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10-28-2019

This is not investment advice.
 

Over the past month, two biographical books have come and gone from my desk – detailing three Rothschild generations and the pro life of Andre Agassi. In juxtaposition of each other and current market cycles, there are many parallels. Two things in particular, that bailouts will continue driving the ship in spite of all shortcomings, and that while execution is important, marketability has a thoroughly higher premium. Finally, going with the flow was critical to track records.

 
That James Rothschild held his French bonds during the 1830 French Revolution is auspicious, just as was Andre Agassi’s return to be a tennis champion after a long fight with drugs. Less than two years from that crash, James had begun throwing balls for new dignitaries yet again, and Agassi was again in the top 10. In today’s markets, data are showing signs of recession globally, but the wildcard in all of this is capital flows. During the first week of October, most economists declared Germany in a recession based on Net export data; similarly, the US found low inflation and reports from both the manufacturing and farming sectors damning. Of course, the largest issue is the debt being heaped on, especially in the face of a worsening trade war. 
 
The progress through this month has seen a blend of good and bad. Homebuilders and banks reported great numbers overall, though almost every corporation otherwise has performed relatively badly, and the trade war has escalated throughout the month. While around 80% of corporations have met or exceeded earnings results for Calendar Q3, the story is misleading for several reasons.
  1. 80% isn’t great
    • These companies largely form their own guidance; it’s farcical that so many companies could miss a target they set for themselves only 3 months prior.
    • Surprisingly, last year’s Q3 results had a 90%+ meet/exceed stat.
  2. Revenue declines Year Over Year (YOY) are estimated to be around 3.5%
    • Micron, for instance, had revenue drop 42% YOY, and guided flat for next quarter
    • If price is a function of earnings instead, Micron’s EPS dropped 87%.
    • Micron’s stock is up 40% since last year, trading at 2.6 times sales and 27 times forward earnings. The trade war has escalated, affecting key relationships.
    • This picture of dropping revenues and earnings is similar for most reporting companies this quarter, though the advance of the market during this month is now 4% and rising. 
  3. Debt-fueled buybacks
    • Micron bought nearly 6% of its stock back over the past 4 quarters, like most other firms. The cost of equity is much higher right now than that of debt. 
    • Corporate debt is costing between 3 and 3.5%. *Corporate debt is predicated on the saleability (i.e. price) of a stock’s equity in most cases.
    • Thus, buying stock back is a 4 step process.
      1. Obtain a rating based on stock price. 
      2. Sell debt to the market and players based on mostly investment grade credit ratings.
      3. Buyback stock to artificially increase stock price.
      4.  Repeat steps 1-3
So what? 
 
This month, I have taken a few short positions against companies that look bad on paper, but my success has thus far been fleeting. Why? Analytically, the companies are certainly in trouble; alas, they have enough cash to survive. The combination of a strong dollar and relatively low rates a corporation can easily keep itself alive cheaply either by funding its own operations, or by buying other companies to guide profitability higher (inorganically). 
 
To look at another company, McDonald’s.
 
  • Revenue has now declined from $28 Billion to $21 Billion since 2013, about a 5.5% drop each year. Net income has risen 10% over that time, as the company focused internationally. However, not considering the tax reform of 2017, profits would have dropped 10%. 
  • The strong dollar certainly is a big reason for the drop in revenue, as international revenues must be translated into USD. This weakness should be reflected in the share price as a risk of the business model.
  • MCD has bought back over 22% of its shares over the 5 years, with a big help from debt issuance – MCD debt issuance has increased 125% over the period. 
  • * Taxes on earnings dropped 44% last year for MCD, which again is common for most companies after the tax reform, and accretive to the increase in profit margin above.
  • Analysts have continued rising their price targets over the 5 year period, now at $225,  19% higher than today’s price, and a return on capital of only 3.5%.
  • Profits of $6 Billion on Market cap around $150 B is about a 4% return on investment for a buyback, but the cost of the debt currently is about 3.2% for MCD in total. So it makes sense to keep buying back if both profit margins and debt costs are sustained.
  • Keep in mind that MCD also pays a 2.5% dividend, earning you about 3% on the stock today. Remember that you buy at the same valuation the corporation buys back. Is that 3% enough for investors to hold stock? Historically, no.
Here, you see very plainly that no matter what revenues do, companies will keep rising higher due to the 2017 tax reform boosting profitability on one hand , and lower interest rates providing for buybacks on the other. Of course, buybacks and analysts can destroy shareholder wealth. For MCD, when/if profits get below $5 Billion, or if rates rise  quarter point, the dividend will either stagnate or reduce. This is evident in most Fortune 500 stocks today. 
 
To spend 3.2% of capital on a 6% return is not good business. A reach for Productive assets is now becoming lottery picking, even in the boardrooms of the largest corporations. Yes, these companies in America have enough cash to survive, but at what point do you say that a 3% return on investment  at the top extreme simply isn’t enough for you? 
 
The new IPO companies promise a negative return on investment, which is, in fact, the same as a lottery – the odds are literally stacked against you. There may be a winner, but there will be hundreds of losers. Without the ability to lose all of your investment, that risk of a win outweighs reward infinitely. Not to mention that a company selling stock likely has a 10% + hurdle for cost of capital today for profitability. Most analysts point to a 20% yearly growth in EPS for 5-10 years in many of these companies. That simply isn’t materializing. Erstwhile, investors continue buying the shares in the hopes that the 20% + CAGR will materialize. 
 
But what happens if more money keeps flowing from other sources and/or the interest rate drops another 1/4 to 1/2 point? This is why companies/consumers/governments can continue taking risks – because they will keep getting bailed out. The Rothschilds were wise to this, and is why James continued his strategy of handing diamonds out and lending money when his French bank plummeted in value during 1830 and 1831. Should James have sold the bonds he held, he would have lost faith in France as a country, which thrived in the century ahead. There was simply no other choice. Likewise, Agassi could have retired, but he didn’t want to go out on the bottom.
 
Though debt in America (i.e. public, corporate, consumer) is 3 times GDP, what’s to say that America can’t refinance (get bailed out by a lender) into oblivion? 
 
Investors refuse to believe that America is not a worthwhile investment, for reasons I discuss in the next segment.
 

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