Inverting To Success

“Invert, always invert.”

Leonardo Da Vinci’s “Vitruvian Man.” Source: Wikipedia

That’s what the 19th century German mathematician Carl Gustav Jacobi said when approaching particularly vexing problems. He made advances in elliptical algebra, number theory, and differential equations. The Jacobi identity and Jacobian sum are named after him. And mathematicians still use the Jacobi Inversion method.

Stated simply, inversion means to assume the opposite of the problem you’re trying to solve, and look at what goes into that answer set. For example, if you’re trying to foster innovation at your company, you could think of all the things you could do to be more innovative. But that’s a tough job: it’s hard to come up with creative ways to be more creative. But if you think of all the things you could do to discourage new ideas, it’s easy to generate a list: reinforce backbiting and sniping; allow meetings to be start late and be rushed, insist that new teammates “learn the ropes” before making suggestions, and so on.

Consider inversion backward reasoning: consider where you don’t want to be, and think backward from there. Most of the time we live moving forward, looking out the windshield far more often than in the rear view mirror. That’s why we have admonitions like the Hippocratic Oath’s dictum to “first do no harm”: we have a bias towards action. When faced with a competitive threat, we ask what we can do about it.

But sometimes the best thing to do is nothing. That was certainly true during the Global Financial Crisis. Folks who panicked and sold, say, after Lehman went bust would have had to get back into the market by the middle of 2009 – when many voices were calling for yet another downward thrust. If you want to avoid losing money, don’t panic when the market falls.

10-year S&P 500 weekly chart, log scale. Source: Bloomberg

Think of inversion thinking as an anti-stupidity tool. It helps us avoid self-inflicted errors. If we don’t want an unethical organization, we’ll inculcate moral factors in every decision we make. If we don’t want a conformist culture, we’ll encourage dissent and discussion at our meetings.

In art, a reflection can be more powerful than the original image. The notes around Leonardo Da Vinci’s famous “Vitruvian Man” illustration – and much of his other work — are in mirror writing. They’re only legible if you hold them it in front of a mirror. No one knows why Da Vinci did this. But sometimes the hardest problems can only be solved if you look at them backwards.

Douglas R. Tengdin, CFA

Eating Failure’s Lunch

Do half of all new restaurants fail in their first year?

Photo: Dick Terry. Source: Morguefile

Starting a new business is hard. There are regulations, suppliers, labor issues, insurance, bookkeeping, and countless other issues. It seems like there are a million ways to go wrong, and just one lonely road to success. You need a plan, you need drive, and most of all you need customers – customers that your competitors also want.

Because of all these issues, it’s commonly claimed that most start-ups fail in their first year or two. This assertion even made it into a 2003 “Do you know me?” American Express commercial. The high first-year failure rate is often repeated by franchisors, who may cite it as a way to encourage would-be entrepreneurs to use their services – and to pay their franchising fees.

But it turns out, the high first-year failure rate is an urban legend – a self-serving story that gets repeated so often that it is assumed to be factual. A couple of researchers looked at 20 years’ worth of Bureau of Labor Statistics data for almost 2 million independent businesses, including 81,000 restaurants in eight different states. They found that 83% of restaurants survive their first year, and the median survival time is 4.5 years. That’s actually higher than the average for non-restaurant service businesses.

Source: Luo and Stark study

The hospitality industry has been expanding, and the number of restaurants has been growing almost 2% per year for the past several decades. It would be almost mathematically impossible for the industry to grow steadily and also have such a high initial failure rate.

But since restaurants open and close all the time, it may seem like the turnover is higher than it really is. And making it in the food business isn’t easy, no matter what the numbers may show. One of the most important elements of any startup is maintaining a healthy work-life balance. Many failed restauranteurs have attributed some of their failure to personal issues, such as divorce, ill-health, and not wanting to miss seeing their children grow up.

Starting a small business is risky. Many things can go wrong. But if you have a great idea, a good product, and a committed team, the dream be worth the effort. As high-school dropout Walt Disney once said, “If you can dream it, you can do it.”

