Active/Passive Debate Misses The Pony In The Pile

By Rob McCreary

“Next the psychiatrist treated the optimist. Trying to dampen his out look, the psychiatrist took him to a room piled to the ceiling with horse manure. But instead of wrinkling his nose in disgust, the optimist emitted just the yelp of delight the psychiatrist had been hoping to hear from his brother, the pessimist. Then he clambered to the top of the pile, dropped to his knees, and began gleefully digging out scoop after scoop with his bare hands. ‘What do you think you’re doing?’ the psychiatrist asked, just as baffled by the optimist as he had been by the pessimist. ‘With all this manure,’ the little boy replied, beaming, ‘there must be a pony in here somewhere!’”    

–  excerpted from How Ronald Reagan Changed My Life, by Peter Robinson

               

Jason Zweig is a well-known finance columnist for The Wall Street Journal and also the editor of the revised edition of Benjamin Graham’s The Intelligent Investor (HarperCollins, 2003), the classic text that Warren Buffett has described as “by far the best book about investing ever written”.

Mr. Zweig recently published an article in The Wall Street Journal that captures one important aspect of the active versus passive debate. As the number of publicly traded companies shrinks through consolidation, acquisitions and mergers, there are fewer undiscovered gems, especially for value investors like Mr. Zweig:

In less than two decades, more than half of all publicly traded companies have disappeared. There were 7,355 U.S. stocks in November 1997, according to the Center for Research in Security Prices at the University of Chicago’s Booth School of Business. Nowadays, there are fewer than 3,600.A close look at the data helps explain why stock pickers have been underperforming. And the shrinking number of companies should make all investors more skeptical about the market-beating claims of recently trendy strategies.

Diminishing Opportunities

In 1999 we started CapitalWorks with an investment fund targeting unloved and misunderstood microcap public companies. Not only were many of these old economy companies out of favor due to the dot-com boom, but they were also extremely hard to research. The consolidation of regional securities firms into much larger broker dealers with sophisticated research departments left many perfectly great industrial and service businesses without any trading sponsorship or investment research simply because they were too small. Geography also was important because many of these microcap orphans were headquartered in the fly over zone. As a consequence there were hundreds of hidden gems waiting to be discovered with hard work of fundamental research and management meetings.

That opportunity space disappeared with the dot-com bust and the subsequent consolidation of survivors. On top of that trend, going public became a rare event as liquidity in the private markets became possible for the first time. Now there is so much less red tape and so much more liquidity that exciting new companies are finding private market ways to support growth and still monetize their investment:

“Back in November 1997, there were more than 2,500 small stocks and nearly 4,000 “microcap” stocks, according to the Center for Research in Security Prices. At the end of 2016, fewer than 1,200 small and just under 1,900 microcap stocks were left.

Most of those companies melted away between 2000 and 2012, but the numbers show no signs of recovering.

Several factors explain the shrinking number of stocks, analysts say, including the regulatory red tape that discourages smaller companies from going and staying public; the flood of venture-capital funding that enables young companies to stay private longer; and the rise of private-equity funds, whose buyouts take shares off the public market.”

Rise Of Private Equity

It is not surprising that the rise of the private equity asset class corresponds almost perfectly with the decline of the micro cap public asset class. The private equity model allowed many management teams to monetize their private investment and still have control of the company they founded. Many management teams also have serial reinvestment and exit cycles side by side with equity sponsors for whom they are owner-managers- two or three bites of the apple. The private equity model became  a better petri dish for growth companies than public markets over-regulated by Sarbanes Oxley and Dodd Frank.

Stress Testing Index Funds

It is interesting that the debate today is centered on whether active managers can outperform passive products like ETFs. Everyone is looking at the costs of active management rather than asking about the risks inherent in a collective product like an ETF. We simply don’t know how a product which trades directly but depends on unaffiliated third parties to stabilize its portfolio price will perform in a market meltdown. In a recent interview of retired value investor Bob Rodriguez by Robert Huebscher writing for Advisors Perspectives on June 27, 2017; I was shocked to learn how concentrated the passive products really are, and, in the opinion of a really smart retired guy, may be much riskier than they seem:

Thus, since 2007, indexing or passive activities have risen from approximately 7% to 9% of total managed assets to almost 40%. As you shift assets from active managers to passive managers, they buy an index. The index is capital weighed, which means more and more money is going into fewer and fewer stocks. When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.

