer Pandarus shot an iron-tipped arrow to break up a truce during the Trojan War, new technology has been abused. But the black hats aren’t always on top. Somehow, society keeps moving forward.

Douglas R. Tengdin, CFA

The Geographical Imperative

Is geography destiny?

Composite image of Earth’s biosphere. Source: NASA

In 1820 – at the dawn of the Industrial Revolution – per-capita GDP in Western Europe was three times that of Africa. By 1992, it was 13 times as high, despite the catastrophic effects of two world wars on Europe

When you look at a map of global economic development, two significant facts stand out: most tropical countries are poor, and most land-locked countries are poor. Many geographical regions are extremely fertile, despite being both tropical and land-locked. But fertile, productive land hasn’t always led to productive economies.

People have to live somewhere. Where they live affects what they do – and how productive they are. Economic geography can be looked at two ways: the physical attributes of the land itself, and the effects of the land on human productivity – and therefore wealth. The tropics are incredibly productive, biologically. But perhaps they are too productive. The fertile tropics are a breeding ground for human pathogens. It’s hard to be creative or productive when you’re sick.

Source: Gallup, Gavira, and Lora: IADB.

The other important influence of geography on economic growth is its impact on trade. Countries with good harbors and navigable rivers have grown more quickly – and more consistently – than those that are land-locked. In early American history, New York grew more quickly than did Vermont. During the Civil War, it was critical for the Union to secure the Mississippi River so grain from the Midwest could be shipped to global markets.

This doesn’t mean warm, land-locked areas are doomed to poverty. Switzerland is one of the wealthiest nations on Earth, despite being land-locked. But they border several prosperous countries with good ports. And Switzerland specialized in financial services, which don’t depend on the physical shipment of goods for trading. Advances in medicine – and the advent of air-conditioning

Attention Deficits

“You just don’t understand.”

Photo: Jeremy P Gray. Source: Jeremy P Gray Photogrophy

When a spouse or close friend tells you this, pay attention. Chances are there’s something important going on. But when you’re looking at an investment and the seller says this, grab your wallet. Either they’re pulling one over on you, or the investment idea is too complicated for its own good.

Over the past decade dozens of companies have maintained that their business was too sophisticated for the average person to comprehend. Lehman, Petrobras, SnapChat—they were all touted as harbingers of a new way of doing things. But the great investor Peter Lynch once said that you should try to buy firms that any idiot can run, because eventually one will. If the business plan can’t be written out in crayon, it’s probably too complex.

ETF Patent Diagram. Source: US Patent Office, Google

A big part of what makes people nervous about the market is the complex nature of the instruments sold by Wall Street. During the housing bubble junk mortgages were put into Rube Goldberg financial structures to try to spin sub-prime straw into AAA-rated gold. When they failed, they took the economy down with them. Now we have wacky Exchange Traded Funds that focus on cancer cures or stock tickers that start with the letter “Q.” Whatever the product is, it’s critical to know how it works.

When family or friends tell you that you don’t understand, it’s time to listen up. When someone in the market says the same thing, it’s probably time to walk away.

Douglas R. Tengdin, CFA

Accounting or Sales?

Is this glass half full? Or half empty?

Photo: Viktor Hanacek. Source: Picjumbo

Sales types look out and see infinite possibilities. Accountants see the world as debits and credits, as a process to be managed. Sales-dominated organizations emphasize growth; accounting-centric firms focus on profitability. Put simply, sales brings in the dough, while accounting gets to the bottom line. Both are necessary to any successful enterprise. But there’s often a lot of conflict between the two.

Sales people can feel like they own the business. After all, if there isn’t anything on the top line, there won’t be any bottom line. And they often have to deal with hostile competitors and regulations to get to reluctant customers who never seem to return their calls. But accountants can feel like they manage the business. Without proper accounting, payments can’t be processed, bills and payroll won’t get paid, reports aren’t filed, investors and lenders will cut off funds, and no one has a job. Both sides need the other, and need to respect the essential role everyone plays.

Photo: Jon Sullivan. Source: PD Photos

The same is true in a diversified investment portfolio. Some companies emphasize growth. They’re continually improving their revenues. They’re in areas that are rapidly developing, like technology or robotics. Their top-line growth is unbelievable. Sales people there are ascendant. Other firms focus on profitability. They’re able to squeeze more money out of stable or even shrinking markets. Their margins are incredible; everyone wants to know how they do it. In those firms, accountants rule, and for good reason.

But no one can afford to be smug. Successful firms balance the top line and the bottom line. They put the right incentives in place so revenues grow, and they make sure those revenues cascade through their financial statements so everyone benefits. And successful portfolios grow too, but they grow with efficient companies that have sustainable processes, that won’t flame out in a year or two.

Optimists see the glass half full; pessimists see it half empty. But seen correctly, it’s balanced. And no bigger than it needs to be.

Douglas R. Tengdin, CFA