1-1-2020

Happy New Year! One of my favorite quotes rings in my mind:

“You are never too old to set another goal or dream another dream.” ~C.S. Lewis
 
*My goal is still to be on the PGA tour… Maybe I should dream a different dream… 
 
In this memo, I discuss a little mentioned macro valuation method and how it may portend success or failure. None of the below is investment, tax or legal advice. Please set up a consultation for advice that fits your needs.  
 
151%. That’s the value of stocks (market cap) versus the Gross Domestic Product of the USA. Traditionally, a reading under 100% is investable, and above that we should be wary of buying too high. 
 
Japan stocks trade around 14 times their earnings, which is an after-tax yield of 7%, which is great, but then again, the GDP hasn’t changed in 25 years, meaning that market capitalization persists well above the 100% level. Two lost decades is remarkable, and while the island will continue to exist, the rise or fall from here in GDP is a quagmire. Do you invest in the economy because earnings are consistent, or for the growth of the economy? Will it grow like California, or stagnate like Mississippi? 
 
OK, let’s look at this ‘market cap to GDP’ ratio differently, in the lens of real estate. Let’s start with a brand new apartment building. If the town the building is in will grow, the value will also and if it grows well, the price multiples of your building grow nearly exponentially. 
 
Mississippi currently has nearly a 5% cap rate on class A buildings, compared to about 3% in California. The discount is from localized economic growth. If you invest in California today, you are betting on growth, while if you bet on Mississippi, you are betting on cash flow. Mississippi, however, still has many properties still underwater from 12 years ago…
 

As mentioned last month, we are buying cash flow now. Momentum stocks have a relatively higher risk of a fall and large tail risk, though of course they can still move upward forever. That doesn’t make them good investments in my mind. However, there are some ‘momo’ stocks that do have great business models, and those that have consistent cash flow growth will be the long term winners, but that’s risky.

And then there’s the China effect. Curiously, any product companies that consolidate global inventories using FIFO are getting killed on cash flow. I would guess that the majority of companies these days use FIFO cost systems, which has dropped cash flows sometimes by more than 150% since the end of 2017. 
 
So, will the tariff war be resolved? Raven’s Beard I hope so! Of course, that would create a great scenario for China, which sports below a 50% Market cap to GDP ratio. Much of that GDP is being fueled by debt, which totals over 3 times the GDP. Excellent GDP growth and low prices for the GDP is nothing if there are giant bubbles around assets like real estate. The price discount in the Chinese markets manifests the debt and tariff concerns, along with the perennial spectre of Socialist government meddling.
 
In the same vein, we have Brexit – an escape from socialism. Will Britain exit the EU on January 31? This is a positive, as I’m of the view that the EU has been a slight success for the worst economies and an outsize failure for the better economies. 
 
Also, I find it ironic that England is trying to escape oppressive, over-taxing governments 250 years after our American forefathers did. Alas, how the world would be different if Parliament had embraced change then rather than now. 
 
In summary, the macro view is – what country will have a higher GDP in the future than today? And then, how will the pricing of that GDP change in the same time period?
 
Here I could speculate on the reasons, but diverse decision making on so many levels forms the success or failure of economies. Therefore, I’ll be somewhat naiive and say that the populism movement won’t have the effect that most reporters tout; I will always back America no matter who presides.
 
A final point (though largely unrealted) on real estate. Series LLC’s – Save money, time, and stress with these. Give me a call for further information. 
 
Tariffs, reprisal
 
Among the diverse product and services businesses getting affected by the US-Sino tariffs are the Manufacturing and farming segments. These segments represent only 11% and 3% of the US economy at this time, leading to an allocation question.
 
We are looking into the abyss – will this be the time that the US gives up its farms and much of its manufacturing to focus on higher margin businesses with more comparative advantages? Or will we take energy and resources away from our best sectors to bolster them? 
 
This may be a point where we cut off an arm to save the body. Your move, Mr. Trump.
 
In any event, the long term investor will reap major rewards by sticking to a well formulated investment strategy. This is the topic of part 2 coming soon. 
 
Make it a great year!

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