While I have written about ETFs and how Dodd Frank circuit breakers unintentionally caused many ETFs to hemorrhage in July, 2010, I have not found anything written about stress testing the ETF model. I know one thing for sure. The owner or decision maker on ETF products is probably the weakest hand at the table and the one most likely to fold at exactly the wrong time. This gives credence to Bob Rodriguez question about who is going to buy when the weak hands are all folding at the same moment on their ETF investments. The institutional arbitrage feature of an ETF is meant to follow, not lead, valuation anomalies so it is hard to predict what help, if any, will come from the arbs if ETF trading prices plummet due to a disorderly market. One might speculate that the arbs will short the market basket of securities if they think the weak hand capitulation will influence the whole market.

 

Rob McCrearyActive/Passive Debate Misses The Pony In The Pile

A Silver Mine For The Taking

By Rob McCreary

 

The Economist” understands something about retiring baby boomers that has eluded the money machine of American business. In a July 8th special report, the editors described the motherlode opportunity:

“With longer lives, more free time and a lot of cash, older people clearly present a “silver dollar” opportunity. In America the over-50s will shortly account for 70% of disposable income, according to a forecast by Nielsen, a market-research organization.   Global spending by households headed by over-60s could amount to $15tn by 2020, twice as much as in 2010, predicts Euromonitor, another market-research outfit. Much of this will go on leisure”.

The only organization that gets it is AARP which has a slick marketing appeal that confuses retirees into thinking they are buying the Platinum Card for retirement lifestyle. In fact, AARP is a sophisticated money maker with a political viewpoint I do not endorse.

With people over 50 controlling 70% of disposable income you would think someone would invent “Abergrammy and B Rich” as a specialty retailer providing trendy leisure wear for Old People (“OP”).  In my early legal career I actually did work for an entrepreneur who wanted to start a specialty retail chain called “Cane and Able”. I loved the business model of a one stop shop for all OP products and I also loved the name because of its biblical antecedents, but I was never sure that fratricide would sell in Brooklyn.

Mastering Subway Surfer

One of my grandkids could be the next Zuckerberg if he or she could invent a paid service that helps seniors master the intricacies of the internet of things and the devices that navigate its networks. All grandparents would certainly pay something for help on how to get under the first hurdle in Subway Surfer and learn to jump for gold coins. You can’t put a price on gaining some credibility with the under 6 years old crowd.

Mother of all APPS

I know we would all pay a small monthly fee to have a seamless and completely dependable password recall service. When they stopped accepting “Hello” I began to struggle. I am sure Amazon has Alexa working on a solution and will offer it for free so they can control access to every one of their competitors. This is the Mother of All Apps.

When someone demystifies the cloud and actually educates OP about it being safer than storing sensitive information on their computer and also closer to heaven so wifi will work in the afterlife, a new business channel will emerge. Someone other than AARP is going to create a data trove on $15 Trillion of spending power.

Fitness and The Zapper

Fitness can flourish if it allows a small group of well toned seniors to join (prepay annually) the 40 year old yoga classes. The only downside is turnover as many seniors will get stuck in the Pidgeon Pose and will require immediate emergency hip surgery. My brother-in-law has been going to Yoga classes for 5 years now and he has never moved past the Child’s Pose. For him it is touch your toes and never close your eyes.

Implants- not the body parts type- are a growth industry as well. You need a zapper mechanism that discourages excessive libation, reminds you to take your statins, gooses you off the couch, encourages you take the first 50 steps in the morning and interprets the importance of all spousal communication. In our house the most important communication always starts when we are 3 rooms apart. The staccato exchanges of “what”, “what”, “what”, “WHAT” “WHAT” ending with a crescendo “I CAN’T HEAR YOU” is the love language of the geriatric set.

Travel As A Substitute

Finally, there is travel. I think retirees are actually more interested in filling the time between meals than they are travelling. I really don’t agree with The Economist about leisure. Leisure time is really a curse and when someone figures out how to package “PURPOSE” for seniors, you will have the true motherlode. For now the “Love Boat” is a poor substitute for a generation with energy, money, intellectual curiosity and experience. If this group ever gets organized politically, it may become yesterday’s America. In any event, if I were a 30 year old with Fifteen Trillion Dollars up for grabs, I would be spending more time with the OP and their friends. The Mother of All Apps will reveal itself if you can become an early riser and a volunteer in a retirement community.

 

Rob McCrearyA Silver Mine For The Taking

BITCOIN HAS GROWING PAINS

By Rob McCreary


Everyone is talking about Bitcoin. Many investors, even those who never bought any, are now claiming to be early adopters. The world loves a winner and Bitcoin has outperformed just about every other asset class on the planet. If you bought $1,000 of Bitcoin in July 2010 at the opening price of 6 cents ($0.06) and held your 16,667 bitcoin until July 3, 2017 when it traded at $2,605.17 you would have $44.0 million of value. The same people who now are claiming Bitcoin victory probably also bought Amazon, Google, Apple and Netfix at the initial offering.

