These Halcyon Days

Good Morning,
 

Stocks closed lower on Friday after it was reported that trade talks between China and the U.S. had stalled and tit-for-tat tariffs soured the process. The late-day sell-off underscored the fragile mood in financial markets destabilized by concerns that the escalating trade war will undermine global growth.

President Donald Trump took steps toward calming nerves by postponing any tariffs on Japanese and European cars, while agreeing to end levies on Canadian steel and aluminum imports. But the status of talks with China remained unclear as investors headed into the weekend.

It was also the fourth straight weekly drop for the Dow.

Earlier this week, under the banner of a threat to the “national security” of the U.S., the administration made it harder for U.S. companies to do business with Huawei, a giant telecommunications company in China. U.S. firms that want to do business with Huawei must now have a license.

On the positive side, U.S. consumer confidence sentiment gauge reached a 15-year high with stocks near records and A Wells Fargo/Gallup survey found small business confidence rebounded strongly in the second quarter, matching a record, as current conditions posted a new high and recession concerns diminished. Top worries were attracting customers and new business, followed by hiring and retaining staff.


Our Take

Take a deep breath, these are halcyon days. Enjoy. The data coming out of the U.S. is for the most part still supportive of the view that things are pretty good (For a nice overview see here). Let's remember that the S&P 500 is still up about 14% YTD.

With stocks struggling to find direction amid heightened volatility over increased tariffs and threats of new ones as the White House and China battle over trade, many investors are overreacting and trading headline noise. *(Interestingly Trump’s China fight/tariffs has enjoyed broad support from American business, the Democrats and the Republicans)

They would be better served if they recalibrated their expectations on the outcome and timing of any future agreement on the China/U.S. tariff issue.
 

We’ve heard murmings that this is a Trump powerplay: a mastery of the art of timing. A sniffing out of the right moment to strike a deal with China to save the day just as Americans head to the polls. Vanquishing a saviour who has adroitly played on what voters hold dear and what they fear would certainly be a difficult task for the Democrats...

The above narrative may or may not be accurate but regardless, to expect a quick deal is to completely misunderstand the deep differences in the two countries economic models (state capitalism vs. free-market capitalism). These differences ensure that their trading relations will likely be unstable for years to come.

It should be remembered that the Chinese government allocates capital through a state-run banking system with $38trn of assets. Attempts to bind China by requiring it to enact market-friendly legislation are unlikely to work given that the Communist Party is above the law.

These are issues that have been around for decades. Stable trade relations between countries require them to have much in common such as how commerce should work, what role the state should have and a commitment to the enforcement of rules. Look no further than the (for the most part successful) renegotiation of NAFTA (Mexico, USA, Canada).

Compounding the friction between these competing economic visions is that fact that many in the U.S. are suffering from a lack of self-confidence (“bullying behaviour”) as they witness China’s rise.

The problem with this administration's heavy handed approach is that it has made it difficult for China’s leadership to frame the trade spat domestically as anything other than an effort to undermine China’s rise. The shift toward a nationalist tone coincides with Beijing’s hardened trade negotiating position.

The problem is that an intensified conflict over trade and nationalism that results in harm to U.S. interests will make China less appealing to foreign investors, something Beijing can ill afford at a time when its economy is already slowing. Moreover, previous protests have shown that promoting nationalism can boomerang on the Chinese state and lead to unwanted social disruptions.

As such, the probability of some kind of a resolution is high.

For the investor, it is important to come to terms with any pervasive “fear” of “losing money” and  corresponding unwillingness to take a long-term view. Making rash decisions each time there is a change in the short-term trend due to a headline is a recipe for the investor to realize low returns on capital or worse: no return on capital.

Musings

This month we were featured/interviewed by two wonderful organizations.

ValueWalk: https://valuewalkpremium.com/2019/05/eter-mantas-and-matthew-castel-general-partners-of-logos-lp-talk-small-cap-investing/

MOI Global: https://moiglobal.com/peter-mantas-2019/

Only a short note this week on portfolio concentration. This month we fielded several questions regarding the concentration of our portfolio and thought it may be useful to explain our view that concentration as a strategy is more attractive than diversification.

Why?

1. Better information increases the probability of superior returns, so a concentrated fund allows the investor to conduct thorough research and understand the intricacies of the business in order to take advantage of mispricings in the market. Instead, lack of concentration leads to making investment decisions based on superficial reasons or worse: emotion.

