Macro rambling: inflation part 1

If you ask a common person about inflation, they will have only complains about it. And then there are these economists and central bankers losing their sleeps on the very low inflation and the potential of deflation. So why is there such a divergence among economists and common people on this?

Nominal vs Real Inflation

Most of the inflation that we experience is nominal and not real and therefore largely an accounting trick and nothing else. Let me explain.

Let’s say – if I earn $10,000 and spend $5000 on food, rent and other essentials, spending almost 50%. Now 10 years from now all these essentials might cost $8000 because prices have increased by around 5% p.a., but if my salary from same job has also increased at 5% p.a., it will still cost me around 50% of my income. So yes, there has been inflation but seems more like an accounting trick than anything else. It costs me same amount of effort to buy same utilities and hence there is no real inflation.

The ultimate finite resource that a human has is: Time. So real inflationary situaion will be if you had to spend more of your time for the same utilities over time. But if you look at the history, we have been able to do more within the same life span. Key reason for this has been continuous advancement in human understanding of the physical universe around us. We call this technological advancement. This has helped us to rearrange the physical universe around us to our benefit, allowing us to do more with less and therefore is a very powerful deflationary force.

So most of the complain we hear on daily basis or the inflation that economists talk about is nominal. This is largely a man-made accounting trick, by-product of the management of one of the greatest tool developed by humans – money. There are some finite resources/assets that we value a lot and therefore have become expensive over time. Think of prime real estate, unique painting of picaso or some other unique prized assets. Also prices for different products and services can move at different rate, and different people will feel different impact from these. But as a whole as long we continue to innovate, world will continue to benefit from real deflation.

Now the question that I have been trying to answer is: whether the nominal inflation is necessary and can one make some reasonable assumption on this for future? I am not sure if I really know enough to answer these yet, but let me share some thoughts on this and how one can think about it especially in the long-term.

I think inflation is a useful tool for economists to manage the economy as it can signal the state of econony. Also as now this is deeply rooted in human psychology, it has huge impact on consumption and investment patterns. Economist strongly agree on the benefits of inflation and fear deflation, so lets just assume its somewhat beneficial without going into details. But again, is this really necessary and especially how much? Is there any way to predict it? If this is man made, why does it get out of control sometime? Why modern developed economies are struggling to keep inflation above 0? My intention is not to be able to forecast it, but having a better understanding of this and have a framework to think about if/when things change in future.

In some of my next posts, I want to explore these questions and share my thoughts on this. It has helped me to think more clearly about the the function of money, value of real assets and how all of this affects the modern economy! Of course ultimately my quest is to improve my investment process and I think this can have significant implications on that.

Market timing and excess returns….

I know that market timing is almost impossible but if you don’t attempt to make a science of it and reduce the number of decisions I think there is decent scope to benefit from the chaos that public markets go thru over time. Like Charlie Munger has said – to generate excess returns one has to be patient but also willing to bet big when the opportunity comes.

To understand the real nature of the opportunity, one has to make sense of it. If one thinks that a particular stock is cheap, I think it’s important to understand the reason behind this seemingly irrational market behaviour. It could be because of market concern of macro, industry or company. One can quickly make sense of this by looking at peers. Most bottom-up stock pickers claim that they are not macro investors but if you were buying stocks at the end of 2008 you were betting on economies to recover eventually and if you picked the wrong economy to bet upon (think Greece/Italy vs UK/Germany), it would have made a big difference on your returns. Of course picking the right company matters but one shouldn’t be oblivious to the fact that lots of time you are also betting on an industry or economy to recover for the company to deliver good returns. Understanding this can be source of significantly superior returns. Recent sell-off in the housing market in Q4 2018 followed by sharp recovery in Q1 2018 is a good example of this. If you believed that US housing market is not overheated and can sustain or grow from current levels, markets presented quite an attractive opportunity in Q4 and rewarded it rather quickly. I think being aware of this can be extremly helpful in the decision making and the returns over the long term.

Tesla – long/short/?

Tesla is probably one of the most polarising stock in the market today. I have no view on this but watching the debate over last couple of years has been both entertaining and insightful for investing purposes. My opinion on this can be summarised as following – its not a long but not a good short either. Outcome depends on many variables which are hard to predict an therefore it doesn’t qualify for an interesting investment to me. Why so – lets look at the reasons:

• Looking at Tesla as an auto OEM, Tesla has already achieved something great that other companies struggle to build over decades. Its not the EV technology – which other companies will develop as well over time. It is the premium brand which customers love and want to own. If you think it is easy, ask any OEM who are trying to take market share from BMW/Audi/Mercedes for years.
• Tesla customers are passionate about it and most people I have talked to would buy Tesla over other cars as long as it is available with similar features and price. Most of them are even happy to pay small premium for this. That might not seem a big deal but it is. Manufacturing millions of cars at scale is not easy but with money, time and demand it is very much a solvable problem. Building a desirable global premium brand is much more difficult task.
  • Demand is certainly not an issue here and with declining EV price will only grow the demand.
  • Tesla has money but most probably will need more – and this is one of the main reason for me not being long here. Tesla has huge reliance on capital markets to fund it and therefore vulnerable to the market environment.
  • Time – other OEMs will start producing EVs in mass soon and that could be good or bad for Tesla depending on how consumers respond to these cars. Good EVs by others could highlights the shortcomings of Tesla cars but also if these EVs are not perceived as comparable to Tesla, it could increase demand for Tesla as more customers become aware of EVs.
• Lastly, for most people with strong opinion on Tesla, its all about Elon Musk. Tesla fans adore Musk’s genius and for Tesla shorts he is nothing less than a fraud. On this I am more inclined to be a fan due to his various achievements so far, but for me sanctity of capital market is very important and therefore anyone playing with it doesn’t stir up best of emotions in me. His constant chants on shorts, solarcity merger, continuous over-promise of goals and many other things do make me question the integrity of his means to achieve the goals, which I do believe are noble and genuine. I do think most shorts underestimate the energy, which a visionary and passionate founder can unleash among others and push them to deliver more than they are capable of. Steve Jobs was notorious to push people on their limits and get more out of them than even what they knew was possible. This doesn’t always lead to great results (and Apple’s history is probably the best proof of that), but it can and that is one of the key reason – why I will not be surprised (in other words I won’t be short on this) if Tesla survives and thrives over next decade.

Anyway I will continue watching this movie as it unfolds and I do hope that it ends well for Elon Musk but I will like it in even more if he appreciates and respects the trust that markets have put in him.

Marcus by Goldman Sachs – a game changer?

It is still in its early days but I think this could redefine the Goldman Sachs of future and in good way. I see several reasons why this could be large part of GS in future:

– No legacy business to compete. Whenever an industry is at crossroads, incumbents know about the challenges and often have the solutions but face innovator’ dilemma and are slow to reposition their business. As retail banking and financial services become more digital, most large banks are digitizing but they don’t want to disrupt their business models too quickly. Marcus doesn’t have this problem and can move faster like these digital challenger banks.

– No legacy costs. This is one of the key reasons I believe new digital banks think they can beat traditional retail banks. Again here Marcus can build a new state of the art technology stack which will be cost efficient and designed to deal with future changes. Only question is – are they designing it to deal with large volume and I hope they are.

– Brand – this is where I think Marcus has an edge on digital challenger banks. Most fintech start-ups underestimate the cost of customer acquisition and in banking/financial services brand is very important. No one is going to put large amount of savings in an unknown bank and here Marcus can leverage it’s GS heritage.

– Strategy – most fintech start-ups are focused on single service – forex, payments, investments and so on. Marcus is aiming to be a full service digital bank, which makes absolute sense to me as you need multiple services to amortize your customer acquisition cost. Most start-ups can’t afford to scale multiple services due to limited capital availability but Marcus doesn’t have that problem.

So overall I think it’s a master stroke from Goldman and could become a massive success if they execute it well. It has already got deposits worth 20 billion in less than 2 year of its launch. Compare that to monzo, a well known digital bank in UK operating for over a year now and has barely 150m in deposits with average customer deposit of 100 pound.

Now how big it can be? I think it won’t be unreasonable to think that it can gather 100B of deposits in next 5 years as it is launched in few other countries beside US. Given that Marcus should have lower cost compared to typical retail bank, it is possible that it earns around 1.5-2.0% net return on assets – which would be around 1.5-2.0B. That would be almost 20% of its total profit. More interestingly they would have a business with high growth potential and attractive economics – and most likely ROE on this would be much higher than their investment banking business. It might take a while before market realizes it and only IF (and that is a big one) they manage to execute it…GS won’t be trading at 1xBV anymore…

Looking back at US Autos…

I had written some thoughts on GM and FCAU in beginning of 2017. Since then both have done reasonably well with GM up by around 20% (>25% incl. dividend), while FCAU has almost doubled. I had held both stocks at that time but preferred GM over FCAU and thats how I had positioned my investments. I sold FCAU long ago as I was sceptical of them reaching their targeted 2018 numbers. Moreover GM looked even more compelling on relative basis and so I moved all my FVAU investment in GM over last few months as FCAU become more reasonably valued.