Actually, if you own 16,667 Bitcoin you know not to talk about it because that makes you and your family prime kidnap targets. Those people who boast about early investment aren’t real Bitcoin investors. The real investors are the ones with the Cheshire cat smile and a fuzzy recollection of its antecedents: “ I’m not crazy, my reality is just different than yours.”

The real Bitcoin investors have withstood a roller coaster ride and the chart below does not really demonstrate the 18% two day decline in June:

 

 

Source: Coindesk price of Bitcoin from inception

 

Bitcoin Has Survived Big Challenges

The biggest exchange and a trusted custodian of a large percentage of the early Bitcoin in circulation, Mt. Gox in Japan, was hacked in 2014 and $350-$400 million Bitcoin was stolen. The digital currency rebounded. New York State decided to regulate Bitcoin dealers who did business in the State of New York by creating a licensing process for companies like Coinbase. The guy who led the charge for New York, Benjamin Lawsky, got the legislation he wanted which put Bitcoin squarely within the regulatory purview of the New York Department of Financial Services. Like any good capitalist, Mr. Lawsky then resigned and went into the business of consulting with Bitcoin dealers who had to interpret and comply with the regulations he had just written. The currency rebounded again.

 

Bitcoin entered adulthood in 2015 and 2016 when it effectively provided wealthy Chinese with an escape route out of the currency restrictions imposed by the Chinese government to halt the flight of capital out of China. Given the easy conversion of Bitcoin to US Dollars and the more stable trading market, the only risk was getting caught trying to convert Chinese assets into Bitcoin.

A Schism Among The Users And Developers

Now that everyone wants Bitcoin I am wondering whether the business model is showing strains. First the price that a Bitcoin miner charges to validate a single transfer has increased from several cents to as much as six dollars. Bitcoin was supposed to lower the cost of friction but the computing power needed to validate the block chain ledger has exploded as the digital currency gains acceptance.

You also need patience to transact in Bitcoin. The average transaction now takes significantly more time than the early days(as long as 20 minutes) to be verified and confirmed.

Finally, the user group that interprets the rules for the Bitcoin business model has many fundamental disagreements principal of which is whether Bitcoin should have a fixed supply of 21 million Bitcoin or an expanded supply and trading characteristics like foreign currencies. The purists want a store of value, like gold, and an anonymous way to subvert fiat currencies. The expansionists are bothered by speed and transaction costs and often comprise larger groups proposing changes to shift the economic model in their favor.

On top of that Ethereum has emerged as a viable competitor to Bitcoin. Its chart looks like Corbett’s Couloir in Jackson Hole:

Source: World Coin Index Price Of Ethereum

As “The Wall Street Journal” points out in its July 3, 2017 edition, Bitcoin can no longer be used to buy a cup of coffee because the transaction price is $6x the cost. This is bad news for holders of Bitcoin because it relegates the digital currency to a doomsday asset class like gold. Given the state of the world, doomsday asset classes will remain popular with people who want some insurance against the manipulation of mainstream currencies by politicians. Whether it is Brexit, the US border tax, the Chinese currency restrictions or Argentina’s once-a-decade devaluation of its currency, Bitcoin will have a place but, for now, maybe not the one Satoshi Nakamoto, its anonymous founder, envisioned. But would you buy Ethereum?

 

 

 

 

Rob McCrearyBITCOIN HAS GROWING PAINS

Whimpy Economy At Its Zenith

By Rob McCreary

I’d Gladly Pay You Tuesday For A Hamburger Today

Bill Gross wants to sell you a bond. For that matter he wants to sell you trillions of dollars of bonds and, preferably, in one of his Janus products. He did catch my attention, however, with an interesting article in Wednesday June 14th’s edition of The Wall Street Journal where he predicts reversal of fortunes for investors who are confidently surfing an equity wave without understanding the jagged coral beneath them:

“Money will currently be made, or at least conservatively preserved, by acknowledging the exhaustion of “making money with money”. Strategies involving risk reduction should ultimately outperform “faux” surefire winners generated by central bank printing of money. It’s the real economy that counts and global real economic growth is and should continue to be below par.”

