Chinese Hard Landing

Tags

china, crisis

Consider two recent comments on the Chinese economy

“A hard landing is practically unavoidable…” – George Soros

“We are going to see an evolution, not a hard landing and a move towards a sustainable growth” – Christine Lagarde

A legendary investor and the highly regarded head of IMF have polar opposite views. And there is no dearth of views in between.

An investor can quite easily be drawn into these discussions about the outlook for the Chinese economy, the perils of hard landing & how it may impact the world. The debates on chinese debt burden, capital flight, currency fluctuations, stock market volatility, etc. can be quite seductive. The more uncertain the economy, more common are such discussions in daily life – at coffee shops, bars, parties, office lunches, and so on.

But do they matter? Not at all, especially for the long term investor interested in high quality businesses. For two key reasons. One, the economy (chinese or global) is a complex system influenced by many factors and any forecasting is a futile exercise. Second, the chances of a high quality business with sound fundamentals surviving a downturn is high.

Watching the economy is a useful habit, as uncertainty and volatility can throw up good investing ideas.

But the investor is better off spending most of his time studying quality businesses.

IBM – A Value Trap?

Tags

Debt, IBM, Warren Buffet

The elephant is wobbling, even as some expect it to dance. Among the admirers is Warren Buffett, which makes IBM an interesting study. Its among his top 4 holdings, worth more than $10 billion. He started buying in 2011 & bought more in late 2015.

What makes Buffett’s choice of IBM interesting is it seems to go against some of his basic tenets. IBM carries huge debt. A massive $40 billion debt on just $14.4 billion equity. It is also in the midst of a turnaround, trying to increase revenue from new high-growth, high-margin businesses and divesting slow-growth, low-margin businesses. Simultaneously, it shows a high >90% return on equity, significant free cash flow of $13 billion, both consistent over the last many years.

Huge debt of this size can kill companies. Also IBM may not need such debt to grow its business, as it generates significant cash from existing operations. Part of the debt has possibly funded dividends & its massive share buyback program over last few years. Both revenues & net profit have dropped over last 5 years. But operating EPS has grown, largely because of the share buybacks.

The business turnaround has shown progress, but its not done yet. IBM’s so called strategic imperatives (high value businesses) has grown to contribute 35% of total revenue. These businesses – cloud, analytics, mobile, social & security – are new, fast changing & prone to disruption by new upstarts, besides competition from the likes of Amazon, Oracle, Accenture etc. As Buffett himself has said before, turnarounds seldom turn, even with great management. This cannot be a sure bet.

An optimistic scenario would be IBM executing well on both its ongoing debt & earnings management, and the turnaround. A pragmatic scenario is a long, uncertain & difficult turnaround, slowing or flat revenues & profits, and debt pay downs using the cash flows.

In the meantime, IBM’s handsome dividends & growing EPS could possibly reverse the drop in stock price. Its fallen from about $170 per share when Buffett started buying in 2011 to about $122 now. Some find it attractive due to its significant cash flows, ability to remain profitable, and strong brand & IP, despite huge debt.

We have a modern Titanic, sailing on unchartered waters, executing a turn-around, with some interesting passengers on board. Will the ship come home?

Is oil a good buy now?

Oil stocks are down. They may look quite tempting, especially for a contrarian who believes in reversion to the mean. The danger is the reversion may take a long time or may not happen at all.

Crude oil has fallen steeply from about $120 per barrel a few years back to about $32. Media is awash with both bullish & bearish forecasts, which are nothing more than amusing reads, considering nobody foresaw the precipitous fall in oil price a few years back. Stories & reasons abound for both scenarios. Oil prices should drop further because of a supply glut, slowing economies & demand, increasing attractiveness of alternative energy sources, and so on. The other camp argues oil prices should increase because of political tensions & diminishing oil revenues in the middle east, rising differences within OPEC, higher costs of production which cannot sustain low prices for long, and so on.

A good way to think about oil prices was put forth by Howard Marks of Oaktree Capital in a note titled ‘The Lessons of Oil”, sometime back. Forecasts are useless, more so for a commodity like oil in an extremely complex & volatile global political economy.

Some savvy value hunters have started taking positions in oil exploration & production companies, based on factors like estimates of proven reserves, management capability, & strength of balance sheet

So what can the trigger-happy contrarian do?

