The Profit Margin Debate: A Look at Capitalism and Competition

Over the past two years there’s been a lot of talk about the mean-reverting nature of margins as a crucial source of the market’s “overvaluation” today. John Hussman and Jeremy Grantham have been two vocal advocates of this point. Here is Hussman’s chart to that effect:

In this debate, Bulls have pointed out a relevant counterpoint: that mean reversion can be to the trend, which has been higher due to more capital lean businesses, greater productive efficiencies, and international diversification, rather than simply to the longer-term average (here's a good post from Joe Wiesenthal which covers this point and more). This trend/mean distinction is important, for a reversion to trend would imply margins still move higher over time, albeit only after a move back to and most likely beneath the more recent trendline.

Mean Reversion in Markets

Mean reversion is a powerful force in markets. One of the reasons why it works so neatly in is that when certain spreads divert from their long-run means, there is an economic incentive in the form of arbitrage for position takers to drive the spread back down to its normal level. An anecdote would be helpful. The following is a chart of the spread between West Texas Intermediate (WTI) Crude Oil (ie the “American” oil supply) and London Brent Crude Oil (ie the rest of the world’s oil supply):

We can see that over the long run, this spread exists within a relatively narrow channel; however, something happens in 2011 that sends the price of London Brent shooting upward relative to WTI. We’ll forget about why and focus on how this spread ultimately reverted back to its normal confines (though it does seem to have perked up again). While there are logistical challenges in sending crude from North America to Europe and vice versa, when the price of oil gets too high in one place relative to another, arbitrageurs can make free money simply by buying oil where it’s cheap and selling it where it’s too high. This is the definition of riskless profit. As more and more arbitrageurs engage in this activity, what is a large spread gets whittled down until there is no more “free lunch” as they say. This is how efficient capitalist markets work.

Capitalism, Economic Profit and Competition

In the latest GMO Commentary, Ben Inker makes the following point about margins, market valuation and corporate investment: “The pleasant way we could be wrong is if the U.S. is about to embark on a golden age of corporate investment and economic growth that will gradually compete down the current return on capital such that overall profits manage to grow decently as the P/E of the stock market wafts slowly down.” What I find ironic is that corporate investment is the most common way margins can and do come down in capitalism, therefore, the most likely way for GMO to be right requires that they are wrong. Let me explain.

In a capitalist system, economic profit is not supposed to exist. Economic profit is the difference between returns on investment and the cost of capital for a business. When economic profit does exist, it is supposed to be followed by a period of economic loss, such that over a cycle, there is no economic profit. This is where the idea that margins mean revert comes from. Here’s Wikipedia’s explanation for how economic profit results in competition and no winners (ie excess profiteers) over the long-run:

Economic profit does not occur in perfect competition in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry until there was no longer any economic profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying as the firms all compete for customers. Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to forming new firms that enter into the industry, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an equilibrium.

This is good explanation, but I have presented it in the form of an oversimplification. Some kinds of companies are able to generate economic profit for long periods of time. These are the so-called quality companies with a moat (aka a sustainable competitive advantage) that Warren Buffett looks for. Since such firms are the rare exception, not the rule, it’s worth studying them and learning about the traits they share. This is something I do on a regular basis, though for the purposes of this essay, it’s a digression. I bring up this point because considering how rare such firms are, it’s safe to apply the concept of zero economic profit to the economy at large, and in doing so, assuming that margins do in fact mean revert.

In essence, high profit margins revert to the mean much the same way as the spread between WTI and London Brent Crude Oil, though the subtle differences are important. Whereas the WTI/Brent spread is brought down with arbitrageurs, the economic profit of high margins is brought down with entrepreneurs. When entrepreneurs see high profit margins, they see an opportunity to undercut those margins, and in doing so, capturing some of the profits for themselves. However, entrepreneurs can’t buy something and sell it elsewhere to capture this profit opportunity. They are called entrepreneurs as distinct from arbitrageurs because they actually have to engage in the “process of identifying and starting a business venture, sourcing and organizing the required resources and taking both the risks and rewards associated with the venture” (the definition of entrepreneur from Wikipedia).