Mr. Gross is right about several things. The Fed’s “QE forever” campaign has created a financial Disneyland where returns on capital are available in only a few asset classes. Those asset classes, however, are squarely reliant on real economic forces that Mr. Gross fears will end the prosperity trade. Among them he especially fears demographics and productivity. Investments in productivity enhancements have diminished and the aging baby boomers just are not spending. There are a number of industries with a “Whimpy- Gladly Pay You Tuesday for a Hamburger Today” business model. Fixed future promises like life insurance, bank deposits, defined benefit pensions (private and public), Medicare, social security, annuities, interest rate swaps and long-term care insurance in exchange for a deposit or a premium dollar today are at risk:

“But asset prices and their growth rates are ultimately dependent on the real economy and, the real economy’s growth rate is stunted by secular forces which monetary and even future fiscal policies seem unable to reverse… Investors have discovered that making money with money is a profitable enterprise and have exchanged the support of central banks for the old-time religion of productivity growth as a driver of their strategy. The real economy has been usurped by the financial economy.”

In the private equity world we have confirmation of Mr. Gross’ real economy observations. Unit growth is hard to find in many of the industrial companies we see. Earnings and cash flow are often enhanced through a plow horse playbook of cost reductions, selective price increases, synergistic tuck-in acquisitions and working capital management. Larger companies increasingly manufacture their earnings by acquiring smaller competitors and, unlike other investment periods, are not penalized by the capital markets for lack of organic growth. Investments in productivity usually mean labor displacement first and innovation second. When once determined rivals like Dow and DuPont merge acknowledging they cannot grow the Whimpy economy is at its zenith and, like a financial “Ground Hogs Day”, rightly predicts a succession of unfulfilled Tuesday promises.

 

 

 

Rob McCrearyWhimpy Economy At Its Zenith

What If Facebook Were At Woodstock

By Rob McCreary

Harvard is among the most selective universities in the world. Gaining admittance is a passport to prosperity and elite networks. The waiting list must be as long as the line at the Apple Store at 9:59am on Saturday morning.  How, then, can ten of the most brilliant and well qualified young people in the world squander a place in the class of 2021 because of highly offensive public opinions?

No Public Record of Stupidity
In 1969 when I was admitted to college there were only a few ways you could reverse the good fortune of your anticipated matriculation. You could fail to graduate from your high school. You could commit a crime.  You could get lost at Yazgur’s farm never to be seen again.  Even if you were expelled from high school you often could still get your final transcript and the colleges were no wiser.  Everyone expected your opinions to be stupid, uninformed and controversial.  Just ask your parents.  But no one had a public record of those opinions.  Mark Zuckerberg changed that with Facebook which started innocently and has morphed into a powerful tool for marketers and an even more powerful enforcer of conformity.  Young people everywhere are trusting the public forum of social media to interpret their changeling character in the best possible light.  This naiveté is startling to me.  In all forms of social media many colleges and universities find a willing enforcer of group thought and political correctness. The Facebook effect is responsible for major changes in how colleges run from the building names on campus to the mascots and even the relationships between men and women.  Social media powers a god squad of self-appointed student judges who wield the power of inclusion to ostracize and create pariahs.  Young people crave inclusion and acceptance; so once you are out, there is little chance to get back in.  Social life is often altered for the outliers.

Dumbest Smart Guys
In 2017 the power of social media is demonstrated by the Harvard admission denials.  The original user group for Harvard incoming freshman was pretty much what Mark Zuckerberg had envisioned with more than 100 incoming freshman exchanging ideas and observations in a social media attempt at getting to know each other.  The 10 offenders must be the dumbest smart people on the planet because they obviously thought their incendiary freedom of expression was protected in the second chatroom where they posted  on horrible topics.  They revealed themselves to the world as bigots, racists, sexists and they paid the price as they should.

Why Go Public
I have avoided Facebook, Instagram, Twitter and most forms of social media because I see it as an intrusion on my privacy.  Why would I voluntarily publish information about me, my family, my friends, my movements, my grandchildren, my religion, my politics and my vacations?  Off the grid is actually far preferable in a world of cyber-crime, social media punishment and banishment, kidnapping and ransom, identity theft, sexual predation, and hacking and phishing.  This is common sense.  When is going public in a cyber world ever better than remaining private?

If Facebook or You Tube had existed in 1969,  the freshman classes of every college on the east coast would have been lighter by at least 10 men and women. Thank goodness for a chance to grow up.

