Weekend Reading

14 October 2017 | by Paul Perrino, CFA®

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

We’re Going to Need More Lithium (Jessica Shankleman, Tom Biesheuvel, Joe Ryan, and Dave Merrill; @Jess_Shankleman@tbiesheuvel@JoeRyanNews@merrill_dave; Bloomberg Business Week)

The rise of electric vehicles has put additional pressure on the need for Lithium. “Starting about two years ago, fears of a lithium shortage almost tripled prices for the metal, to more than $20,000 a ton, in just 10 months.” But, the actual impact to the cost of batteries is minimal. “Even if the price of lithium soars 300 percent, battery pack costs would rise only by about 2 percent.” ”

Victoria’s Secret Is on the Right Runway (Sarah Halzack; @sarahhalzack; Bloomberg Gadfly)

The CEO of L Brands (the parent company of Victoria’s Secret) Les Wexner had to make some tough choices. This had some short-term consequences, but is expected to benefit the company in the long-run.

Mastering three strategies of organic growth (Kabir Ahuja, Liz Hilton Segel, Jesko Perrey; @AhujaKabir@JeskoPerrey, McKinsey&Company)

Most well run firms seek to grow their business through organic growth. The best approach to achieving this goal is through a diversified approach of strategies. Continuous investing and creating leads to the best results.

No, That Robot Will Not Steal Your Job (Ruchir Sharma, NYT)

The employment landscape looks very different now than it did in more than 25 years ago. “…McKinsey & Company, the consulting firm, has pointed out, about a third of the new jobs created in the United States were types that did not exist or barely existed 25 years ago.”

Hash Power – A Documentary on Blockchains & Cryptocurrencies (Patrick O’Shaughnessy, @patrick_oshag, The Investor’s Field Guide)

A 3 part podcast series that explores blockchains and cryptocurrencies.

Clients of Ensemble Capital own shares of L Brands (LB).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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“Reality is a cloud of possibilities, not a point.” -Amos Tversky

Amos Tversky is one of the most important economic thinkers most people have never heard of. Along with Daniel Kahneman, Tversky upended classical economic thinking by demonstrating that the key assumption of classical economics – that humans are rational actors who seek to maximize their own best interest – bears no resemblance to how the world actually works.

That Kahneman was the sole author of the groundbreaking book Thinking Fast and Slow and the sole winner of the Nobel prize in economics (despite being a psychologist, not an economist), was due only to the sad fact that Tversky’s life was cut short by cancer. The remarkable intellectual partnership of these two men was described in what can only be called loving detail by Michael Lewis in his book The Undoing Project: A Friendship that Changed our Minds

Far too many economists and investors have what has come to be called “physics envy”, the unattainable wish that the social sciences can be “figured out” by discovering some unifying mathematical theory that will allow us to predict the future (and yes, physicists really can predict the future). What Tversky and Kahneman showed the world however is that this dream will never be realized because economics and investing are driven by non-rational, unpredictable human behaviors, not natural laws.

Every time you read an economist or an investor (including us!) talk about their expectations for the future, remember Tversky’s quote:

“Reality is a cloud of possibilities, not a point.”

Is the market overvalued? Is a recession about to occur? Will the economy ever return to strong growth? Will Apple’s new iPhone sell well? Will self-driving cars transform the world?

The fact is we simply don’t know. There is no correct answer to these questions, only a cloud of possible futures.

This is why an investment strategy cannot be based on the idea that an investor can predict what is going to happen, but instead must involve a process that is prepared for a range of possible futures. If the future is unpredictable, the right approach to investing is not to pick the most likely point and assume it will occur, but to build a portfolio of investments that are prepared for a range of possible futures, while doing your best to understand what areas of the “cloud of possibilities” are more likely to occur.

When you evaluate an economist or investor, one of the most important things to look for is whether they frame their expectations in terms of predictions or probabilities. Those who claim they know which “point” economic or financial market reality will gravitate towards in the future are operating under a discredited economic model that is based on the assumption that humans are rational. Those who recognize that we live in a probabilistic rather than a deterministic world at least have a fighting chance to arrange their affairs in such a way that they are prepared for the uncertainty of tomorrow.

We know that our own writing and thinking sometimes falls into the trap of believing the future is predictable, but recognizing this trap exists and working hard to avoid it is one of the most fundamental underpinnings of any successful approach to investing.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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For much of the past seven years, various stock market pundits have been declaring that the stock market is wildly overvalued and headed for a crash. Much like earthquake insurance being easy to sell just after an earthquake, the proclamations of a stock market bubble found a ready audience among investors who had experienced the 2008 stock market crash less than a decade after the Dot-Com bubble. However, while the stock market might be in for a decline of 10% or 20% any time (these sorts of declines happen regularly; note the 15% decline from December 2015 to February 2016), stock market bubbles are not common occurrences and investors who see them around every corner are like the fabled economist who has predicted nine out of the last three recessions.