Douglas R. Tengdin, CFA

Lost in Translation?

Do currency exchange rates matter?

Brazilian Real priced in Dollars. Source: Bloomberg

More and more companies do business around the world. Toothpaste-maker Colgate-Palmolive has 30% of its sales in Latin America, but only 20% of its assets there. About half of their long-term assets are in Europe and the US. Clearly, they’re a global company with a global brand focused on basic needs. Their worldwide revenue growth has fluctuated, but their value has definitely grown over time. The shares have returned about 13% per year for the past 30 years.

But how do they get there? Under our accounting rules, foreign-currency transactions are essentially marked to market using the current exchange rate. Gains and losses – both realized and unrealized – are included in reported income. Foreign currency translation adjustments are broken out in a separate line item.

Because Colgate operates around the world, it has many functional currencies. These all have to be translated when the company reports its consolidated earnings. This can lead to some distortions. In 2014 and 2015 they reported over $600 million in losses because of the strong dollar. Their non-US operations didn’t return as much in dollar terms because those currencies have been falling. But is it really the case that the value of those businesses fell?

The answer has to do with the balance sheet. Because almost all of the company’s borrowings are issued and payable in dollars, there is some risk that a falling dollar makes it harder for them to service the debt. In theory, a company can hedge their borrowings through currency swaps and other off balance sheet activities, but – in Colgate’s case – gains from swaps don’t fully compensate for the currency translation losses. But the risk is small: the company is worth $72 billion, and only 8% of that is from debt – and very little is short-term debt.

Colgate Capital Structure. Source: Bloomberg

People often mistake accounting for bookkeeping. They think that financial statements are like a checkbook balance – you just have to add up the categories to get the final number. But accounting is more art than science. It’s critical to understand the assumptions that go into the calculations. Translation risk is real, and shouldn’t be ignored. But foreign currency effects aren’t likely to be sustained for more than a year or two, and may create market opportunities, if analysts are superficial in their treatment of a company’s bottom line.

There’s no substitute for careful, fundamental analysis of a company’s structure and operations. Too much aggregation can be hazardous to your financial health.

Douglas R. Tengdin, CFA

Technological Feudalism

Technological Feudalism

Are we technology serfs?

Reeve and Serfs harvesting wheat. Source: British Library

In the Middle Ages, serfs were tied to the land. They weren’t slaves—it was worse. They and their descendants were perpetually bound to their Lord’s estate. They couldn’t just leave. If the Lord wanted different crops, the serfs had to plant them. If the Lord went to war, the serfs had to take shelter. The nobility had a lot of privileges but very few responsibilities. In exchange serfs got security, of a sort: by storing the harvest in the Lord’s castle, raiders couldn’t just steal all their food.

In the tech world today, we are bound to our technological Lords—Apple, Google, Microsoft. We let them gather our data and we hoping they’ll keep it safe. They do maintain some kind of order—looking out for virus-infected apps, or protecting us from other data dangers. But they really are like feudal lords.

And they exact a price. They control the social space around their products; it’s difficult to have an email account not linked to the cloud, it’s hard to get your resume out if you’re not on LinkedIn. And they reserve the right to change the rules of the game, updating operating systems, installing security patches, even rebooting our machines in the middle of the night.

Companies like Facebook and Google insist our data is theirs, to do with what they will. Maybe it has been. But data, like land, can revert to its original owners. Is it time for a data jubilee? Will the serfs rise?

Douglas R. Tengdin, CFA

Running With The Herd

Are investors just herd animals?

Source: South Dakota Department of Tourism

Investors have to wrestle with lots of issues—economics, financial reporting, asset structure, valuation—but perhaps the most difficult factor they face is their own nature. People are naturally social creatures, something Aristotle noted 2500 years ago. We like to do what other people are doing. Going against the crowd can feel like standing up against a herd of charging buffalo.

But strategists have long seen the advantages of going against popular opinion. “Never follow the crowd,” Bernard Baruch says. Sir John Templeton put it this way: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” We need to buy when most people are pessimistic and sell when they are optimistic.

