August 23, 2019
An important read: Why profits matter (and value investing is not dead)
We have currently reached the point in this cycle where many investors/commentators have started to question whether profits no longer matter, and also whether value investing is dead. As is often the case, the arguments put forward in the affirmative derive mostly from recent market experience/outcomes, rather than reasoning from first principles. Hyper-growth (and generally loss-making) tech companies have seen outsized share price gains, with many recent IPO vintages also seeing triple-digit gains, despite the absence of any profits either in the past or foreseeable future, in echos of the dot.com bubble. Meanwhile, many profitable and cash-generative companies with low growth, and especially with falling earnings/revenues, have been absolutely massacred.
Profits are vitally important, not only because that is the only means by which stocks ultimately generate returns for, but also because profits (and losses) are absolutely vital to the healthy functioning of a capitalist economy, and indeed are the ultimate test of whether a company is doing anything worthwhile at all.
Over the past decade, the need for profitability has broken down in many areas of the economy, as loss-making companies have not only been allowed to survive but are also rapidly growing. In many cases, they have only grown because an extraordinary amount of capital has flown into venture capital and other tech-based funds.
Many investors today are currently impressed with rapid rates of revenue growth, regardless of the state of the bottom line. Much as with the dot.com bubble and its subsequent unraveling, where many 'old world' value businesses were left for dead, only to stage dramatic recoveries in the following decade, a likely consequence of the coming tech wreck will be a significant resurgence in the performance of many 'value' stocks, as their sales, market share, and profitability recover as 'disruptive' competitors go broke, and their multiples dramatically recover.
When will the reckoning occur? It is impossible to say, but it will occur when the funding bubble bursts and companies are forced to once again fund themselves from operating cash flow.
Could it be when the pace of cumulative losses across the upstart tech ecosystem starts to exceed the pace of new fundraisings? Softbank has been a major contributor to startup fundraising with its outrageously-sized US$100bn Vision Fund. Softbank has already blown through the majority of this funding in only two years. But the pace of operating losses continues to mushroom, and Softbank is now running out of money. As a result, Softbank is currently trying to hastily prepare a second US$100bn Vision Fund to keep the house of cards intact. Time will tell whether they succeed.
On the Other Hand - implications of the Fed's interest-rate management
Is it the Fed's job to sustain expansions and keep market dislocations at bay ad infinitum?
Many people take Fed actions at face value. When the Fed cuts interest rates investors take that as a "buy" signal. Their thought process is simple: weak economy ? rate cuts ? economic stimulus ? stronger GDP ? higher corporate profits ? higher stock prices.
Are low-Interest Rates a Good Thing?
The Fed's decision early this year to depart from its announced program of rate increases to the S&P 500's gain of roughly 20% so far this year. But how, exactly, do low rates contribute to wealth creation?
Low rates reduce the discount factor used in calculating the net present value of future cash flows.
By reducing the interest expense on companies' floating-rate debt, low rates enhance companies' profits; make it easier for them to service their debt; and leave them more cash for capital expenditures, and dividends and stock buy-backs.
What about the downside?
Low rates stimulate the economy, and most economists and businesspeople believe there's such a thing as the economy becoming too hot. The principal worry is excessive inflation. While some inflation is a good thing, too much isn't.
When low rates penalize savers by reducing the returns available on instruments like cash, money market funds, savings accounts.
Should we be happy to see the Fed trying to prolong the economic expansion and the bull market when they're already the longest in history? Should it try to produce perpetual prosperity and permanently ward off a correction? Are there risks in its trying to do so? It all depends on which hand is doing the weighing.
Three Mindsets of Great Investing Teams
Culture reflects the mindset of a firm. The mindset is the set of attitudes that the firm holds. So what sorts of mindsets correlate with investment success and better decisions?
Great investment teams are more interested in getting the facts on the table and searching for the truth than they are in winning the argument or looking good. The best among them learn to recognize when they have become defensive so they can shift back to that curious mindset.
The ego wants to win, but the good team member wants to encourage open and honest communication. Success means that we have encouraged others to remain curious. Failure is when the discussion turns defensive and unproductive.
All criticism and no appreciation creates a fearful environment. When we're in such a space, we wonder if any of our work is valued, if we're doing anything right. And we become more risk-averse and myopic: If our normal work generates negative feedback, why take a chance and stretch beyond our already constricted comfort zones?
Less size and more insight
The age of asset gatherers has peaked and the asset management industry is re-entering the age of the boutique, where it began. What will matter is less size and more insight, which will support the outcomes sought by asset owners. Delivering that added value will require closer economic alignment between asset managers and asset owners.