First, let’s define what we mean by a “bubble” and why it is entirely different from the normal (but often scary) run of the mill volatility that stock market investors must accept in exchange for earning higher rates of returns than low volatility assets typically provide. A bubble is formed when investors bid up asset prices to irrational levels based on an illogically optimistic view of the future or the belief that they can sell the asset to other investors at an even higher price without regard to any fundamental value that is intrinsic to the asset.

The first famous bubble was Tulipmania in Holland in the 1600s.  For psychological reasons that can be difficult to explain (because the very nature of a bubble is illogical) people started buying and trading tulip bulbs and as the fad caught on the price of certain tulips skyrocketed to values higher than the cost of a home. When the bubble popped, again for no particular reason other than the psychological mania running its course, prices of tulip bulbs fell back to pennies and investors who had got caught up in the bubble were wiped out.

Bubbles like Tulipmania, the late 1920s just before the Great Depression, the Dot Com bubble and the housing bubble all tend to be based around an illogically optimistic view of the future that takes hold with investors. While they are illogical, it is difficult for humans to identify them in real time because we are all influenced by the same socio-psychological memes that are causing the bubble in the first place. But in retrospect, bubbles are pretty easy to see.

For instance, here’s the Dot Com bubble illustrated by Jake at EconomPic Data (an excellent blog that’s been illustrating market and economic trends since 2008):

Source: @EconomPic

This chart shows the valuation of growth stocks vs value stocks since 1978. You can see that historically growth stocks have sold at relatively small valuation premiums during periods of investor pessimism such as in the early 1990s recession and during the Great Recession in 2008-2009. They’ve traded at higher premiums during more optimistic times. But during the stock market bubble of 1997 to 2001, investors paid irrationally high premiums for stocks with strong growth prospects. While the rest of the 40 year time period showed growth stocks trading at premiums of 20%-60% over value stocks, at the peak of the Dot Com bubble the premium reached almost 140%.

Today, growth stocks trade at a premium over value stocks of just 30%, below their long term average. If you look at the technology, consumer discretionary and industrial sectors, where many growth stocks reside, you’ll find that their current PE ratios are not inflated at all, but instead are just about in line with their long term average levels. It is the stocks of slow growing, conservative, historically “safe” businesses that are driving up market valuations (see this post for a case study of a “safe” bubble stock we wrote last year).

This chart from Econompic shows the historical forward returns to growth stocks based on their valuation premium over value stocks. The red circle is the Dot-Com bubble. Subsequent to this time, returns to growth stocks were terrible. The blue circle highlights the past times that growth stocks traded at a similar premium to value stocks as they do today. As you can see, these level of valuations have typically led to growth stocks outperforming. Far from being a bubble in speculative stocks, today’s market valuations are for growth business are consistent with historically attractive levels.

Source: EconomPic

Like the person buying earthquake insurance just after an earthquake, investors are looking at yesterday’s crisis and assuming it will repeat. But that’s not how bubbles work. Bubbles are a mania connected to the psychology of crowds. In the Dot Com era, serious investors came to believe that the business cycle was dead and that we’d never have another recession. That sounds crazy today, but it was one of the irrational beliefs that super charged the Dot Com bubble. Not all stocks went up in value. In fact, even at the peak in March of 2000, many stocks of slow growing “old economy” businesses were incredibly cheap. Today, investors believe in the New Normal, that economic growth will be forever be lower than we’ve seen historically.

Now readers may point to some examples of excitement about speculative investments. We certainly aren’t saying that stocks are cheap or that all growth stocks are good buys. But with growth sectors of the stock market selling at average valuations while “safe” sectors like utilities and consumer staples are trading near all time highs, and bond yields near all time lows, investors are voting with their dollars in favor of slow growth investments, not chasing speculative investments.

This mirror image to the Dot-Com bubble isn’t a coincidence. When bubbles burst they cause the burned investors to promise themselves they’ll never make the same foolish mistake again. In the wake of the Dot Com crash, investors swore off growth stocks and decided they would only invest in something tangible. Something with real value, unlike the paper trading vehicles of Dot Com stocks. Something like… houses.

The stock market crash of 2008 was not due to a bubble in stocks (stock valuations going into the crisis were pretty much right in line with average historical valuations), it was due to the popping of a bubble in home prices and the devastating impact this had on the economy. With their firm commitment to never make the mistake they made during the Dot Com bubble, many investors, with the very best intentions, focused their attention on what seemed like the exact opposite of Dot Com stocks. But like a crowd of passengers all lurching to the other side of a boat in stormy weather, the rejection of growth stocks led to a new bubble forming. Investors were making the same mistake, but because houses felt so safe compared to Dot Com stocks, they believed they were doing the exact opposite of the mistakes they made in the late 1990s.

