Monday, October 6, 2014

Markets are topping -- Should I care?

Well, personally I have had the opinion that the markets were near their peak about 4 years ago! Got that wrong!  However, now the consensus is that the markets are near their peak (there's always a consensus that support your views/opinions).

How did we get to such high levels -- today earnings as a percentage of GDP are at a historical high (12% of GDP).  Companies are sitting on mountains of cash (granted most of that cash is offshore and will not be repatriated for tax reasons.  Companies continue to do well, and yet all earnings are directed to either dividends or stock buybacks.  Paying dividend is rational (some would disagree) and in many low growth sector essential.  But stock buybacks are another story: either funded by free cash -- or via more debt (debt is always cheaper than equity -- and has been incredibly cheap recently).  The CEO's decision to buyback his company's share are driven by a number of factors:


  1. Increase earnings per share (smaller number sharing the income pie)
  2. Increase the price of shares (as a management goal -- think CEO compensation)
  3. Better allocation of capital:  That's the worrying one!
In general, companies are well aware of the impact of share buybacks on executive compensation.  Maybe 10/20 years ago the wool could be pulled, but in reality the decision by management is often driven by an inability to find attractive investment opportunities -- and aside from keeping cash for acquisition (and making the company attractive to raiders).  the reason to buyback shares is driven by short term goals (not abnormal for  companies that change CEO every 4 years).  The reason that CEO prefer buybacks is that they cannot find (or fathom) attractive investment opportunities.  This has been a growing trend over the past few years.

This inability to find productive use for their capital, is telling with regards to future economic growth.  The engine of growth (job and GDP) is entirely driven by the growth of companies.
When these prefer returning capital to its shareholders it is an indication of a deep malaise.

This is a reason I work almost entirely with private companies.  They too have their blind spots (trust me it can be harsh too), but their investment horizon is very different.  In conversations, it is clear that a return horizon is not 36/48 months, but 72/96 months.  They understand that they are building a business for the long term.  What I mean is that they will invest with a view to making a long term return that may take some time to generate profits.  Historically they have been more conservative (although listed companies are simply not investing -- and have not for several years), but this is no longer the case.  They are conserving cash now, looking for opportunities the next time there's a correction.

As I recently explained you should only care about correction if you need to money tomorrow.  Those who stayed calm after 2008 now look at their portfolio as unchanged (with some exceptions -- looking at you Blackberry).  But it remains that calm is the best option.  Obviously some sectors suffered permanently -- Citibank was trading at $540 per share in 2007,  it trades around $50 today! That's been a permanent impairment.  But GE that was trading around $35 is now around $28 -- and you got lots of dividends.  If you bought the DOW in 2007 at 13,000 its now at 17,000.  Not a bad trade a 30% increase is 7 years!

If you need the cash in 20 years there is no reason to take a short term view of the market.  Your broker (whoever he may be) is right.  You may want to get out of certain sectors, but as a whole the market has been a good (if not great) investment.  Income has not risen, but earnings from capital is doing well!

No position in Citibank, GE, Blackberry or DOW



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