I came upon a child of God
He was walking along the road
And I asked him where are you going
And this he told me
I’m going on down to Yasgur’s farm
I’m going to join in a rock ‘n’ roll band
I’m going to camp out on the land
I’m going to try an’ get my soul free

 

Rob McCrearyWhat If Facebook Were At Woodstock

Truth On A Slow News Day

By Rob McCreary

 

It is always interesting to read The Wall Street Journal (“WSJ”) on days when the NYSE is closed and mainstream business is snoozing.  Memorial Day 2017’s edition contained opinions you never read when the markets are open. While the mainstream bias of WSJ is still squarely in favor of groups who pay them, it was nice to see the other side of the story on a day when few advertisers would be reading.

Illinois Privilege Tax on PE Firms

Illinois is insolvent. It hasn’t passed a budget in two years. It needs revenue to pay for the mismanaged state pension plans and entitlement programs. As Kristina Rasmussen reported in a WSJ article on Memorial Day, May 29 the Illinois mess is as follows:

“Illinois hasn’t had a budget in two years, since the Democrats in Springfield continue to insist on more taxes. The state has $267 billion in unfunded retirement liabilities, a $14 billion backlog of unpaid bills, and a $7 billion projected deficit this fiscal year.”

To address this train wreck The Illinois Senate passed a 20% privilege tax on financial advisors that would apply to hedge fund and private equity managers. That legislation is now in the House of Representatives. If passed, the tax would certainly apply to portfolio company realizations. I am not sure whether it would also be a sur-tax on compensation and whether it would apply to stock brokers and investment managers as well?

Ms. Rasmussen suggests hunting productive people like PE firms will end poorly for Illinois. While it is a great political sport to impose a sur-tax on a small group of high earners, it is usually a fool’s errand. Ms. Rasmussen says PE managers can and will move to tax friendlier states and the multiplier effect will be greater than the legislature ever figured. There are many service jobs that support PE including law, accounting, due diligence, consulting, insurance, and recruiting.

Trump Will Prevail in Travel Ban

Until Memorial Day I had never read anywhere (including law school commentary) that President Trump will win if the US Supreme Court agrees to review the recent Fourth Circuit Court of Appeals legal decision declaring the President’s revised travel ban is illegal. According to the WSJ authors, David B. Rivkin, Jr. and Lee A. Casey a reversal is a sure thing:

“In ruling against the order last week, the Fourth U.S. Circuit Court of Appeals defied Supreme Court precedent and engaged the judicial branch in areas of policy that the Constitution plainly reserves to the president and Congress. The high court should reverse the decision.”

The story reviews legal precedent and concludes that the Circuit Court has clearly politicized its decision:

“It is therefore difficult to avoid the conclusion that the Fourth Circuit and the other courts that have stayed Mr. Trump’s executive orders on immigration are engaged in the judicial equivalent of the “resistance” to his presidency. Judges are, in effect, punishing the American electorate for having chosen the wrong president. That is not the judiciary’s role.”

Greedy CEO Stock Options

The Monday Memorial Day edition also slammed Patrick Drahi, CEO of Altice, for rearranging his compensation plan to provide more upside after his shareholders complained. You never read an article in the WSJ that slams executive compensation. In this case it was neither an American CEO nor an American company. The target was an Amsterdam based company’s leader about which the WSJ reported on the stock options as follows:

“Such a payout is a powerful incentive, but it is doubtful Mr. Drahi needs it. Never mind his outstanding stock options under separate agreements, which are collectively worth €55 million at the current share price; he already owns 59% of Altice—a stake worth about €19 billion today. If the share price triples, his stake is worth another €38 billion ($43 billion). This is surely incentive enough.”

The article incorrectly states that stock options are a way to give executives “skin in the game”.  As I have written before, stock options are a one way bet with the shareholders money and do nothing to align manager and owner. The article finally corrects itself and concludes that some managers like Mark Zuckerberg and John Malone do not need options because they are already aligned to shareholders through massive personal holdings.

In the PE world incentive options are typically granted only to managers who have already invested side by side and at the same price as the PE fund and share downside risk. The point about stock options is they have no downside. If you miss a plan, you don’t lose your own money.

Get Ready for the Next Holiday

Make Sure You Read the July 4th edition of The Wall Street Journal for all the news you can’t see on a real news day.

 

 

 

Rob McCrearyTruth On A Slow News Day

Buffet May Be Clearing Out The Competition

By Rob McCreary

Most of us who have been investing for a long time know what kind of investor we are. Some of us are growth investors, some are growth at a reasonable price and some of us are unabashed chickens -also known by the more prestigious pedigree of “value investors”. Given the unrelenting rise of stocks of all types from 2009 to 2017 as shown in the chart below, most chicken investors are having trouble channeling Graham or Dodd or, for that matter, scratching up an investment idea:

I took some comfort in a recent Barron’s interview of Bruce Greenwald by Leslie Norton called “Channeling Graham and Dodd in Today’s Market”. Professor Greenwald teaches Finance and Asset Management at Columbia and is the author of the popular “Value Investing: From Graham to Buffet and Beyond” which will see a second edition in 2018. When Mr. Greenwald took over the value investing course in 1991, he likened his quest to “an anthropologist trying to save a dying language”. Of course, Warren Buffet changed all that by reinterpreting the Dead Sea scrolls of Graham and Dodd in the modern vocabulary of his Coca-Cola investment and his home spun annual reports about Mr. Market.