2. If the target range of holdings is narrow, the investor is setting a higher hurdle rate for investment quality and return. Investors can be more discriminating, avoiding stocks or sectors that are not high quality and focus on a smaller group of companies that meet their strict metrics.

3. There is also the issue of cost. With low to no-cost ETFs, there is simply no justification for an active investor/manager to construct a portfolio with a large number of holdings that mimics the benchmark. Better to own the benchmark in a low cost way.

Charts of the Month


According to a new survey by Charles Schwab, almost half of millennials (49%) say their spending habits are driven by their friends bragging about their purchases on social media vs. around one-third of Americans in general. link

Tech bubble all over again?


Logos LP April 2019 Performance
 

April 2019 Return: 10.08%
 

2019 YTD (April) Return: 23.87%
 

Trailing Twelve Month Return: 6.60%
 

Compound Annual Growth Rate (CAGR) since inception March 26, 2014:+15.58%

Thought of the Month

"Knowledge is learning something new every day. Wisdom is letting go of something every day.”-Zen Proverb

Articles and Ideas of Interest 

 

• Why we’ll never be happy again. Ben Carlson suggests that there are two things people need to understand about humanity:(1) Things are unquestionably getting better over time. (2) People assume things are unquestionably getting worse over time. Is there a silver lining?

• Inflated credit scores leave investors in the dark on real risks. Consumer credit scores have been artificially inflated over the past decade and are masking the real danger the riskiest borrowers pose to hundreds of billions of dollars of debt. That’s the alarm bell being rung by analysts and economists at both Goldman Sachs Group Inc. and Moody’s Analytics, and supported by Federal Reserve research, who say the steady rise of credit scores as the economy expanded over the past decade has led to “grade inflation.”

• What makes a great business? Great article by Travis Wiedower regarding what makes a great business. In summary, there’s no getting around that businesses have to invest capital at high rates of return to be successful. To do so, they probably need several strong competitive advantages that keep potential competitors away. Finally, organic growth of new products usually outperforms other types of growth, especially large acquisitions. Those are the base rates of what makes a great business.

• Putting your phone down may help you live longer. By raising levels of the stress-related hormone cortisol, our phone time may also be threatening our long-term health.

• If this is a tech bubble in stocks, it’s the expansionary phase. Is this the tech bubble part two? It’s fair to ask, given how big that index is getting versus the rest of the market. At about 36 percent of the S&P 500, it’s creeping up on 1999-style dominance. Arguing against the comparison is the share of overall earnings its companies generate. Going by the quarter they just reported, it’s four times as much as 20 years ago. 

• The Age of the influencer has peaked. It’s time for the slacker to rise again. It’s hard to remember a time when scrolling through Instagram was anything but a thoroughly exhausting experience. Where once the social network was basically lunch and sunsets, it’s now a parade of strategically-crafted life updates, career achievements, and public vows to spend less time online (usually made by people who earn money from social media)—all framed with the carefully selected language of a press release. Everyone is striving, so very hard- #nevernotworking. And great for them....But sometimes one might pine for a less aspirational time, when the cool kids were smoking weed, eating junk food, and… you know, just chillin’. Quartzy suggests that the slackers are back…

• Getting rich vs. Staying rich. Fantastic article by Morgan Housel in which he explores the following pattern: Getting rich can be the biggest impediment to staying rich. It goes like this. The more successful you are at something, the more convinced you become that you’re doing it right. The more convinced you are that you’re doing it right, the less open you are to change. The less open you are to change, the more likely you are to tripping in a world that changes all the time. There are a million ways to get rich. But there’s only one way to stay rich: Humility, often to the point of paranoia. The irony is that few things squash humility like getting rich in the first place.

• Private equity’s allure poses big risks for the stock market and its investors in the next recession. Private equity is becoming the go-to for active investors — a trend which AllianceBernstein expects to continue for the next decade. The shift, which is well underway, could have implications for the stock market and its investors, especially in a recession. “It throws a spotlight on the resilience of the liquidity of public markets and even questions the point of a public stock market,” Bernstein senior analyst Inigo Fraser-Jenkins says. No wonder Buffett has also sounded the alarm suggesting that private equity returns have been inflated and bondholder covenants have “really deteriorated”.

