Tag Archives: Growth

Investors from Mars and Venus

Can we ever understand one another?

Photo: Amshudhagar. Source: Wikipedia

In 1959 English novelist C.P. Snow gave a lecture on “The Two Cultures,” bemoaning the lack of understanding between literary intellectuals and scientists, between science and the humanities. At the time, folks were worried that scientists had never read Shakespeare or Dickens, and that the Atomic Age would usher in a technocratic tyranny, along the lines of Huxley’s “Brave New World.” But to these humanities scholars Snow asked, “Can you describe the Second Law of Thermodynamics? Or what is meant by mass and acceleration?” In other words, can you understand basic physics? The lack of understanding isn’t just on one side.

Snow was concerned that the ignorance of science by people educated in the humanities would limit the benefits of technological progress. His influence was so great in England that he was offered what amounted to a Cabinet post. There was controversy around the idea, but the notion of “two cultures” persists – with much of liberal education trying – and failing – to bridge this gap.

Investors also experience a sort of “two cultures” debate – between value and growth investing. These two approaches are sometimes caricatured. Value investing has been defined as finding half-smoked cigar butts on the street and taking a drag, or as dumpster diving in the stock market. Growth investing, on other hand has been described as “buy high, and sell higher,” or as momentum investing. Value investors are thought of as painstaking, cautious, and obsessed with a margin of safety, while growth investors are portrayed as fun, go-go trendsetters focused on finding tomorrow’s winners that would be “cheap at any price.” The value/growth dichotomy is reinforced by analysis that divides the market into style-boxes: a matrix of small, mid, and large companies that are value, growth, or a mix.

Source: Moneyandmarkets.com

Often the two camps criticize each other, citing academic studies and investment gurus to support their respective cases.

But the purpose of investing is to make money, not score debate points. There’s more than one way to skin a catfish, and there are lots of ways to assemble a profitable portfolio. In fact, there are as many different portfolios as there are investors, depending on return requirements, attitudes about risk, time horizon, liquidity needs, and so on. Every investor has a unique financial and psychological profile. Their investments would no more fit into a style box than they themselves fit into personality-box.

Both growth and value styles have their place in money management—just as humanities and science education do in the University. They key in both cases is to keep growing.

Douglas R. Tengdin, CFA

Pennies from Dividends

What good are dividends?

Public Domain. Source: PD Photo

It’s a good question. Dividends can limit a company’s options, forcing them to cough up cash that could be used to run the business. If they money flows out of the company, they might have to increase their borrowings. Ford paid a big special dividend in 2000—they called it their “Value Enhancement Plan.” Management probably wished they still had that cash a few years later during the financial crisis.

You’d expect that paying dividends would make those companies more risky. But in fact, the opposite is the case. It turns out that the stocks of dividend-payers are less volatile than non-dividend payers. Why?

Part of the reason is the accountability. When a company pays a dividend, they have to come up with cash every quarter. This keeps them from doing anything too foolish. Investment bankers can cook up some awfully creative structures. Dividends require a certain amount of management discipline. Second, dividends are totally transparent. You’ll never hear about an accounting scandal where dividends were misstated. Earnings, cash flow, and even revenues can be fudged, but if a company says it’s paying a 50-cent dividend, there better be a check for 50 cents per share in the mail.

Finally, dividends are an admission by management that the shareholders—not the managers—own the company. If a company generates free cash flow—the cash from operations that remains after capital expenditures—it can do three things with the money that directly benefit investors: pay down debt, buy back shares, or pay dividends. Because boards are reluctant to cut them, dividends represent a concrete statement of faith—by those in a position to know—in the company’s stability and potential for growth.

Photo: Emmanuel Douzery. Source: Wikipedia

It’s easy to get distracted by PE ratios, Sharpe ratios, cash flow yield, and other metrics. These are important, but we should never forget that a stock represents a real company making real business decisions. When companies decide to give consideration to their shareholders, that’s always a good thing. After all: ultimately, it’s our money.

Douglas R. Tengdin, CFA

Chief Investment Officer


Why is the economy growing so slowly?

Source: St. Louis Fed

Since the Great Recession, the economy has never gotten back into high gear. We’ve always seemed to be teetering on the edge of another downturn. Quarterly economic growth has averaged 2%, while a normal recovery is usually above 3.5%. Why?

First, the workforce is changing. We are now entering the period where baby-boomers are beginning to retire. Like most things the boomers have gotten involved with, they are transforming retirement. Their family finances may be stretched by having debt from putting kids through college, or because one in four have adult children living with them. Also, the changing nature of health care is changing everyone’s work patterns.