Greenwald’s Secret Sauce

Interestingly, even in 2017 Professor Greenwald suggests that good value investors should start with a company’ balance sheet as its first indicator of value not the discounted cash flow model which has many opportunities for bad assumptions. Why the balance sheet? First it can tell you where the intrinsic bottom value lies by looking at liquidation value and also where the top intrinsic value lies in the cost of reproducing the assets that comprise that balance sheet. For example, The Wizard of Omaha would have found a pretty paltry downside balance sheet liquidation value for Coke (a few mixers) but a remarkably high replacement value for the Coke formulation which actually began with a small dose of a popular narcotic-cocaine.

Discounted Cash Flow Models Are a Deceit

Professor Greenwald then instructs that only after looking at the balance sheet should you look at the company’s earnings power TODAY (not the future) and ask how protected that earnings power really is? This reminds me a little bit of drafting fantasy baseball hitters based on how well they are protected by the hitters before and after them which could lead to The Encarnacion Effect where you actually pick a stock in major decline but well protected by Fransico Lindor and Carlos Santana. Nonetheless, I get his idea.

Professor Greenwald also wonders how value investing can have any place in a market that is primed by Fed monetary policy and tilted in favor of passive momentum investing. He is right that any card carrying value investor just cannot wrap his arms around Facebook, Amazon, Netflix and Google. They defy gravity buoyed by the human propensity to believe in cheerful forecasts. If Brexit and the Trump victory proved one thing to me, forecasters don’t have a clue, but humans are wired to believe in hopeful outcomes so experts stay employed. The main culprit in his estimation is discounted cash flow models built on faulty optimistic assumptions.

Value Grounded In What You Are Today

Value investors are more focused on what the company can do for me today. Professor Greenwald thinks those “today” insights are honed by industry specialization, a fixation on free cash flow generation as a percent of reported net income (Apple) and aftermarket service dominance (Deere). Would you believe that Apple was trading at less than 6x Enterprise Value to EBITDA and only 10-11x its unlevered free cash flow just one year ago? The only question a value investor had to ask then about Apple is how likely is abandonment of that device by that community? I defaulted to asking family and friends about Apple and they all said that substitution is too painful. Samsung reinforced that opinion recently when its phone was banned by the US Airline industry for catching on fire.

Buffet Says Don’t Try This Yourself

Professor Greenwald is also suspicious of Warren Buffet’s warning that only 1 % of the investor population has the skills to be an active manager. He seems to understand that “the nightmare scenario for value investors isn’t passive investing; it’s everybody takes a value approach”. As a value investor I feel pretty safe for the foreseeable future now that Warren Buffet has scared everyone away. Nonetheless, I still am searching for the next Coke in that pile of unloved equities even as my robo funds and ETFs are chunking out pretty good FANG dominated returns.

Rob McCrearyBuffet May Be Clearing Out The Competition

Ballmer’s Gift: “Just The Facts, Maam”

By Rob McCreary

Few businessmen make outright gifts to the American people. John D. Rockefeller gave his estate in Maine to the National Parks to create what is now one of my favorite venues, Acadia National Park.  The views of the Atlantic Ocean from Rockefeller’s carriage roads are simply breathtaking and certainly worthy of a place on your bucket list. Recently, Steve Ballmer, former CEO of Microsoft, published the first ever Annual Report and 10K on American federal, state and local government. While he did not match the natural majesty of Rockefeller’s gift, in many ways his compendium of government information is possibly more valuable, coming at a time when no one knows the truth and powerful forces are attempting to bend reality to their own agenda.

Mr. Ballmer personally underwrote the project which took several years and more than $15 million. He explains the purpose of his Annual Report and 10K as follows:

“USA Facts is a new data-driven portrait of the American population, our government’s finances, and government’s impact on society. We are a non-partisan, not-for-profit civic initiative and have no political agenda or commercial motive. We provide this information as a free public service and are committed to maintaining and expanding it in the future.”

