Rumors of War

What happens when an irresistible force meets an immovable object?

Map: US Army. Source: Wikipedia

That’s an old philosophical question. The answer, of course, is that no force is really irresistible and no object is truly immovable. But when they seem that way, spectacular conflict can be the result.

That was the case during the 5th century BC in Greece. Sparta had been the dominant power in Greece. They had a militant, military culture built around their army. Athens was a rising power. It had a commercial culture and a powerful navy. What made war between the two city-states inevitable, according to the ancient Greek historian Thucydides, was the growth of Athenian power and the fear which this caused in Sparta. The immovable object was Sparta. The irresistible force was Athens. The Peloponnesian War was the result.

The Thucydides Trap is a conundrum that’s been studied by the historian Graham Allison. He found 16 instances of a dominant nation threatened by the rise of a growing power. Twelve of those sixteen cases ended in war – the most destructive of which was the rising industrial power of Germany challenging the British Empire in the early 20th century. That did not end well.

Today, the rising power is China. The dominant nation is the US. After the Cold War, the US was left as the world’s sole remaining superpower. Western political and economic institutions became so dominant that Francis Fukuyama declared that liberal democratic capitalism was the “end of history” – that there was no comparable, coherent system.

But the rise China threatens this Pax Americana. They have a fast-growing economy, a rising middle class, and the desire to be taken seriously on the global stage. They are now the world’s largest producer of ships, steel, aluminum, autos, cell phones, and computers. Baidu rivals Google as the world’s largest search engine. Alibaba rivals Amazon as the world’s largest online marketplace. Conflicts at sea, in space, in cyber-space, and in trade are all possible, and need careful, cautious management.

War doesn’t always happen when a rising power displaces an established power. The UK took the long view in the 1890s when President Cleveland accused the Salisbury government of establishing a new colony in Venezuela, violating our Monroe Doctrine. Britain backed down, and agreed to go to arbitration rather than war. Our special relationship with England has been the result.

Public Domain. Source: Wikipedia

War isn’t inevitable, but war has happened 12 out of 16 time with the “Thucydides Trap.” If we do business as usual with the Chinese, we may end up with history as usual. Let’s hope not.

Douglas R. Tengdin, CFA

Modern Portfolios

What’s the best way to put a portfolio together?

Photo Andrijko Z. Source: Wikipedia

Modern Portfolio Theory was born in 1952, when Harry Markowitz published his famous (and first) paper, “Portfolio Selection.” He won the Nobel Prize for his insight, which incorporated risk as a critical element of investment portfolio design. The key insight is that an asset’s risk shouldn’t be assessed in isolation, but in the context of how it contributes to a portfolio’s overall risk and return.

Return is easy to calculate. It’s just the weighted average of the returns of the assets in the portfolio. But risk is trickier. First we have to define it, then we have to measure it. For most people, risk is the likelihood that they will lose money. So short-term Treasury Bills have little risk, as do bank deposits less than the FDIC-insured maximum. On the other end of the scale, volatile assets – like small-cap stocks or commodities – are much more volatile. There’s a far greater probability that they will go down in price, just when you need them.

Small Cap stock return distribution. Source: Bloomberg

We can compute the probability of loss by calculating the variance of the returns. While no one worries about upside risk – the chance that a portfolio will do better than expected – the fact is that upside risk goes along with downside risk. But a portfolio’s risk isn’t just the average of all its constituents’ risk. You also need to consider how correlated those returns are. That was Markowitz’s key insight: by combining assets that weren’t perfectly correlated, investors could reduce their portfolios’ overall risk. So the three major elements that go into portfolio construction are return, risk, and correlation.

This is fairly simple when you just look at two assets. But the more assets you add, the more complex the math becomes. Still, the insight is intuitive – and profound. By assembling a portfolio of non-correlated assets, investors can have higher returns for a given level of risk – or lower risk, for a given level of returns. In fact, the insight was so novel back in the ‘50s that Markowitz almost didn’t get his Ph.D. for his dissertation – which became the basis of his Nobel Prize-winning contribution. One member of his thesis committee argued that his contribution wasn’t Economics, so they couldn’t award him a degree in Economics.

Efficient Frontier. Source: Wikipedia

It might not have been part of Economics back then, but it is now. Every investor should understand that not all risk is bad risk – depending how it fits in with the rest of your portfolio. The most important thing about diversification, though, is not to give up on an asset class just because it doesn’t seem up to scratch. Chances are it will turn around just after you sell it. Diversification works, but only if let it work.

Douglas R. Tengdin, CFA

Roses for Education

Will education solve our problems?

Photo Viktor Hanacek. Source: Picjumbo

Economists of all stripes trumpet education as a key to improving economic outcomes. Whether it’s literacy, math skills, or the ability to write computer code, our society has become so technological, they state, that an extensive – and expensive – education is necessary to thrive in today’s world.

This is nothing new. Education has been considered crucial to society since Plato wrote The Republic 2400 years ago. In fact, he thought that a complete education would take about 40 years. Thank goodness we haven’t gone that far – at least, not yet. For Plato, the main goal of education was moral, not technical. But it’s striking that a well-rounded education was considered critical way back then.

Fast forward to the post-colonial developing world in the late 20th century. These countries invested in public education, calculating that well-trained workers would get jobs in the developed world and send money home, lifting their native economies. But the developed nations didn’t always go along with the plan. Folks in the US and Europe don’t like losing their jobs to foreign competition, even if the immigrants are highly skilled. So these highly educated engineers and business majors ended up selling fruit and flowers on the street. It should be no surprise that they found something else – revolutionary – to do with their minds, and time.

Tahrir Square, February 11, 2011. Photo: Jonathan Rashad. Source: Wikipedia

Two centuries ago, William Blake wrote that “the modest rose puts forth a thorn.” Education can lift the economic potential of any society. But if the economy fails to fully employ its newly minted human capital, serious unrest will be a thorny issue.

Douglas R. Tengdin, CFA

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