Weekend Reading

19 August 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Too much of a good thing (The Economist)

Most articles I’ve read focus on the benefits of growing profits. The Economist looked at the recent recovery and found a few interesting points. The profits in this recovery didn’t expand capital investment but went back to shareholders. This may eventually revert because this rise caused greater income inequality, which could lead to lower demand. The persistence of these profits was also unexpected. Typically, as a firm experiences excess profits, this draws competition and reduces or eliminates those excess profits. This hasn’t been happening. “An American firm that was very profitable in 2003 (one with post-tax returns on capital of 15-25%, excluding goodwill) had an 83% chance of still being very profitable in 2013; the same was true for firms with returns of over 25%.” The high M&A during this period helped those companies widen their moat to help protect their excess profits.

Tech Giants Gobble Start-Ups in an Antitrust Blind Spot (Steven Davidoff Solomon, @StevenDavidoff, NYT)

Like many other aspects of technology, it’s also disrupting the M&A landscape. The outdated view and metrics used by antitrust regulators aren’t capturing the essence of most technology companies, monthly active users. The top tech companies (Google, Facebook, Amazon, etc.)  have amassed billions of monthly active users. In most of their respective markets (internet search, social media, internet shopping), their audience is typically materially higher than their next competitor. Some of these companies have been consolidating, such as Microsoft buying LinkedIn or Facebook buying WhatsApp. It remains to be seen what this type of consolidation will mean for the market and consumers/users. Other mergers of brick and mortar companies with technology companies are driving competition among the top. Walmart, the largest retailer in the world, acquired Jet.com in an attempt to compete with Amazon. While Walmart may be a behemoth in brick and mortar retail, Amazon is dominant in internet sales. This should lead to increased competition and benefit consumers.

You’ve got a nerve (The Economist)

The race for Artificial Intelligence (AI) has been strong over the past few years. One version of AI has been to make computers resemble the brain, in a process called neuromorphic computing. IBM has been a dominate player in this space and made a leap forward earlier this month, with a paper published in Nature Nanotechnology. It describes their development of an artificial version of a neuron. This is different than other AI, which creates artificial neurons in software programs, called neural nets. This may work, but it’s thought to be inferior. As the article put it, “That works, but as any computer scientist will tell you, creating an ersatz version of something in software is inevitably less precise and more computationally costly than simply making use of the thing itself.” They’re working on linking these neurons to create networks, which could eventually be built in small devices or standard computer chip processors.

Bond Funds Turn to Emerging Markets (Carolyn Cui and Mike Bird, @Birdyword, WSJ)

In a world where some government bonds have a negative yield, the search for yield is never ending. In this search, some investors are extending their risk profile in order to maintain a >1% yield. “The average bond yield on Bank of America’s developed-market index is 0.56%, compared with 4.44% for emerging-market sovereign bonds.” This extended risk profile is causing funds to flow to emerging market bonds. This flow to emerging markets is causing yields to compress. Debt maturing in 2020 from Ecuador that was yielding 22% has seen the yield drop to 10.4%. These flows to emerging markets are not being driven by credit fundamentals. “Credit quality is also deteriorating. Nineteen corporate issuers have defaulted in emerging countries this year, up from 15 at the same time last year, according to S&P Global Ratings. Nearly one-third of all emerging-market issuers are at the risk of being downgraded.”

Ensemble Capital’s clients own shares of Apple (AAPL) and Google (GOOGL).

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