• Is CBD the cure-all it’s touted to be? The cannabis derivative is being tested as a treatment for everything from brain cancer to opioid addiction to autism-spectrum disorders. Whether it can live up to the hype is still an open question, writes Moises Velasquez-Manoff in the New York Times Magazine. Meanwhile Americans can expect to bombarded by ever more CBD-infused products as Green Growth Brands Inc. is partnering with Abercrombie & Fitch Co. to sell its CBD-infused bath bonds and other body care products in a limited number of stores.

Our best wishes for a fulfilling May,

Logos LP

Market Cycles

Good Morning,
 

Bit behind on this July update but better late than never!
 

Stocks fell on Friday for the fourth straight day, capping off a volatile week for investors as rising trade fears and a tech sell-off led to broad weekly losses. The Nasdaq Composite fell 0.3 percent to 7,902.54, led by declines in Apple, Amazon and Alphabet. The tech-heavy index posted its fourth straight loss — its first since April — and is worst start to September since 2008.

The S&P 500 pulled back 0.2 percent to close at 2,871.68 as utilities and real estate both dropped more than 1 percent.

President Donald Trump, speaking from Air Force One, said Friday the U.S. is ready to slap tariffs on an additional $267 billion worth in Chinese goods. His remarks come after a deadline for comments regarding tariffs on another $200 billion in Chinese goods had passed last night.

"The $200 billion we're talking about could take place very soon, depending on what happens with them," Trump said. "I hate to say this, but behind that, there's another $267 billion ready to go on short notice if I want." (targeting a sum of goods equal to virtually all imports from China)
 

The selloff pummeling emerging market currencies shifted to stocks as contagion concerns weighed on risk assets. MSCI Inc.’s EM equities gauge entered a bear market on Sept. 6 and had its worst week since mid-August.

The fear also comes after the Wall Street Journal reported, citing U.S. officials, that the possibility of the U.S. and China reaching a trade deal are fading as the Trump administration tries to revamp the North America Free Trade Agreement (NAFTA). Meanwhile, Bloomberg News reports that the U.S. and Canada will likely end the week with no trade deal in place.

Wall Street was also under pressure after strong wage data stoked fears of tighter monetary policy in the U.S. Average hourly earnings rose 2.9 percent for the month on an annualized basis, marking the largest jump since 2009. The U.S. economy added 201,000 jobs in August, more than the expected increase of 191,000.

Treasury yields jumped to their highs of the session following the jobs report release, while the dollar also rose. The Fed has already raised rates twice this year and is largely expected to hike two more times before year-end.

Our Take
 

There is little doubt that the U.S. economy is in a boom. The Conference Board is reporting the highest levels of job satisfaction in more than a decade given a tight labor market — the ratio between the unemployment level and the number of job vacancies is at its lowest level in a half-century. A broader measure, the prime-age employment-to-population ratio, is back to 2006 levels. Meanwhile, real gross domestic product growth for the second quarter was just revised up to 4.2 percent. Corporate profits are rising strongly. And investment as a percentage of the economy is at about the level of the mid-2000s boom.

Wages are still lagging. But all other indicators show the U.S. economy performing as strongly as at any time since the mid-2000s — and possibly even since the late 1990s.

Why? A few reasons present themselves as outlined recently by Noah Smith:

1. Demand Side Explanations:

   1. Low interest rates: lowered borrowing rates for corporations and mortgage borrowers, which tends to juice investment. Fiscal deficits provide an added boost to demand, and deficits have been rising as a result of President Donald Trump’s tax cuts. Typically pumping demand will eventually lead to rising inflation but this hasn’t happened yet.

   2. “Animal spirits” or “sentiment” as small business confidence is at record highs, and consumer/investor confidence also is very strong.

   3. Tail end of the long recovery from the Great Recession — consumers and businesses might finally be purchasing the houses and cars that they waited to buy when the recovery was still in doubt. Housing, traditionally the most important piece of business-cycle investment and consumption, is still looking weak, with housing starts below their 50-year average. But business investment might be experiencing the positive effects of stored-up demand.

2. Supply Side Explanations:

   1. The Trump tax cuts removed distortions that held back business investment, and that fast growth — and the attendant low unemployment — is the result of the economy’s rapid shift to a higher level of efficiency.

   2. Technology: Information technology advances such as machine learning and cloud computing might be driving the investment boom — perhaps also spurring companies to invest in intangible assets such as brands and workers’ skills.

Which one is responsible? It is difficult to say but determining which are responsible matters as it can give insight into how the boom will end and how it can be prolonged. In our view all these factors have played a role, albeit certain ones have played a more crucial role during different stages in the bull market.  