GM still seems very interesting to me. I recently made a presentation summarising my thesis on GM. As highlighted in the presentation key reason for this are:

1) Rational management making tough decisions driving shareholder value

2) Strong product/market portfolio with high market shares in most segments/markets, in which GM is operating

3) Solid balance sheet and improved labor cost structure enabling it well prepared to weather next downturn

4) Growth opportunity in GM finance, premium brand (Cadillac) and Chinese market

5) Attractive valuation with cheap option to play growth in autonomous vehicles as GM has the most advanced technology among OEMs in terms of AV development. I see autonomous part of GM’s business as kind of free option but it good to see Softbank investing in GM’s autonomous division. This somewhat verified GM’s strong position in the autonomous technology.

More on this can be found here.

Germany’s biggest banks..

Which is the most profitable bank in Germany? Make a guess and I am quite sure you will be surprised to see the following data:

in M EUR	Earning before taxes (2017)*	Book Value of Equity (End of 2017)
Deutsche Bank	1,974	68,099
CommerzBank	1,306	30,040
VW Financial Services	2,673	27,472
Daimler Financial Services	1,970	12,378
BMW Financial Services	2,207	14,740

*) For Deutsche and Commerzbank it is excluding unusual items (e.g., restructuring, legal settlements)

It is quite interesting to see how these German auto companies have become such large financing companies. It does raises some interesting questions:

– Does it make these companies more of less risky?

– Most investors/analysts looking at these auto companies are focusing on auto business but the financial services business is contributing to almost 25-30% of total profit. Auto loans were quite resilient even in 2008 crisis and if one assumes that these will remain so, this will make these businesses less cyclical and should have quite a significant impact on how these are valued.

– On the other hand, one has to question the capability of these auto companies in managing large balance sheet with massive liabilities across the world. As long as they don’t venture beyond auto financing, it should not be that concerning. Nevertheless running a large financing business requires quite a different skillset than auto business and one has to question if these companies have built that know-how or not.

Case for UK Auto dealerships…

I have been looking at UK auto dealership companies for last one year and have been invested in some of these for a while. Though I don’t have much to show in my account for these, I still find these as good investment opportunity at this point.

So first to the business: it’s quite simple to understand. You have franchise dealers which acquire new cars from car companies and sell to consumers. Margin on these is quite thin, working capital high and new car sales are quite cyclical, so not much to like here at first glance. But these stores also sell used cars (typically less than 5 years old) and service the cars (especially the new ones which most people bring to franchise dealership instead of local cheap garage to ensure that typical 3-year OEM warranty is maintained). These two components are not that cyclical and higher margin, resulting into a business which is much better than what most people imagine auto dealership to be. For example, in case of Lookers after-sales account for 9% of revenue but over 38% of gross profit and this part of business is rather counter-cyclical.

With declining new car sales and weakening consumer sentiment, shares in these companies have sold off significantly and are now trading at quite low multiple on trailing earnings. Of course million dollar question is: where are earnings going from here? Decline in new car sales did pressure the margins in car sales in H2/2017 but dealers and OEM seem to have adjusted to the market changes and margins have improved in last two quarters. Also with stable old car and after-sale market, overall profitability is not much affected. Another concern among investor is high reliance on financing by consumers for car purchase. This is more of an economic cycle question and I don’t have much opinion on this but in general I don’t view it very concerning. Also usage of PCP financing seems to be good for dealers as it increases the interaction between dealer and buyer post car sales.

Another trend working in favour of large companies is that market is consolidating as smaller dealers struggle to keep up with the various trends working against them (e.g. digitisation, OEM looking to consolidate number of dealerships). Overall industry is quite fragmented with largest groups selling only around 4-5% of all new cars and <2% of used cars. Result of all this is: large dealership groups able to grow by consolidating the marker while making decent return on capital.

Now to companies: like in any business it all comes down to management in the end. I found three companies (Lookers, Marshalls Motors, Cambria) which I believe are some of the best managed among listed ones. All three have one common thing: a large or controlling shareholder. All of these are trading at PE in the range of 7-9 and growing the business at low-teen rate. Dividend rate is around 3-4% and top-line is expected to grow at double-digit rate over next years. Lookers also started share repurchase program to take benefit of depressed stock price, so looks quite well aligned with shareholders. I prepared a detailed presentation on Lookers, which you can find here.

Forecasting macro or timing the market are impossible to do, but both macro and timing are important to the returns!!!

Other day I saw a chart which really got me thinking. It highlighted the stark differences between the outcome for two retirees starting with the same investment, but with small difference in terms of when they started (within a span of few months during 1969-70). I strongly believe that timing the market is impossible and one should not spend any energy in figuring out the short-term direction of markets or macro-factors, but I also believe that one should be aware of the market conditions and have some opinions on the macro in terms of its long-term trajectory. As always Howard Marks has put it quite clearly: We may not know where we’re going, but we sure as heck ought to know where we stand.