So with the collapse of the housing bubble, what did investors do? They promised themselves that they would never speculate again and they invested in bonds or just held cash in the bank. Maybe these investments would generate low returns, but gosh darn it they weren’t going to crash… right?

If the natural bubble follow up to the twin crashes of Dot Com stocks and housing is super conservative investments, investors might not experience negative returns when the bubble unwinds. Instead, their loss may just have been the opportunity cost of missing out on the 13% annualized returns offered by the stock market since the end of 2010. Or, if we get a big surge in interest rates, we might well see a selloff in supposedly “safe” areas of the stock market such as Utilities and Consumer Staples.

While “safe” assets aren’t supposed to see sharp losses, they also haven’t historically traded at such high valuations. The risk in these “safe” assets, which represent the opposite of the go-go growth stocks that most investors assume must drive a stock market bubble, was apparent in the aftermath of the most recent presidential election. When the 10-year treasury yield ran from 1.4% in June of 2016 to 2.6% in December 2016, the utilities sector lost 14% even as the overall market rallied 10%.

The bottom line is that investors worrying that the stock market is too high and due for a decline need to recognize that it is not speculative growth stocks driving the rally, but conservative, low growth companies that have reached record high valuations. This stands on its head the way most investors think about stock market bubbles. We can’t prepare for the next crisis by buying insurance against the last crisis. Unfortunately there are new and different lessons for investors to learn in the years ahead.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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Weekend Reading

16 September 2017 | by Paul Perrino, CFA®

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

The curse of middle-aged capitalism (Robert J. Samuelson, The Washington Post)

The business landscape has undergone a change. “In 1975, 109 firms accounted for half the profits; by 2015, 30 companies did.” Those 30 companies are much different than the 109 in 1975. They’re older. This average age has increased because of merges. Small firms are being bought out by companies that are making huge profits, such as Apple, Google, and Microsoft.

China Fossil Fuel Deadline Shifts Focus to Electric Car Race (Bloomberg News)

Following the plan from the UK, China announced to end the production and sales of fossil-fuel-powered vehicles. The exact time-table is still under discussion. This shift is expected to improve the air quality, which has been an issue in China. They’re already selling EV. BYD, BAIC and GM delivered over 83,000 EVs in the first seven months of 2017. This may sound like a lot, but that only represents “0.04 percent of its 2.1 million vehicles sold in total in China during the seven months.”

How Kirkland Signature Became One of Costco’s Biggest Success Stories (Sarah Nassauer, @SarahNassauer, WSJ)

Costco developed a strategy to help their customers find the best quality products and save money. This came through the development of Kirkland brands. By simplifying the packaging and eliminate the marketing costs, Kirkland can offer similarly sourced products at discounts.

Apple explains what exactly happened when Face ID ‘failed’ during iPhone X demo (Chance Miller, @ChanceHMiller, 9to5)

During the Apple event this week there was a hiccup during the iPhone X demo. When Craig Federighi went to demo the new face recognition software by unlocking the new iPhone X with his face, the phone appeared to not recognize his face and required the text pass-code to unlock.

Clients of Ensemble Capital own shares of Costco (COST), Google (GOOGL), and Apple (AAPL).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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Weekend Reading

2 September 2017 | by Paul Perrino, CFA®

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

The Internal Combustion Engine Is Not Dead Yet (Norman Mayersohn, @n_mayersohn, NYT)

While many automakers, like Ford, have shifted to developing hybrid or electric cars, Mazda has developed a new combustion engine that is “20 to 30 percent more efficient than the company’s best existing engines.” The professor of mechanical engineering at MIT thinks the combustion engine will still have a major role to play for some time.

Robopocalypse Not (James Surowiecki, @JamesSurowiecki, Wired)

This counter-piece to many Silicon Valley leaders, like Y Combinator’s Sam Altman and Tesla’s Elon Musk, argues that there isn’t any evidence that this is occurring. “Back in the heyday of the US economy, from 1947 to 1973, labor productivity grew at an average pace of nearly 3 percent a year. Since 2007, it has grown at a rate of around 1.2 percent, the slowest pace in any period since World War II.”

The Housing Industry Still Hasn’t Realized It’s Building Too Many Homes for Rich People (Daniel Gross, @danielgross, Slate)

There could be a number of new home buyers being priced out. The number of high-end homes being developed isn’t keeping pace with overall income growth. “In July, 9,000 new homes worth more than $500,000 were sold in the U.S.—only 8,000 homes worth less than $200,000 were.”

 

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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