To paraphrase, in order to capture the excess economic profit born of a too high profit margin, entrepreneurs need to raise capital, they need to make tangible investments in building the infrastructure of a business, and they need to hire people on the ground to make the business work. Simply put, margins don’t just go down, they get competed down and eroded over time through factors and forces that actually improve the economy at large, with the benefit at the end of the day being lower prices and better supply available for end consumers. This reversion in margins is always a process, never a one-off event, and it surely happens faster in some areas than others (Clayton Christensen’s Innovator’s Dilemma is a great example of the forces of competition and innovation in the rapidly evolving hard disk drive industry, see my post on The Essential Mental Model for Understanding Innovation).

Two Tales of Margin Erosion Today

Sometimes these entrepreneurs are startups with a cheaper, more scalable way of capturing the margin, and other times they are large competitors with lower margins who see an opportunity to grow their own business. Two anecdotes would be helpful. Let me note, for the purposes of these comparisons I’ll use only operating margins.

First is the case of RadioShack losing to Best Buy who in turn is losing to Amazon (it’s worth mentioning that Circuit City would be a nice addition to this chart, for it was competed into bankruptcy).

In some ways Amazon is not the perfect example, because its own margins are virtually unprofitable, but if we can see past that for a second it becomes clear why they are a fine example. RadioShack started with the highest margins of the bunch, but the longer Best Buy and Amazon stayed beneath them in margin, the more pressure there was building on RadioShack’s own business model to cut prices. Sadly for RadioShack, the company doesn’t have the infrastructure to compete on today’s playing field. While Best Buy held up admirably during the initial assault on RadioShack, we see clear signs that Amazon’s own low-margin model has been pulling Best Buy down with it.

How was Amazon able to drive the margins down of some of its biggest competitors (note: this happened in books with Border’s and Barnes and Noble having experienced Amazon’s rath before the consumer electronics companies)? They did this with massive amounts of investment. If you total Amazon’s investments over the past 5 years (capital expenditures + acquisitions + technology and content) you see that Amazon invested $21.1 billion. Compare this to Best Buy and RadioShack’s combined market cap of $13.5 billion and you can see why Amazon is a feared competitor. Again, it’s important to point out: Amazon was able to drive down Best Buy, RadioShack and Circuit City’s margins, much to the detriment of those companies, one of whom no longer exists and another of which is on the brink. In doing so, Amazon experienced tremendous growth in its own revenues of about 33% compounded over the past 5 years, all resulting from the company investing substantial sums of money and hiring a whole lot of workers. This is how capitalism is supposed to work.

Some might counter that this obviously won’t end well for the economy too, because Amazon makes 0 profit and any multiple of 0 is inherently 0 (ie 0 profit for the S&P multiplied by an average P/E of 15 equals $0). My counter would be a) Amazon could make a whole lot more money than they do, though we can never be sure exactly how much, but they choose to invest in future growth instead; and, b) that’s why I have this next example for you.

Here are Apple and Samsung’s respective operating margins over the past either years:

Apple wowed the world with its innovative iPod, iPhone and iPad. This trifecta launched Apple’s operating margins up from a puny 3.94% in 2003 to a high of 35.3% in 2011. The problem for Apple was that it’s profit margins became too juicy. They were so juicy they were practically begging competitors to steal some of their profits, and in the chart above, we can see clearly how as Apple’s margins fall from peak levels, Samsung’s shoot up. Up to this point, Samsung was only a bit player in the handheld phone business, and did most of their business in more commoditized, low-margin consumer electronics like TVs. With such a huge opportunity to undercut Apple in price and to improve their own margins in doing so, Samsung jumped in with great success. While Apple’s margins took a hit in the past year, their revenues continued to grow, as Samsung’s revenues surged (Apple’s revenues grew 9.2%, while Samsung registered 22% yoy growth). All in all, the size of the smartphone market pie grew tremendously over the past year, though the margins earned by its earliest, most profitable player declined. Meanwhile, both in aggregate and individually, Apple and Samsung were tremendously profitable.