I see lots of of smart/value investor claiming that they are looking at individual companies only and don’t want to time the market, but at the same time many of these say that they are waiting for a correction. Now this can be explained up to some extent by their bottom-up analysis concluding that nothing is available at the prices they want. But this also sounds somewhat like they are trying to time the market as if they believe that market is overpriced and due to fall. Furthermore I have few more observations on this:

• Many of these investors have been saying this for few years now. So even if market corrects by 20-30%, if one missed out the gains from last couple of years, you will be still behind the market if you invested after such a correction.
• I agree that one should not invest on the basis of interest rates prediction for next 1-2 years or other macro variables but I think one needs to be acutely aware of the variables and need to have some opinion on this. Companies don’t operate in vacuum and their fate is highly dependent on the external environment.

So why I am having all these thoughts…few reasons:

1) People ask me this a lot in my job and this is kind of unavoidable for me till I change my job 🙂

2) I also used to think like that I am waiting for a correction but then over last 5 years this has cost me quite a lot of money…not sure if correction will make me that.

3) Timing is impossible…and looking at history I doubt if we have a big correction soon…it is very much possible that a big correction is still many years away…like it took almost 13 years from 1987 to 2000 before we got a >20% correction.

So how should one deal with all this? I have no clue where interest rates will be next year but I do think one needs to be aware of long-term macro view/trends into finding great investments. It would not have helped if a Greek investor bought even the best managed Greek bank after financial crisis as even that would have gone to 0 few time over next years. And some very good value investors actually tried this and failed.

Focusing on companies with good economics, strong balance sheet and great management certainly helps. Good companies generally come out stronger from the crisis. JPM, WFC are few good examples for this, though like everything else in the market this is not a rule (think of Lloyds). I think taking a long-term view also helps and this includes taking a long-term view on external conditions. For example one could have looked at US housing market few years ago and made a macro/industry call that housing market is likely to do better over next years as supply catches up with the demand.

Overall I think even if you are investing in a company on the basis of its fundamentals, macro dynamics will be relevant for the total return and therefore one needs to have some framework to think about these especially in the long-term.  For example equity markets are likely to do better in the countries which have right conditions for companies to deliver good shareholder returns (think of properties law, society’s attitude toward capital and capitalism, economic growth potential). A good example of this is US banks versus European banks. Though US was the epicentre of 2008 crisis, US banks have been a better investment than European banks over last 10 years. Even the highest quality Spanish or Greek bank delivered lower return than US banks ETF. So yes it is important to do investing based on bottom-up analysis, but macro context and timing matters a lot in the outcome and one should at least be aware of it!!

Investing in high quality companies…

Investing in high quality companies is extremely popular and makes sense. But what constitutes high quality is not easy to define and it is even more difficult to identify those characteristics in a company. Given these challenges, most investors have used simple heuristics derived from historical returns or what famous investors like Bufett has said about quality. But one thing that I have learned from my investing experience so far is: one needs to think independently to generate above average returns.

Given my bullishness on some auto companies, a friend of mine sent me a talk by Aswath Damodaran on valuation. It is a very good talk indeed. In this talk Aswath, talks about how horrible auto industry is and this is what my friend wanted to highlight to me. Since I actually listened to the whole talk, I would say it depends on the story like Aswath says. But most investors don’t bother to do the hard work to think about the story and take the easy route of listening to his simpler message that auto industry is a bad investment. Anyway so that got me thinking and I decided to compare the returns of a well known high quality stock like Coke with one of the best known auto company to me – BMW. Here is what I found:

Returns as of 27-04-2018 (%)	KO	BMW
5-year	18	56
10-year	98	245
15-year	221	343
20-year	90	353
25 year	653	2132

I must say I was surprised by the consistency and scale of out-performance. Now with favourable results and Bloomberg at my hand I put few more companies into the list to compare and again was surprised by the results:

Colour highlighting is across the rows and dark green cell highlights the best performer over that period. From this short data analysis, I can say at least following:

• SPX, and defensive companies like Coke and Pepsi were not the best performers in almost any time frame over last 25 years
• High quality companies even in the industries notorious for wealth destruction were often the best performers e.g., Ryanair, Southwest, BMW
• Companies disrupting the existing industries (e.g., Microsoft) generated the best returns over last 25 years
• Berkshire is somewhere in the middle – better option than SPX and other defensive companies certainly
• Price matters as high-performance led to under-performance in later years in almost every case

So from all of this, I could conclude only following:

• Focus on high quality companies and not on industries known for high quality companies
• Not all companies in industries perceived as low quality are low quality. BMW sells premium cars and comparing this to VW or Ford might not be the right comparison.
• Independent thinking is absolute pre-requisite, though not gurantee, for generating outsized returns. One needs to think hard about what makes a company high quality and whether price justifies it.
• Like I read sometime ago – investing is hard and easy investments like Coke, which worked out fine in 80s and 90s, are unlikely to generate outsized return 🙂