11-11-2019

This is not investment advice. This second part is a lengthy piece, as there was a lot to cover, and I could not find a way to cut corners on such important thoughts. I don’t expect to provide such extensive thoughts in future memos.
 
Happy Veteran’s Day! Both of my Grandfather’s served during World War 2, and they were pillars in our family. Discipline, perseverance, integrity. Both have passed, but what my Mother’s father did for NASA and what my Father’s father did for the Groton submariner school will live on.For all of the veterans, I salute your accomplishments and sacrifices.
 
In part 1, we looked at current returns on capital and why figures may get worse before they get better. Below, let’s look at macro concepts as they relate to short and long term perspectives altogether with shades of grey. Election season is here in the US, the trade war with China is still escalating, and debt is becoming too hard to ignore, especially with historically low interest rates. Basically, much of these things have happened in the past and we can glean what the future holds, or at the very least give us probabilities thereof. Based on reports, refinancing the American economy has gotten tougher.
 
Election – The trade war caused higher public debt, put businesses in a vulnerable position, and didn’t accomplish much for the US. I fully agreed that the IP transfer needed to be corrected, but I also knew that China held a lot of cards, namely the population is about 4 times the US. So, who will back the US debt going forward? More importantly, who will convince such a person that US is credit worthy? A liberal probably isn’t the right candidate to make such an argument, for instance Elizabeth Warren, who plans to charge wealthy for a new medicare plan. Such a plan might attract the bottom 90% of voters, but will ostracise the wealthy. Taking asset allocation power from the private sector and putting it in public hands can’t work for America. The US premium from the beginning was the efficiency and encouragement of the private sector.
 
Adam Smith said of America “Individual Ambition serves the common good… The best result comes from when everyone in the group does what’s best for himself.” [paraphrased]
 
To provide historical perspective about this axom, let’s consider two examples. In 1836, James Rothschilds explained the Rothschild strategy in a letter to his nephew:

“When you are buying and selling securities in Paris, try not to look at making a profit, but rather your aim should be to get the brokers used to the idea that they need to come to you… One initially has to make some sacrifices so that the people get the idea to come to you, my dear nephew, and as such one first has to spread the sugar about in order to catch birds later on.”

Keep in mind this ‘capital for influence’ strategy worked brilliantly for more than 50 years until income tax was introduced in 1842 in London (and soon after Europe) – governments were almost bound to borrow from wealthy without an internal revenue service. Additionally, there were no public bond issues until a number of years after that.

 
It’s no surprise that business dried up, and the Rothschilds went to rough emerging markets, namely Russia in the mid 19th century. Now, let’s not mince words – Russia is no America by any metric, which is part of the reason investing there is so attractive – investors expect economies to behave rationally. Importantly, relations with the Prime Minister were poor from the beginning, but the opportunity was better than those in other countries. The internal struggle, however, was fierce – Russia only needed Rothschild money during the war with Poland, and loans could buy lasting influence in St. Petersburg. On the other hand, James said – “If we support Russia against Poland, I will be clubbed to death, as France is passionately is behind Poland.”  Nathan sold nearly 28,000 guns and provided millions of pounds sterling (hundreds of millions in today’s Pounds). Much of the loan was never recovered, the family never obtained influence following the war, and relations with the Prime Minister grew worse.
 
George Soros ended up getting burned by Russia in the 1997 to the tune of ~$1.5 Billion. Soros provided private financing (highly illiquid) behind the IMF’s back, only months before the Russian Ruble was devalued and economic reform all but died. Soros thought Russia would behave as a developed economy would, loan rates skyrocketed to 165%, and Soros gained a black eye in Russia and the IMF he still hasn’t shaken.
 
So Russia has been a failure multiple times, but the importance of this perspective is that the opportunities there attracted big money. Should America get into a situation of high inflation and plummeting asset prices, hundreds of financiers would stand ready to trade capital for influence. After all, if billions can flow into Russia’s backward economy, America must never have the possibility of such vast disappointments.
 