The past 20 years have seen this borne out twice in the US: once during the internet boom and bust, and then again during the housing boom and bust. Lately there’s been a bubble in “bubble spotting”: looking for investments inflated by optimism and leverage, as investors try to avoid the fallout when they pop.

Portuguese Stock Exchange. Source: Bloomberg

But the very fact that people are looking for bubbles means bubbles are less likely to form. We may be social animals, but other investors are our competitors. Just because a stock has gone up a lot doesn’t mean it’s going to go right back down. From 1975 to 1990 the shares of Wal-Mart grew by over 100 times. But if you waited for that “bubble” to burst, you were disappointed. The stock grew another 10 times over the next ten years. And their fundamental value proposition – people buying essential goods at low prices – has allowed the share price to stay around that level since.

Wal Mart Shares. Source: Bloomberg

That’s why it’s so difficult to invest. You don’t want to miss out when someone is doing something especially innovative that provides value. But you also don’t want to just follow the herd – especially when its headed off a cliff.

Douglas R. Tengdin, CFA

Motoring On

Where is the economy headed?

Photo: Thomas Nilsson. Source: Pixabay

Market-watchers are always looking for insight into what’s happening in the economy. It’s important to separate the signal from the noise. We can easily get distracted by politics, headline news, and our personal perspective. If you have a friend who can’t seem to find a job, it’s easy to conclude that the economy isn’t creating many jobs – even though your sample size makes the observation statistically irrelevant.

But one economic factor that has a lot of statistical relevance is auto sales. Consumer purchases drive the economy, and consumers don’t go out and buy a new car (or light truck) if they don’t feel very good about their personal finances. Yes, we also respond to short-run incentives, like “cash-for-clunkers” or special financing terms. But gradually rising auto sales are a good indicator of the long-run health of the consumer. It’s hard for the economy to turn down when auto sales are rising.

And what are sales doing now? Automakers just achieved a record seventh straight annual sales gain – one of the longest strings of annual increases ever.

Total US Auto Sales. Source: St. Louis Fed

In the past, a quick recovery in sales was followed by gradual weakening. But coming off of the deep decline in sales during the 2008-9 recession, consumers have increased how many cars they buy each year for the past seven years. December’s strong sales put 2016 over the top – despite a modest fall early in the year, a late-year push lifted 2016 sales to 17.6 million units, 0.4% above 2015’s level.

At this point, it’s probably a mistake to assume auto sales can continue their uninterrupted rise. While strong consumer confidence should keep sales at these high levels, all kinds of other factors can get in the way. There are a lot more used cars in the market now – and their prices are falling. In December, manufacturers offered a lot of incentives, something they say they won’t do again. And there are only so many car buyers out there.

Still, it’s encouraging to see all the new car sales. Driving a new car off the lot makes people happy. And happy consumers often lead to a happy economy.

Douglas R. Tengdin, CFA

Chief Investment Officer

Charter Trust Company

Xi Loves Pencils

Where do pencils come from?

Photo: Daniel German. Source: Wikipedia

In 1958 economist Leonard Read wrote a charming essay entitled “I, Pencil” about the miracle that the humble pencil represents: wood, zinc, glue, and graphite combined in a form that makes writing possible. There’s no hive-mind directing the countless individual actions necessary to bring pencils into being. Rather, individual shippers and machinists and miners and foresters work in their own individual interests, and their know-how is organized to offer a coherent product—at a miniscule price.

Over the years, comparable presentations have been written and produced: “I, Smartphone,” “I Toaster,” even “I, Whisky.” The point is the same: the spontaneous organization of individual interests to create complex products based on what we want is little short of a miracle. Four hundred years ago Thomas Hobbes wrote that mankind’s state of nature would be a “war of all against all,” with people living lives that were poor, solitary, nasty, brutish, and short.

Engraving: Abraham Bosse. Source: Library of Congress

But the lesson of “I, Pencil” is that we have incredibly creative energies that need merely be organized to provide a seemingly infinite number of delightful products.