Interestingly, the New York Times’ Andrew Ross Sorkin really likes the project and for the first time in years I can provide a quote that is actually balanced:

“In an age of fake news and questions about how politicians and others manipulate data to fit their biases, Mr. Ballmer’s project may serve as a powerful antidote. Using his website, USAFacts.org, a person could look up just about anything:  How much revenue do airports take in and spend? What percentage of overall tax revenue is paid by corporations? At the very least, it could settle a lot of bets made during public policy debates at the dinner table.”

When you read it, you will like it too. What struck me about the 162 page Annual Report for the year ended September 30,2014 was how we have improved as a country in only a few objective measures over the measurement periods. On a positive note, I was stunned to learn the average net worth of the bottom 20% of the US population was $86,000.

Like many of you, fake news has been making me anxious. I have stopped listening to all network news and am increasingly suspicious of iconic brands like The New York Times, The Washington Post and The Wall Street Journal. They broadcast in loud and urgent tones suggesting end of days mostly to promote only one way of thinking.  It is nice to read the government’s own facts and form your own opinion. Here are some examples comparing 2014 to 1980 unless otherwise indicated:

  • Persons in jail grew from 184,000 in 1980 to 1.6 million in 2014
  • Married Parents dropped from 40.6% to 29.4%
  • The poverty rate is about the same while aid to disadvantaged  is up 3.4x
  • Obesity increased from 16.8% to 29.8% of the population
  • Average household debt rose from $51,000 to $117,000
  • 6.5 million young adults (25-34yrs) live at home
  • Federal, state and local governments have a combined negative net worth of $5.3 trillion
  • Hate crimes based on race declined from 5,396 in 1996 to 2568 in 2014
  • Religious hate crimes were unchanged for the same period

I urge you all just to browse through this wonderful gift to America. It sure beats all the fake news on TV. It may lift your spirits (race relations) or depress you (governmental deficits) but for the first time in a long while you will be thinking for yourself.

Rob McCrearyBallmer’s Gift: “Just The Facts, Maam”

Bezos Rocked Me Like Muhammad Ali

By Rob McCreary

I have a great high school friend who knows how to motivate me. When I was editor of the high school newspaper he would always provoke me to write controversial editorials by posing the unanswerable question knowing, full well, I would be crazy to find an answer.

Fast forward to our respective retirement transitions and he is doing it again, but this time he is suggesting answers to tough questions. I guess that is maturity-his not mine. The letter he sent me was from Amazon’s 2016 Annual Report entitled “Jeff, what does Day 2 look like?”

If you like business and want to understand winning organizations, this is an insightful and inspiring message from Amazon’s CEO, Jeff Bezos. He gets business just like Warren Buffet gets the stock market.
Jeff answers his own question like this:

I’ve been reminding people that it’s Day 1 for a couple of decades. I work in an Amazon building named Day 1, and when I moved buildings, I took the name with me. I spend time thinking about this topic. Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1”… at Amazon

We all should be interested in the question of how you fend off Day 2? What are the techniques and tactics? How do you keep the vitality of Day 1, even inside a large organization?
Mr. Bezos recommends a “starter pack” of essentials for Day 1 defense:

• Customer obsession;
• Skeptical view of proxies;
• Eager adoption of external trends; and
• High Velocity decision making

Customer Obsession

“There are many advantages to a customer-centric approach, but here’s the big one: customers are always beautifully, wonderfully dissatisfied, even when they report being happy and business is great. Even when they don’t yet know it, customers want something better, and your desire to delight customers will drive you to invent on their behalf. No customer ever asked Amazon to create the Prime membership program, but it sure turns out they wanted it, and I could give you many such examples.”

Resist Proxies

This intrigued me, what does Mr. Bezos mean by proxies? He can’t be talking about those mind-numbing, single spaced documents I get from my broker? Not really. He suggests that taking comfort in process may be a proxy and can be“dangerous, subtle and very Day 2.” He suggests that market research and customer surveys can become proxies for customers:
I’m not against beta testing or surveys. But you, the product or service owner, must understand the customer, have a vision, and love the offering. Then, beta testing and research can help you find your blind spots. A remarkable customer experience starts with heart, intuition, curiosity, play, guts, taste. You won’t find any of it in a survey.

Embrace External Trends

Mr. Bezos says that spotting big trends is easy but they are hard to adopt. He points to machine learning and artificial intelligence as one such trend that affects Amazon. That Amazon beat Apple, Google, Microsoft and Samsung with Echo and Alexa is just like four successive Ali jabs followed by his signature uppercut. This is especially true for Google which is reputed to have a huge lead in voice recognition and artificial intelligence.