 
Early in his career, Andre Agassi couldn’t afford to get an ice cream bar at a 7/11. Agassi had turned pro in 1986, had a pink mohawk with earring, obviously the antithesis of a disciplined player. Nobody considered him at the time. A Nike rep arranged to meet Andre at a bar in Newport, telling him how talented he was. A $20,000 investment later, Agassi would go on to use Nike throughout his career, generating an enormous influence and ROI on that meeting. Over the years, Agassi would consider other brands, but fall back on Nike for seeing what no one else saw. There really isn’t too big a difference between funding a startup like Agassi and refinancing a dying country like Russia. The risks of not getting a return on your money are high, but the investment scales are obviously different.
 
Elections offer a turning point similar to the two incidents above, where money flows to purchase influence. Today, the influence is diluted by the vast capital sources for a government, but anyone living in Washington will tell you influence is still bought. Any sell off in America will probably be bid back up. Though debt in America (i.e. public, corporate, consumer) is 3 times GDP, what’s to say that we can’t refinance (get bailed out by a lender) into oblivion? It’s all a matter of who is president. Perhaps America can still outperform relative to other countries and attract capital – this question is above my pay grade. 
 
BUT…. 
 
I would think this is the case due to the relatively high standard of living we enjoy in the US. So, it may not matter who’s running the country after all, or if the economy is visibly dropping as it has been. 
 
Nonetheless, the question remains – what happens if the US can’t find money to refinance? The US and USD lose purchasing power – the government can’t pay its employees (i.e. defense), corporations can’t pay to innovate, people can’t pay for food. This is a form of Austerity seen over and over again, most recently in South America over the last few years. Rates will rise to the sky. Chances of this are still low, but have risen lately in my mind.
 
BUT….
 
Three rate cuts later, the Dollar is still strong while 10 year treasury yields have picked back up. Long a proxy for inflation, is the 10 year predicting a rise in prices and a drop in USD value? Seems unthinkable to me, but there are certainly too many variables to turn over. In any case, I’m hanging on to US bonds.
 
There isn’t much to say about the trade war except that the odds are very high it will get worse. If they do, the Fed can step in to lower rates again. “Bad news is good news”.
 
Accounting Issues:
 
So, if revenues are dropping and will drop further next year (as Amazon and others have predicted), why is the market rising? Recently, I met with the Chief Legal Officer of Axos Bank, which bought a clearing company this year. He explained, without reservation, that Algorithmic Trading is to blame on rising markets. The economy has a daily battle of Carrot and Stick, Eshel said, where almost all institutional money trades by algorithms, and if a security drops a certain percentage, the algorithm will trade it down into oblivion. It’s no longer possible to drop bad news without sugar coating. We went further and I surmise from the discussion that the carrot of presenting bad numbers in a good way is now greater than the stick of presenting bad numbers in a fair way.
 
In light of Enron remembrances, the risk of accounting fraud at these levels is heightened, and I constantly find myself putting too much emphasis in forensic analysis rather than fundamentals. If a company is returning capital at over a 5% rate right now, it is virtually certain that accounting issues are at play. *Caveat – some sectors that are impacted by the trade war (construction, agriculture, metallurgy) show those returns, but the risk is high that such returns will deteriorate.
 
The risks are higher for all assets, but in my research, forensics has become as important as fundamentals. This is an area that is taught by researching thousands of corporate lifespans. The problem of placing such high value on forensics is twofold – you turn away almost all investments shown to you and that it really only works reliably in microeconomics.
 
Dividends
 
Dividends are now mostly a loser’s game, and have lately been utilized more to attract investors than return capital prudently. If a bank account promised 5% return when other banks are returning 1%, would you go for the 5%? In my opinion, equity investments should only in rare cases pay dividends. The Rothschilds beat rivals by not paying themselves much for almost 50 years as they grew their bank. See Realogy at bottom. As I detailed in part 1, McDonald’s has falling revenues and profit, but the dividend is increasing each year.
 
Anything making over a 5% non-levered, risk adjusted total return over the next 2-3 years will be incredibly attractive to me. In part 1, I explained how a drop in revenue and earnings should lead a mature company to lose value, not gain. Sales growth always takes priority over other fundamentals. Period. We lost that mojo, but we are at record highs….
 
Who really cares? Bottom line is that even if numbers are getting worse, people are better off without recessions anyway. Perhaps human nature is to blame for the preference of continuing forward in the short term and destroying long term competitive advantage versus prospering in the long term. Delayed gratification ain’t what it used to be.
 