At the current stage of the bull market we see evidence that the demand-side “animal spirits” or “sentiment” factor is doing a lot of the heavy lifting.

It should be remembered that although of late there has been a minor repricing of high multiple/risk assets, the trend is still firmly in place: investors are not put off by unprofitable companies. In fact, the proportion of companies reporting losses before going public in the United States is at its highest since the dotcom boom in 2000.

Last year, 76 percent of the companies that listed were unprofitable in the year before their initial public offerings, according to data compiled by Jay Ritter, a professor at the University of Florida's Warrington College of Business.

That's lower than the 81 percent recorded in 2000, but still far higher than the four-decade average of 38 percent.

Investors are currently keen on “new business models” and are willing to overlook losses. In fact, many are questioning whether “value investing” and classic investing principles even makes sense anymore. The market's euphoria for so-called "growth companies" has even made billionaire hedge fund manager David Einhorn question if classic investing principles that worked for him still make sense today.

As Howard Marks reminds us, in investing as in life, there are very few sure things. Very few things move in a straight line. There’s prograss and then there’s deterioration. We must remain attentive to cycles.

The process/cycle is typically the same: 1) the economy moves into a period of prosperity 2) providers of capital thrive, increasing their capital base 3) because bad news is scarce, the risks entailed in lending and investing seem to have shrunk 4) risk aversion disappears 5) financial institutions and investors move to expand their businesses - that is, to provide more capital 6) they compete for market share by lowering demanded returns (e.g. cutting interest rates), lowering credit standards, lowering prudence, disregarding the linkage between price and value, paying less attention to profits or disregarding them all together and providing more capital for a given transaction.

At the extreme, providers of capital finance borrowers and businesses (investments) that aren’t worthy of being financed. This leads to capital destruction -that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

Is this time any different?

Chart(s) of the Month

JP Morgan shows us that holding cash for too long can be a dangerous proposition. 

Are overall tech valuations overstretched or only certain segments?  Notice the absence of earnings in the dot com bubble years. Valuations do not appear stretched when put into perspective, prices appear to be in line with the underlying earnings picture. The NASDAQ-100’s price to forward earnings ratio is still a little below its longer run average of about 23x. 
 

Musings
 

What of valuation? What of the relationship between price and value? For an investor (whether a “value” investor or not) price has to be the starting point regardless of where we are in the cycle and especially in the last innings. No asset is so good that it can’t become a bad investment if bought at too high a price.

As an example of the current “animal spirits” climate we should consider the following:

Cannabis : the thesis or “story” here is that cannabis, like alcohol, tobacco and other hedonistic instruments, has now achieved positive momentum with policymakers across the world. As such the fragmented industry will consolidate and a few early movers will reap the profits of this new multi-billion dollar industry. But just like investing in the nascent stages of many industries that in essence were revolutions from a status quo, speculation will initially replace prudent financial analysis of price relative to value.

As Easterly points out in a recent article Cronos' (CRON) current valuation is an outright manifestation of "extraordinary delusions" stemming from the madness of crowds.

Cronos trades at about 17.25 forward price to sales (TTM price to sales of 332.97 and TTM price to earnings of 874.69) compared to its peers. For some further clarity, highly valued SaaS stocks prized for their recurrent revenue stream and high gross margins seldom trade at 17.25 forward P/S ratio. The average P/S ratio for stocks in the software application industry is around 6.8, compared to 2.16 for the S&P 500.

Hence, why does an agricultural commodity producer trade at a higher valuation than Shopify and other?

In Deloitte's "A society in transition, an industry ready to bloom" 2018 cannabis report, they expect legal cannabis sales during 2019, the first full year post-legalization to be [CAD]$4.34 billion. This figure is likely inflated when compared against the results of other markets. Further, the study only surveyed a sample size of 1,500 adult Canadians, which is not significant enough to estimate the Cannabis purchase habit of millions of Canadians.

For some perspective, California, which is regarded as the most important Cannabis market on Earth realized sales of [USD]$339 million or [CAD]$444 million (at current spot USD/CAD) during the first two months post-legalization. Extrapolating this across a full year would infer total sales of [USD]$2.01 billion or [CAD]$2.7 billion. Sure there are other factors to consider like a larger Californian black market and a different set of regulations and taxes. However, the Californian market has also not been as stringent on marketing as Canada will be.