Macro Applications of Micro Lessons

If we compare this to GDP and corporate profit margins, the GDP (ie smartphone market size) increased tremendously, the aggregate profits earned also increased, but the average margin across the market dropped. This is a win/win for the market, for consumers and for the competitors, though is not necessarily ideal for some of the status quo players. Again though, this is how capitalist markets work: things evolve and move forward, with growing greater good in aggregate. And this is how profit margins inevitably will decline.

Using microeconomic examples is a worthy exercise in order to extrapolate what should happen on the macro level. Who knows exactly when/where/how margins will decline, if they do. There is every reason to believe they will at least eventually regress towards the trend of the recent past, which is towards higher profit margins but at a more tepid pace than has been seen of late. Most importantly though, microeconomics teaches us how it is that margins contract when they do. High margins are an important component of the capitalist process. They are one of the most obvious factors which openly invites new market entrants, ultimately encouraging new investment and new hiring.


Disclosure: No position in any company mentioned in this post.

Navigating the Global Economy - Buttonwood Gathering 2013

I had the privilege of attending The Economist’s Buttonwood Gathering 2013 replete with a stacked lineup of speakers and panelists. At a conference such as Buttonwood, one of the most interesting elements is the opportunity to exchange ideas with attendees who are generally pretty brilliant in their own right. I had numerous conversations with other Gatherers on topics ranging including Mexico’s pro-market reforms, Canada’s housing bubble, the European banking environment, and much more. Measuring consensus on such topics at Buttonwood provides a great glimpse into what the “Smart Money” is thinking. Sure enough, smart money seems abundantly optimistic in Mexico’s steps toward and capacity to successfully implement said reforms, Canada’s housing bubble is very real, and the European banking environment will have to pivot from an arena of nationalistic-driven excess to centralized decency.

These are simply some topics I conversed about with fellow gatherers. The panels themselves covered a wide range of topics, from the global economy, to the emerging market landscape and today’s optimistic venture capital environment for technology. While it’s impossible to completely cover each topic and the panelists’ thoughts in this post, I want to share some of the points that were more striking and relevant to me personally in the themes and topics that I focus on.

The two-day event kicked off with a conversation on the “global economic outlook” between José Manuel González-Páramo, Robert Rubin and Nemat Shafik, moderated by Zanny Minton Beddoes. All the panelists echoed the theme that Europe was improving and a decent coefficient of global growth was moving from emerging back to developed markets. Robert Rubin took a strikingly pessimistic tone towards the US growth outlook, given his belief that the conventional narrative of a fiscal drag was overstated and the real problem remains lack of demand and therefore anemic consumption. Shafik explained how there is increasing decoupling and dispersion amongst the various emerging markets and how each unique country thought of in its own unique way. Gonzalez-Paramo mused that Europe had the greatest potential to outperform estimates in the coming months should the relevant parties continue on the path towards a formalized banking union.

The discussion on Europe offered a natural segue into the second panel covering “Europe’s Burden” with José Manuel Campa, Bruce Richards and Nicolas Veron. Véron explained how the stress tests in Europe would be completely different this time around. Rather than pure stress tests, the exercise would be an intensive Asset Quality Review (AQR) done by the ECB instead of the European Banking Authority. Richards seconded this sentiment, and noted that the EBA tests were “laughed at.” Richards further explained how Europe’s banks have $42 trillion in assets compared to a GDP of $13 trillion, far larger than the US, which has $15 trillion in assets on a GDP just shy of $17 trillion. While Europe’s economy “has bottomed” it will take time for the banks to grow out of their size problem, with the US Savings and Loan Resolution Trust Corporation wind-down offering the best analog. Richards called Europe today “the largest asset disposition in the history of the world” and said the opportunity is in the very early stages, with assets like Spanish Non-Performing Loans available for 3 cents on the dollar.