It’s worth keeping in mind as we look at potential trade restrictions and tariffs. Last week China’s president Xi Jinping made a speech in Davos, Switzerland defending the world’s liberal economic order against the dangers of protectionism. Trade has helped hundreds of millions of people rise from poverty to plenty—and allowed consumers to purchase pencils for a few pennies each.

It may be that the protectionist voices we hear today are just rhetorical devices necessary for driving better deals. But let’s hope the rhetoric doesn’t become reality. An essay entitled “I, Protectionist” would not be so charming.

Douglas R. Tengdin, CFA

Charter Trust Company

Super-Size Me?

How big is too big?

Woodblock of a sumo wrestler in Japan. Public Domain Source: Wikipedia

80 years ago the Nobel Prize-winning economist Ronald Coase set out to explain why people organize themselves into businesses, firms, and corporations rather than just freely trade goods and services amongst one another. If Adam Smith’s “invisible hand” is so efficient, why don’t we all organize ourselves independently?

The economic answer has to do with efficiency. It’s cheaper to build a company around one product or service and aggregate the inputs and outputs needed to get the product to market, rather than everyone negotiating every little detail with everyone else. With a large and complex system like an automobile, there are millions of parts and systems, each of which must be designed and built to precise specifications. It would be too inefficient for the billions of transfers to be negotiated independently.

Transactions costs can be lowered dramatically by bringing them into a single firm. When this works, it works beautifully: an engaged workforce creates and produces something the sales-force can market effectively, gathering feedback from customers as they go, funneling this to an R&D group that solves problems imaginatively.

But nothing fails like success. Small firms that innovate effectively grow into behemoths that become caricatures of themselves: cubicle farms straight out of “Dilbert.” That’s partly why there’s investor skepticism around giant companies: no tree grows straight to heaven. Mega-firms create mega-administrations and bureaucratic nonsense: Soviet-style “republics” where meeting the plan and planning the meetings are far more important than innovation and customer service.

Efficiency then leads to inefficiency, creating opportunities for new competitors to enter a market and provide better products at cheaper prices. That’s why small cap stocks outperform large caps over the long run. The firms grow faster, but they’re also riskier. Money isn’t wasted on paperwork and corporate politics, but there isn’t as much of a safety net if things go wrong. The higher risk is the price investors pay for the extra return.

Stocks, Bonds, Bills and Inflation 1926-2016. Source: New York Life

Someone once asked Abe Lincoln how long a man’s legs should be. His answer was simple: long enough to reach the ground. In the same way, we might ask how large a company should be. The answer is equally simple: large enough to be efficient—and no larger.

Douglas R. Tengdin, CFA

Chief Investment Officer

Charter Trust Company

High (Financial) Anxiety

Do your finances keep you up at night?

Photo: Bhoj Rai. Source: Unsplash

Researchers have found that folks often fall into six common errors when they deal with their money: risk-takers, hoarders, retail-therapists, cash-splashers, controllers, and avoiders. Each of these mistakes is avoidable – and they typically stem from personal issues that have little or nothing to do with money. Instead, they may be compensating for some personal needs they have.

Risk takers have a bias towards action. Given a choice between waiting and doing, they almost always choose to do something. They tend to be overconfident, and trade frequently. Paradoxically, they don’t usually measure their performance in any tangible way. That’s because they’re focused on the next opportunity, rather than learning from the past. Trading fires up the endorphins in our brain; it can be addictive.

For hoarders, money represents security. They often stockpile cash rather than invest it. If they were raised at a time when money was tight, they may find security in a large bank account. While we all need an emergency fund, there’s no reason to let cash build up excessively. At a time when interest on bank deposits doesn’t even equal inflation, the real value of cash is steadily eroding.

Retail-therapists feel good about shopping: shopping makes them happy. They don’t even have to buy things for themselves. Just pulling out their credit card can boost their self-esteem. At the extremes, these folks resemble alcoholics—stashing bags of new purchases around the house, the way problem drinkers stash empty bottles. Both women and men can indulge themselves this way. These folks often end up with debt problems.