Second, there are some special factors that have made this recovery more difficult. Because the boom was in housing—creating oversupply—lower interest rates have not been able to stimulate the homebuilding sector very much. The Euro crisis and China’s economic restructuring have put a serious dent in demand for US exports. Long-term financial challenges in the States have reduced government hiring.

GDP Composition. Source: FRB Richmond

Finally, there are some long-term trends in productivity that began about 10 years ago. Growth in technology has been centered around software—an informational product—which doesn’t get consumed when someone uses it. My web-search doesn’t prevent you from searching the web. There’s also evidence that much of our newest economic activity isn’t being measured. For example, more pictures are being taken than ever before. But the GDP contribution from photography has actually plummeted over the last decade, as many people use smart-phones to take, upload, and share photos. This is a way that the measured economy is depressed by new technology.

There’s no magic here. Our slow-growth economy hasn’t developed because rates are too low or the Chinese are stealing our jobs or unicorns in Silicon Valley are too greedy. If we want to get the economy moving again, we need to encourage what creates economic growth in the first place: innovation, ingenuity, and productive people.

Douglas R. Tengdin, CFA

Chief Investment Officer

Chinese Fortunes

What’s happening in China?

Forbidden City in Beijing. Photo: Saad Aktar. Source: Wikimedia

Anyone who wants to understand the global economy needs to have a sense of what’s happening in China. China has the second largest economy in the world–almost 2/3rds the size of the US. Last year they grew more than the US and Europe combined. They’re essentially tied with Canada as our largest merchandise trading partner, providing 15% of our imports and exports–$300 billion worth.

So what happens in China affects the United States, and what happens in the US affects China. And for the past decade China has been restructuring their economy. They are shifting from an export-oriented development model to a service-based internal orientation. And it takes longer to ramp up service production than to build factories and export cheap goods, so China’s growth has down-shifted. For thirty years China had average 10% growth per year, but since 2010 they’ve grown just a little more than half that rate.

Chinese Real GDP Growth, 1979-2015. Source: China National Statistics Bureau, Bloomberg

This is disruptive. For three decades China has pursued a path of economic liberalization within a socialist framework. The economic reforms that began during Deng Xiaoping’s regime have increased the opportunities for hundreds of millions of Chinese peasants, who often leave their ancestral homes to relocate where they can find better jobs. But when the plan changes, people have to adapt. But it’s not that easy to change the expectations of hundreds of millions of people.

As a result, China’s market has been volatile. It’s had short bursts of dramatic growth, followed by years of contraction and stagnation. The central government wants to open up the economy without giving up political control. The economy and the market are experiencing growing pains, as China’s leaders struggle to get their institutions and incentives aligned properly.

Shanghai Composite Index, 2000-2016, Log scale. Source: Bloomberg

China is too big to ignore but too young to depend too much on. They’re trying to get the benefits of free markets without the cost of political turmoil. But it’s unclear if you can have one without the other. Not matter what happens in the immediate future, China’s role in the global capital markets will only grow.

Douglas R. Tengdin, CFA

Chief Investment Officer

Incomes and Outcomes

What can investors do about low rates?

Source: St. Louis Fed

Low interest rate around the world are challenging investors and savers everywhere. And it isn’t just households: state and local pension funds—once fully funded—are now underfunded by almost $2 trillion. With expected returns so low, governments and employees are being called upon to increase their contributions to make up for the shortfall. The resulting strain on public budgets has led to credit-rating cuts in places as diverse as New Jersey, Kentucky, and Chicago.

But individuals are struggling, too. Balanced portfolios that used to yield 4% now only yield 2%. A ladder of bank CDs only yields 1%. So lots of investors have shifted to high-dividend stocks to make up for lost income. The rationale is that AAA-rated Johnson & Johnson has a stable and growing dividend, and even lower-rated companies like Verizon and AT&T have strong business models. Why not use them as proxies for bonds, and enhance your income with equities?

Ratio of high-dividend stocks to S&P 500. Source: Business Insider

This unconventional thinking has become so widespread it’s almost conventional by now. Almost ten years of ultra-low interest rates have changed investor expectations. The yield spread between high-yielding stocks and the overall stock market has narrowed dramatically. We won’t know how this works out until we go through a full market cycle. Until then I have three observations.

First, equities are more volatile than bonds. This is because they have a junior claim on corporate cash flow. This was the case even when rates rose in the ‘70s. If investors aren’t psychologically prepared for greater variability in their portfolio values, they will be tempted to sell when the market falls, turning a temporary market fluctuation into a permanent loss of capital. And most people become more risk-averse when the market falls.

S&P 500 vs. Lehman Aggregate Bond Index, 1972-1982. Source: Bloomberg

Second, many of the vehicles that investors are now using to capture market returns haven’t been thoroughly tested in the courts. We haven’t had many bankruptcy cases or shareholder lawsuits that involve ETFs, MLPs, REITs, or other alphabet-soup investment vehicles. We’re flying in airframes that have been designed and constructed by computers, but haven’t hit a lot of turbulence yet. Make sure a good portion of your investments is in direct holdings of stocks and bonds.