“At Amazon, we’ve been engaged in the practical application of machine learning for many years now. Some of this work is highly visible: our autonomous Prime Air delivery drones; the Amazon Go convenience store that uses machine vision to eliminate checkout lines; and Alexa, 1 our cloud-based AI assistant. (We still struggle to keep Echo in stock, despite our best efforts. A high-quality problem, but a problem. We’re working on it.)”

High Velocity Decisions

Mr. Bezos respects Day 2 competitors for making high quality decisions, but suggests they make them way too slowly. He sees the Day 1 culture as having four horsemen of innovation:

• Differentiate between reversible and irreversible decisions – so what if your wrong;
• Being slow is worse than being wrong – don’t wait for all the information;
• Disagree and commit; and
• Escalate misaligned viewpoints.

Check Out His Stock Price

Mr. Bezos closes his letter with an invitation to read his 1997 Letter to Shareholders. He believed then, as he clearly believes now, that taking the long view to profitability is the right business model. While Amazon is still chasing its first profitable year, it is clearly not being penalized by an unusual business model.

Rob McCrearyBezos Rocked Me Like Muhammad Ali

Kashkari and Dimon Debate Too Big To Fail

By Rob McCreary

I was inspired by another archived podcast I heard on Planet Money about former Goldman Sachs partner Neel Kashkari. As interim Assistant Secretary of the Treasury For Financial Stability, Mr. Kashkari is best known for overseeing the TARP program in 2008 and 2009 under his former boss, Hank Paulson. Mr. Kashkari is now President of the Minneapolis Federal Reserve. Neel grew up in Stow Ohio and attended Western Reserve Academy in Hudson. According to Wikipedia, Neel’s grades were not good enough to apply to top tier universities. He made up for that later by attending the Wharton School of the University of Pennsylvania.

We all owe Neel a debt of gratitude. He correctly surmised in 2008 that the US Banking system would fail if TARP funds were not administered to replace worthless residential mortgages (a gift from Barney Frank and Fannie Mae) with liquid treasury securities. He oversaw the process by which the banking system was recapitalized and determined which banks got relief and how much. He was close enough to the potential meltdown to understand the real pressure points of the banking system.

Kashkari and Dimon Disagree

Recently, Mr. Kashkari challenged Jamie Dimon about his assertion that “Too Big to Fail” restrictions were curtailing loan growth at JP Morgan Chase. While Mr. Dimon may be right about bank balance sheets improving under Dodd-Frank, he has a hard time explaining why he has used billions of bank capital for stock buybacks instead of loans. According to Charley Crowley and our friends at Boenning & Scattergood, a well-regarded investment banking firm serving the middle market financial services industry, there has been meaningful balance sheet progress under Dodd-Frank with tangible capital as a percentage of total assets moving from a low of 4.28% in 2008 to 8.50% in 2016. This is as high as I ever remember.

However, Mr. Crowley also sees an unintended consequence of Dodd-Frank being forced small bank consolidation. The little guys simply cannot meet the regulatory hurdles of a 22,000-page attempt to legislate good banking processes. Mr. Crowley explains it as follows:

“One unintended consequence of Dodd-Frank and other aspects of the regulatory pendulum swinging is that consolidation has been very active, and the too-big-to-fail issue has certainly not gone away. Twenty years ago, the top 10 banks controlled an aggregate of 23.6% of the nation’s deposits.  According to the most recent data, it is now 52.9%. Community banks (generally speaking) had virtually nothing to do with the financial and real estate crisis, and yet they have been paying a heavy toll in terms of increased regulatory costs and the presence of ever-stronger competitors.”

Kashkari- 70% Chance of Bank Failure This Century

Neel Kashkari is even more adamant about” Too Big to Fail”. In a recent interview on Fox, he told its viewers that the only way to insure bank safety and soundness is doubling the minimum equity capitalization of large banks. He confirms Mr. Crowley’s belief that a strong banking system is challenged by the consolidation of the smallest banks and the concentration of depositors. His bottom line is “Too Big To Fail” has not been solved. Mr. Kaskari initiated his message for an impressive story on Planet Money in its podcast on May 26, 2016. Mr. Kashkari claims he is not angling for Janet Yellen’s job, but each of his impassioned “Too Big To Fail” speeches have a familiar populist twang. He is channeling the same anger that pogoed Trump to the White House. With Neel’s rising popularity, can we expect Trump is going to dump Janet Yellen and bring in the son of immigrants and a fellow refugee from the fly over zone as the next chairman of the Federal Reserve?

Rob McCrearyKashkari and Dimon Debate Too Big To Fail