Assuming the Canadian market is at least on par with California, the author models the potential market using an optimistic CAGR of 23.54% from 2019 - 2023 which is more optimistic than some market reports. The author also models Cronos' revenue for the years from 2018 - 2022.

Cronos' current market valuation of [USD]$1.75 billion or [CAD]$2.29 billion is around 84.81% of the total Canadian legal cannabis market in FY2019. (And this does not take into account the fact that the total estimated legal cannabis sales [CAD] $4.34 billion number mentioned above represents a total retail sales projection and that will likely be shared between grower, distributor, retailer, and the government through taxes. Taxes will be large, perhaps even 30%. Retail will be handled by government in a few big provinces like BC -- yet the government will still take a retail margin cut. What will be left for growers could be as low as sub $4 CAD / gram.. half or less of that total [CAD] $4.34 billion number…

At a current market valuation of [CAD]$2.29 billion ($2.79 billion at time of writing) which is around 84.81% of the total estimated Canadian legal cannabis market in FY2019, has the fairness of Cronos’ price been considered? Or have people without disciplined consideration of valuation simply decided that they want to own something because the story is good, risk aversion is low and the future looks bright?

Overall, we see current valuation trends in certain growth stocks (cannabis, select tech.) (not to mention that the ratio of bearish option bets to bullish ones is waning as the S&P 500 keeps churning out records. That implies investors may be loading up on derivatives as way to make up for lost ground should 2018 deliver a year-end rally similar to last year’s, when stocks closed with a 6.1 percent fourth-quarter surge) to be evidence that the demand-side “animal spirits”/“sentiment” factor is doing a large portion of the heavy lifting to prolong the current bull market.

As such, we would advise caution before increasing exposure to these “loved” and therefore richly valued businesses. Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. For our portfolio, given where we are in the present cycle and overall market conditions we are abiding by the following maxim:
 

“The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price can only go one way: up.” -Howard Marks

Logos LP July 2018 Performance

 

July 2018 Return: -0.34%

2018 YTD (July) Return: 0.00%

Trailing Twelve Month Return: +12.79%

CAGR since inception March 26, 2014: +18.29%

Thought of the Month

 

"The polar opposite of conscientious value investing is mindlessly chasing bubbles, in which the relationship between price and value is totally ignored. All bubbles start with some nugget of truth: 1) Tulips are beautiful and rare 2) The internet is going to change the world 3) Real estate can keep up with inflation, and you can always live in a house.” -Howard Marks

Articles and Ideas of Interest

 

• After Coltrane, there is nothing left to say. The saxophone virtuoso pushed jazz as far as it could go, and it’s been downhill ever since.            

• These Fake Islands Could Spell Real Economic Trouble. Glitzy property projects and financial crises tend to go hand-in-hand.

• U.S. Household wealth is experiencing an unsustainable bubble. Jesse Colombo suggests that Since the dark days of the Great Recession in 2009, America has experienced one of the most powerful household wealth booms in its history. Household wealth has ballooned by approximately $46 trillion or 83% to an all-time high of $100.8 trillion. While most people welcome and applaud a wealth boom like this, research suggests that it is actually another dangerous bubble that is similar to the U.S. housing bubble of the mid-2000s. In this piece, he explains why America's wealth boom is artificial and heading for a devastating bust.

• Who needs democracy when you have data? Here’s how China rules using data, AI and internet surveillance.

• How tourists are destroying the places they love. Travel is no longer a luxury good. Airlines like Ryanair and EasyJet have contributed to a form of mass tourism that has made local residents feel like foreigners in cities like Barcelona and Rome. The infrastructure is buckling under the pressure. Great 2 part expose suggesting that travel has almost become a human right yet it has become predatory - devouring all the beautiful places which drive it. Has nature itself come to be viewed as merely one more good to be consumed? ; Have we developed a shallow, modern need to present a life free from the tyranny of a nine-to-five office job in the tight frame of Instagram? No wonder you are not original or creative on instagram. Everyone on Instagram is living the same life.  
  
   

• Peak Valley. The Bay Area’s primacy as a technology hub is on the wane. Don’t celebrate. Although capital is becoming more widely available to bright sparks everywhere yet unfortunately the Valley’s peak looks more like a warning that innovation everywhere is becoming harder.  

• Americans live in the ruins of the 2008 financial crisis. Prosperity is undercut by broken institutions, from health care to law enforcement. NYT presents some astonishing facts. Is the American dream dead?

Our best wishes for a fulfilling month, 

Logos LP