Cash-splashers are conspicuous consumers, and it’s the having, not the getting, that’s the thrill. They are likely to wave their checkbooks at charity auctions, and spend money on visible, frivolous things. They’re unlikely to quietly go to the front of a restaurant and quietly cover the tab. Rather, they’ll make an announcement that the meal is on them. Often, these people are motivated by wanting to be admired. But there’s nothing admirable about showing off.

Public Domain. Source: Pixabay

Controllers are obsessive about bank balances, credit card points, and comparison shopping sites. They want to keep on top of money matters, but sometimes this is because they have lost control in other areas of their lives. And – let’s face it – life can be unpredictable. While keeping on top of money matters is a good thing, controllers can make it too much of a good thing.

Finally, there are the avoiders: ostriches who bury their heads in the sand. Bills and bank statements lie unopened. Either they are easily distracted, or they don’t want to decide, because making no decision is always easier than the possibility of making the wrong decision.

The way to break out of these habits is to have a plan and stick to it. Start by keeping a money journal, and make entries for purchases and investments. Work into it gradually, starting by reviewing your finances for a half hour every week or so. This may be like shock therapy to a controller, but the rest of the people on this list need to address – not avoid – their money issues. Ultimately, you want to have a budget – one that includes long-term investments, as well as categories for day-to-day spending.

Photo: Michael Jarmoluk. Source: Pixabay

Because the most meaningful things for us come from experiences we share. And they don’t have to be expensive – like going to the park or the library with kids, or cooking a meal for friends. As Art Buchwald – the political columnist and satirist – once said, the best things in life aren’t things.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Death of Retail?

“the report of my death was an exaggeration”

Photo: A.F. Bradley. Source: Library of Congress

 That’s how Mark Twain responded to a story that he was dying of poverty while on a visit to London. He was undecided whether to be annoyed or amused. He was just 62 at the time, and while a little frail, was in excellent health. A cousin of his – James Ross Clemens – had been seriously ill, and the papers confused the two. The report of Twain’s illness grew out of his cousin’s illness, who soon recovered.

 That’s how I feel when I read reports about the “death” of retail. Amazon and other online retailers have certainly taken a bite out of traditional stores. JC Penney is on bankruptcy watch. And Sears – with 1,600 outlets – is also in the retailing dead-pool. They’re projected to lose $2 billion this year. Their CEO, hedge fund executive Eddie Lambert, has been selling off well-considered brands like Craftsman to raise the cash they need to adapt to today’s internet marketplace. But it’s unclear whether he will run out of cash before they can adjust.

 The outlook isn’t good. Sears’ stock price has fallen to under $10 from almost $100 seven years ago. Revenues have dropped to $25 billion, while Amazon has sales over five times as large, with just 30% more employees. Comparable store sales fell 12-13% at Sears this Christmas. I did almost all my Christmas shopping online this year. It’s just so much more convenient than fighting holiday traffic and waiting in long lines at the checkout counter.

 But brick-and-mortar stores aren’t going away. There’s no law of nature that says Amazon has to be the only online retailer. Amazon appears to know this: their free-shipping membership, Amazon Prime, increasingly offers other services, like streaming music and movies and online photo storage, to keep customers loyal. And there’s this little detail: we want our stuff—now. Sellers have to have a way to get it to us as quickly as possible. Sears has 1,600 distribution points already. They just have to figure out how to make them profitable.



Retail has always been a fast-changing field. 20 years ago the big-box stores were eating the world, now it’s Amazon. A century ago catalog merchants – including Sears – revolutionized the industry. Now it’s online and mobile apps. CEO Eddie Lambert has been famous for his financial engineering, with rights offerings and trigger loans designed to get him the capital he needs, when he needs it. But Sears needs to answer a harder question: how to get us all the retail goods we want when we want them.

Douglas R. Tengdin, CFA

Chief Investment Officer