Finally, it’s not always the case the reaching for yield ends in tears, but it’s happened enough times to worry about. Looking for more income by shifting investments from senior bonds to junk bonds to preferred stock to common dividends is moving down in the capital structure. Traditional asset allocation looks to stocks for growth and bonds for stability, but we may need to re-think this—especially in a slow-growth low inflation world.

Source: Alephblog

The indications are that long-term returns from all asset classes are going to be low for a while. Figuring out how to adapt is the biggest challenge this generation has faced. And what works for one investor probably won’t work for anyone else.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Political Roots of Prosperity

Why do some economies grow faster than others?

Photo: Paul Anderson. Source: Morguefile

In his recent book, “The Origins of Political Order,” Francis Fukuyama argues that democracy is a stool that stands on three legs: a stable society, political accountability, and the rule of law. Without any one of these elements, democracy is not possible. A stable society means it is safe to come and go. Political accountability provides a way to discipline leaders. And the rule of law means that the law is supreme—that everyone plays by the same rules.

These three factors correspond to the three branches of US Government—executive, legislative, and judicial. The Executive branch establishes order, Congress is the most politically accountable branch, and the judiciary adjudicates property rights. Contrary to anarchistic utopian dreams, a truly weak state doesn’t safeguard liberty. It encourages the rise of gang warfare and the rule of tribal warlords.

Economic growth depends of three items that roughly correspond to Fukuyama’s three political factors. A stable currency is like a strong government. It’s necessary for economic exchange, and for people to be able to make long-term plans. Part of the problem with inflation and deflation is that you can’t make long-term economic plans.

Market accountability is like political accountability. Companies geet feedback via a free marketplace for goods and services. If their products don’t sell, they’re not going to stick around. Also, they get feedback through the daily price mechanism of securities markets. Sometimes this can lead to short-term thinking, but over time, the market delivers good information, and more data is better than less data.

Apple stock price with date of iPhone launch. Source: Bloomberg

Respect for property rights—especially economic property—is analogous to the rule of law. People need to know that their assets can’t just be confiscated. In 1952, when President Truman nationalized the steel industry in to avert a strike, the Supreme Court ruled that he didn’t have the authority to do this, in spite of our need for more steel during the Korean War. The court said that if the federal government wants steel, they can buy it just like everyone else. The rule of law protected property even in wartime. Thirty years later most of these strategic assets went bankrupt, as steel production shifted overseas.

A stable currency, market accountability, and robust property rights are essential infrastructure for economic prosperity. They send deep roots into the political soil that allows the economy to grow. Countries that establish and maintain these institutions will prosper.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Elusive Steady-State

Will the economy ever get back to normal?

Source: Wikipedia

Everyone wants the economy to normalize—normal interest rates, normal economic growth, normal inflation. The Fed is talking about that issue this week in Jackson Hole, Wyoming. But we never seem to get there. Something always seems to come up.

Ten years ago, the economy crashed during the financial crisis. Five years ago we had a Euro crisis and fears of “Grexit.” Now “Brexit” and the most bizarre presidential contest in memory are roiling expectations. Economists debate whether we’re in a “new normal” or secular stagnation or if the rising “gig economy” will turn us all into innkeepers, taxi drivers, and dog-walkers.

Some see the market as a complicated machine, with levers and buttons for policy-makers to push and pull. All we need to do is find the right mechanism to increase output. But it’s really a complex ecosystem, with stresses and stimuli from invasive species, new adaptations, over-harvesting, and an infinite number of other internal and external factors. If you walk into a forest, nothing is ever stable. It’s always in a transition from something old to a new new thing.

Photo: Petr Brož. Source: Wikipedia

The economy never has been nor ever will be in equilibrium. The economy we have is the economy we need to work with: first to understand it, then to encourage increased, sustainable growth. Markets are always shifting, challenging the most nuanced and elegant models. But markets don’t do elegance. If you want elegance, see a tailor.

Douglas R. Tengdin, CFA

Chief Investment Officer

Growing, Growing, Gone

Is growth worth it?

“Enchanted Forest.” Photo: Dave Meier. Source: Picography

We live in a deflationary time. Excess investment in productive capacity has provided more and more goods at cheaper and cheaper prices. Global trade and technology means that the marginal cost of labor minimal. Even professional services will be affected by globalized labor. The Microsoft-LinkedIn merger means that there will be millions of human “Clippies” waiting for us inside our Word or Powerpoint files, offering to do our animations and graphics or edit our documents for just a few dollars.