Next, Roger Altman and Thomas Horton spoke about the changing corporate landscape in the US. Altman insisted that “uncertainty” in the business community stemmed predominantly from a shortfall in demand in the economy and not from Washington. The biggest trend Altman has been watching is the rise in activism amongst shareholders, and the willingness of institutional shareholders to embrace activist proposals. Meanwhile, Horton opined that US tax policy’s limitations on repatriation offered a significant hurdle to prudent balance sheet management in corporate America and that regulatory uncertainty has been a particularly large obstacle for him personally in helping American Airlines emerge from bankruptcy.

Day two started with an interesting discussion on monetary policy between Mohamed El-Erian and Vincent Reinhart. Both gentlemen generally agreed that central bank policy cannot create supply, but that it can move demand. In this context, the risk/reward balance of further quantitative easing has shifted decisively towards the direction of risk, with little reward. While the Fed has emphasized the importance of forward guidance, they completely underestimated the market’s interpretation as to when tapering would begin. El-Erian worries that in this environment, people are being “pushed, not pulled into trades.” Reinhart stressed that in the future Yellen Fed, there will place a greater focus on the dual mandate. Further, she will take it as her responsibility to provide guidance that is both broader in scope and deeper in explanation.

Next, Jim Millstein and Mary Schapiro talked about the financial regulatory environment. Millstein highlighted how in Too Big To Fail, there is no market discipline happening in either the equity or debt markets for banks. As such, there is no natural free market check on these institutions considering debt is subsidized with the TBTF guarantee and equity is too large for an activist to impose changes. Ultimately, Millstein sees finance heading towards a more utility-like role in the economy. Schapiro expressed some concern that while a stronger regulatory regime has been constructed, it has effectively been rendered toothless by a lack of funding, but that ultimately she was optimistic regulators will find a middle ground and bridge some of the gaps present between political goals and regulatory reality.

Japan was next up in the Gathering’s coverage of global economies. Koichi Hamada and Paul Sheard both shared their belief that Abenomics so far is working, particularly on the monetary policy side. Hamada noted that excess capacity to GDP declined from 3% to 1.5% and inflation actually started moving in the right direction for once. The problem, both agreed, is that little light has been shed and little progress made on supply side reforms that are ultimately necessary for Abenomics to truly work. Both believe that in time this will happen, but for now, Abe will have to combat an entrenched and powerful bureaucracy to get his way. Sheard made the point that no central bank in world history has tried to dislodge deflation expectations knowing it will inevitably have to re-anchor inflation to a 2-2.5% target. Japan has plenty of room to do more when compared to the Fed, as the US central bank increased its balance sheet by 250% during the course of the crisis, in contrast to Japan’s 54% increase. Both explained how while many worry about Japan’s “demographic” challenges,” Japan does have an opportunity in that women make up a smaller percentage of the workforce than in most developed countries and there is considerable room to improve.

Robert Shiller and Lewis Alexander then held an interesting discussion about bubbles. Shiller started with a definition of a bubble: they are a price-mediated feedback between prices and market participants, with excessive enthusiasm, media participants, and regret from those who are not involved. The “psycho-economic phenomenon” is a defining characteristic that becomes ingrained in a culture and is related to long-term expectations that cannot be pinned down quantitatively. Alexander offered a distinction between those bubbles that are a systemic risk verse those that are not. Bubbles carry systemic risk only when they have a credit component. Thus, in the absence of a credit component, the risks of a bubble are not all that severe for society at large. The housing bubble was one such systemic risk event, though both emphasized this was clearly not the fault of the Federal Reserve Bank (as many skeptics proclaim). Home prices began their rise in 1997 and continued to rise even during periods within which the Fed was raising interest rates. Shiller explained that there simply was no correlation at all between the path of rates and home prices, and that the efficient market hypothesis was the real culprit for inducing a sense of complacency in market observers that all prices are rational. Further, right now, people are calling for bubbles everywhere and they can’t all be the Feds fault, as is evidenced by what Shiller said is “most likely” a bubble in Brazilian real estate. Though Alexander cautioned that the problem with monetary policy is how it is a “blunt tool” and influences all or nothing with regard to price, so some distortions can happen. These distortions are mainly in interest rate risk, not credit risk right now and he does not see accompanying systemic risk as a result.