Thus, as lackluster results continue to grow louder and louder, the bailout will either be from wealthy foreign financiers looking for influence or cheap money by way of the Federal Reserve. The can will continue to be kicked for the next couple years and maybe longer. Go with the flow. As legendary trader Jesse Livermore would say, “It’s a bull market, after all!”
 
P.S. “Sign of the Times” segment –
 
Yelp and Realogy (as of 11/8/2019)
 
Yelp for years has been a crowdsourced reviews company, but as of a few years ago, Google has dominated the niche. How has Yelp fared? Let’s look at the numbers:
 
  • Profitability peaked in 2017 at an 18% net margin on 20% revenue growth YOY. Market cap was about 3 Billion, or 20 times earnings. Last year, profitability dropped to less than 6% on revenues only 10% higher than 2017 revenues. Shares traded about at 2.6 Billion or 50 times net income.
  • This year, yelp is trending to improve revenues over last year at 7%, while the net margin has deteriorated further to just above 4%. Market cap is currently at 2.5 Billion, or over 60 times earnings.
  • The original business model is second chair to Google, which also controls SEO, something Yelp also touts as a strength. In the call this quarter, C-Suite detailed the challenges and explained how hard it would be to maintain growth long term.
  • At these levels and trends, the market is buying Yelp for a roughly 1.5% return on capital, and that’s if the business can maintain net margin. I agree with management that Google will destroy Yelp, but the market isn’t listening. 
  • On another note, ‘Free cash flow’ has increased by 33% total (to $~200 M) since EOY 2017.
    • However, free cash flow includes $120 Million of Stock Based Compensation, a non cash charge figured into Free Cash Flow. Total FCF is normalized at $80 Million in 2019.
    • However, more than $300 Million is being spent on stock repurchases, which is draining assets that could otherwise be used to grow the business.
    • Repurchases only make sense if the return on capital from such a purchase is higher than spending directly toward business growth. Generally this is seen when the business model is ironclad (i.e. the company is minting money it can’t use). 
    • This is a poor use of capital. A cash dividend of the free cash flow would be preferred, but building the bottom line is the best use.
  • I’d expect Yelp around $18 based on what I see. The risks are just plain too high. However, I don’t have a position nor will I near term.
Realogy
 
RLGY for years has owned the largest person to person real estate firms, like Century 21, Coldwell Banker, Sotheby’s, and Corcoran Group, among others. The business model still appears intact, even though Compass, Zillow and Redfin are all vying for RLGY’s collapse.
 
  • Similar to Yelp, recent profitability peaked in 2017, when the net margin was 7% on revenue growth of 5% from 2016. This coincided with the lowest rates on the mortgage index in the history of mortgages. Market cap at the time was around 3.7 Billion or 9 times earnings. The last year of such profitability was 2013, when RLGY traded about at 7 Billion, or 16 times earnings.
  • Last year, net margin was 2% on a 1% drop in revenue. Market cap was about 1.5 Billion, or 10 times earnings
  • This year, RLGY is on track to lose about $0.03 on every dollar of revenue (loss of 170 Million in 2019), while revenue dropped 5% from last year. Market cap is currently $1.1 Billion.
  • More than 6.5 Billion is intangible assets. These assets are wastes of money by RLGY, where the company used capital to overpay for brokerages that are currently not panning out. Hard to think those assets will retain any value long term.
  • Net working capital has been negative since 2014, as RLGY is bailed out by lenders. Again, we have a situation where there are more claims on assets (most of which are intangibles) than assets themselves. RLGY is underwater.
  • This quarter, impairments are listed as $186 million YTD and the dividend has now been cut from $0.36 to 0. Interestingly, the dividend was only begun 3 years ago.
  • Long Term Debt is about $4 Billion, and total payments are going to be around $200 Million in 2019, growing in future years. 
OK, RLGY is losing money, losing revenue, and is heavily underwater. Still, over $1 Billion is still invested. How can any investor expect to breakeven on the investment, outside of a lottery-like buyout from [Softbank]? Interestingly, as RLGY posted another loss on lower revenue and cut its dividend this week, the stock gained roughly $200 Million. 
 
I don’t have a position in any of the stocks listed at this time.
 

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