“Clippy.” Source: Wikipedia

Falling prices for goods and services around the world means that future money is more valuable than it is right now. It’s the opposite of an inflation problem. It’s why interest rates are so low right now. It’s also why safety is so important. Deflation creates credit issues for everyone except sovereign borrowers. In an age of deflation, countries can print their own currency without the normal inflationary worries.

The increased value deflation puts on future cash flow is why companies that can squeeze a little growth out of a depleted economy’s toothpaste tube have such high valuations—some of them eye-popping.

Source: Finviz

(The 40 “PE” for US Treasuries is just the 2.5% yield on 30-year bonds inverted, so that it is comparable with stock market price-earnings multiples.)

This helps explain why growth companies have outperformed value for the past several years. Deflation puts a premium on growth, because future cash will be worth more, if deflation continues. That of course, is the rub. Nothing continues indefinitely. As a Greek writer noted 2500 years ago, the only constant is change. No one steps into the same river twice.

Investors, policy-makers, and businesses have placed their bets that the economy will change back towards “normal”—towards 2% inflation and 1.5% economic growth. When we read the Fed’s minutes and speeches, it’s clear that committee members are concerned that inflation will pick up soon and they will have to raise rates rapidly to avoid falling behind the curve. They fear this would be disruptive.

But the that was the issue 20 years ago. Resources would get scarce and push prices higher, lifting inflation and inflation expectations. Now excess capacity is lowering prices, leading to deflation and putting a premium on growth. And what if deflation intensifies? We know things will change. But which direction with they go?.

Science fiction writer William Gibson says, “The future is already here—it’s just not evenly distributed.” With inflation and deflation both vying for significance, we don’t know what future that will be.

Douglas R. Tengdin, CFA

Chief Investment Officer

Stock Market Values (Part 3)

Now what?

Photo: Dave Meier. Source: Picography

Once you have a sense of a firm’s business-lines, how do you put numbers on those realities? Financial theory states that the fair value of an ongoing business is the present value of its expected cash flows. This requires that an analyst estimates the cash flows, the discount rates, and how fast a company can grow. Simple, right? All you need to know is the cash from here to eternity.

That’s the rub. Because nothing ever works out according to plan. So we use probabilities and higher discount rates to account for the risk. We also need to estimate the growth rate. On paper, accounting for all these variables can look intimidating.

Source: CFA Institute

In theory, this looks like a lot of advanced math. But in practice, it’s actually pretty simple. The way a only way company can increase its value is to increase the level of cash flow available to investors. It can do this by increasing sales, decreasing expenses, or decreasing the cost of capital. Of these three, increasing sales is the only sustainable way to grow, since costs can’t fall below zero.

This is why the market value of a stock may fall even after they report a bang-up quarter. The market is more concerned with their prospects going forward, and how sustainable those prospects may be. The reported results are simply history—a way to evaluate management’s credibility, if they hit their numbers or not. History isn’t bunk, but it is in the past. What matters to investors is the prospect for future cash flows.

There are no shortcuts in valuation. Either a company can pay money to is owners or it can’t. In the end, valuation depends on value-added.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Dragon in the Mist?

How fast is China growing?

Part of “Nine Dragons" by Chen Rong – Museum of Fine Arts (Boston). Source: Wikipedia

That’s what everyone wants to know. Their economy represents 15% of global GDP—the second largest in the world. Officially, they’re growing at 7% per year, down from the double-digit growth they boasted a decade ago, but still more than twice the rate of the developed world. China has been following the same script that every other developing nation has–turning farmers into factory workers, making them much more productive until the entire economy lifts off.

The problem is, who is going to buy all that production? Until now, China has been able to export its way to prosperity. But what works when you’re little doesn’t work so well when you’re a giant. China has been planning to shift its economy from export-led, investment-driven to consumption-led, consumer-driven, but that process can be bumpy.

Additionally, their economy is basically a black box. Alan Greenspan once dismissed the Chinese statistical bureau as an agency that determines the quarterly GDP statistics on the first day of the new quarter. The country’s premier, Li Keqiang, admitted as much to the US ambassador some time ago. It’s hard to get an accurate read of their internal dynamics. So outside observers use other data, like power generation or passenger travel, to come up with estimates.

Source: Wall Street Journal

These questions are roiling global markets. If China really is growing at the official rate, their economy is generating the equivalent of a Switzerland every year—50% more than new US production. But if it’s filled with zombie factories making things no one wants, kept alive through restructured loans because the managers are politically connected and the factory jobs are essential to social stability, then there’s a problem. All we have now, though, are stories. And the plural of “story” is not data.

Confucius once wrote that true knowledge consists in distinguishing between what we know and what we don’t know. Right now, no one knows very much.

Douglas R. Tengdin, CFA

Chief Investment Officer