Perhaps allocate a small amount, which has to be written off as lost capital from day one, to buy a few such stocks to learn (not earn from) the lessons of oil. Skin in the game is a good way to learn.

What the Gita & Stoics teach us about investing?

Tags

detachment, duty, gita, Investing, stoics

Nothing directly, of course, but their ideas provide interesting approaches to modern capitalist riches.

1. Detachment

Both Gita & the Stoics caution against too much attachment – to family, friends, material possessions etc.  They encourage us to live life with joy, do not advice abdication of worldly pleasures, but also urge us to practice detachment.  Be aware all people & possessions are temporary, and they may be lost.  Practice negative visualization – imagine losing your prized possession or loved one – this will help you appreciate the present & live well.

Lesson for the investor – Don’t get infatuated by the stocks or businesses you buy, or plan to buy. Buy or sell based on facts, not on rumors, tips, fads or impulse. Beware of behavioral biases.  Be rational. Can you stomach a 50% drop in the price of your favorite stock?

2. Do your duty, don’t obsess over results.

The Stoics believed in being fully engaged in their worldly roles as teachers, public servants, family folks, merchants etc.  The Gita urges us to practice Karma Yoga – play the role we have been given, or have taken up.  And, importantly, both the Stoics & the Gita caution us to not obsess over results, and many other aspects of life which are beyond our control. You may want to be a world-class athlete, and practice rigorously towards that, but winning at the Olympics is not 100% under your control. Be aware of areas you can control, and focus your efforts.  Ignore areas you cannot control.

Lesson for the investor – Focus on your circle of competence. Work on industries & companies you understand well. Do your due diligence, obsess over the evaluation process, keep an eye on the goal, but don’t brood over expected outcome.

3. Reality & Maya

The Stoics realized our well-being is directly tied to how we react to the external world. We can choose to be happy, sad, angry or calm. Your neighbour may insult you – you can choose to ignore him & be calm, or get angry & beat him up. Your government may be corrupt – you can choose to shut-up & endure, or speak-up & fight. You may be thrown into jail – you can choose to suffer, despair, endure, learn, improve, grow etc. Reality is what you choose it to be.

The Gita says life is an illusion & nothing is real. You have to cut through this Maya to enlighten yourself.

Lesson for the investor – The stock market volatility, news, commentaries, research, rumours, tips & fads – all these mask reality. You can choose to ignore, revel, read through, be-friend, or over-analyze them. Only being rational helps you wade you way through market maya and mayhem. Your financial well-being is directly tied to how you react to Mr. Market.

Drawing anymore parallels may be obsessive & illusive.

Sorting luck from skill

Tags

luck, reversion to mean, skill

Why some of us do better than others?

All of us know of richer, or happier, or more competent, or better performing, or more blessed, people.  From whatever angle we may wish to see, some people do better than others.  And so is the case with institutions, sportsmen & teams, companies, governments etc.

Is it luck or skill?  This is quite intriguing.

The concept ‘reversion to the mean’ (RTM) is useful to understand this.

RTM is based on the fact that, in most human endeavors, the outcomes are a combination of skill & luck.   Of course, some (like chess) are based on pure skill while others (like casino games) are based on pure luck.  But the vast majority fall somewhere in between.

In cricket, for example, a batsmen can lash with great skill, but yet he may score low because of chance events. Companies with great success streaks stumble (New coke). Political leaders adored in their ‘growing-up’ years prove to be disastrous failures after landing the top job.

The reverse also happens.  The unseeded tennis player wins the championship.  An upstart company startles the market leader.

RTM is a statistical concept which says everything hovers around an average.  This means that things tend to average over time.  This is because, by definition, luck is a chance event and not permanent.  Luck comes & goes, only skill is constant.  An amusing way to look at this is,

Success = some skill + luck
Great success = some skill + lots of luck
(this can be restated for failure as well)

We need to sort skill from luck, when contemplating people, or institutions or entities.

Tending to average doesn’t mean becoming mediocre, because skill is a individual or entity-specific characteristic.  The average performance, over time, of a vastly talented sportsman will continue to be superior to the average performance, over time, of his lesser talented colleagues.

RTM also means that good and bad times don’t last for ever.

From a personal point of view, focusing on improving skills is more important, relevant & easier.

Luck also can be managed.  Good exposure to positive events, people, books, locations, groups etc. can lead to delightful serendipity.

But skill first, luck next.