The two Bagehot Lectures were given by Agustín Carstens and Alan Greenspan. Carstens discussed the role of emerging market central banks in a crisis environment. Central banks should continue to focus on keeping inflation under control, and could use some macroprudential policies to offer a countercyclical buffer, though such policy should be used “like tequilia--only in moderation.” EM central banks also should play a supervisory role to regulate the flows of currencies and help mitigate volatility, but monetary policy can’t do all this on its own. Many EMs need serious structural reforms and it’s unfortunate that these needs are only recognized on the down side of the cycle, not the up. This is equally true in other areas. For example, Mexico opened a permanent line of credit with the IMF when times were good, while now countries who would benefit from such a line don’t want to do so for fear of appearing to “need” it and in the process, looking vulnerable. Alan Greenspan then took to the stage. He explained how there is a significant bifurcation in our economy whereby capital investment of a less than 20 year duration is doing quite well and of greater than 20 years is in a deep slump. Greenspan believes this is the result of uncertainty in long-term planning and blames tax policy as the culprit. Right now in the US we are seeing one of the greatest spreads ever in term structure between 5 and 30 year Treasuries and this is a reflection of the gap between the short and long-term economies.

In the ensuing panel on fiscal priorities with Roger Ferguson, Laura D’Andrea Tyson and Carmen Reinhart, D’Andrea Tyson quickly launched into her rebuttal of Greenspan’s argument. She explained how the fiscal stimulus relative to GDP was rather small, and the premature austerity undertaken by the government since emerging from crisis has made the recovery slower than it needs to be. There is considerable excess capacity in our economy, and this is a far bigger culprit in weak long-term investing than anything else and this uncertainty is over demand, not politics. Carmen Reinhart agreed with most of these points and added that private sector deleveraging continues to be a headwind to growth. She also noted that the US has done particularly well relative to others around the globe, but worries about how the US will unwind it’s large fiscal deficit when all is said and done. Ferguson elaborated on how big the private sector short-fall was during the crisis and how much more the government could have stimulated the economy instead of leaving monetary policy as the “last man standing” to help. He complained that “politicians are acting Ricardian in a Keynesian world” and hurting, rather than helping our cause. He and D’Andrea Tyson remarked on how the negative real interest rates on Treasuries offer a serious opportunity for the government to borrow and invest in much-needed infrastructure projects, but unfortunately everyone in a position to do something is focused on discretionary spending as a problem when it’s really entitlements. If only discourse were more rational.

While this is hardly an exhaustive summary of the Buttonwood Gathering, these were some of the more relevant discussions on topics that I am concerned with. I took fairly extensive notes during the two days, and if anyone would like some more insight on any of the specific panels discussed here (or those that I didn’t mention), please feel free to leave a comment below or email me and I will be sure to answer.

European Investing Summit: How Superinvestors are Navigating the EU Crisis

Last week, in addition to attending in person the Santa Fe Institute conference, I also “virtually attended” the European Investing Summit put on by ValueConferences and the Manual of Ideas.  It too was quite the experience, in terms of the quality and quantity of content and its groundbreaking format for connecting global value investors.  These days it’s nearly impossible to amass the brainpower and experience of informed presenters in one conference room over the course of two days in any physical sense.  That’s why the Manual of Ideas had the idea to orchestrate a virtual conference, with a blend of live streaming and pre-filmed interviews, replete with presentations and interactive conference rooms to connect with fellow attendees and presenters alike.   Many thanks to John and Oliver Mihaljevic for conceiving and executing on an outstanding idea, and for gathering some of the foremost talent in the industry.

I spent a whole lot of time last week and over the weekend listening to and absorbing as much as I could from the videos.  I particularly liked the fact that nearly all of the videos offered great lessons on the process and philosophy side as much as they did on the ideas front.  I went into the conference with plenty of thoughts on Europe and where I saw the crisis inevitably leading to, plus I had already deployed capital strategically into four distinct European investment opportunities, but I really wanted more considering the vastness of opportunity amidst crisis. (Be sure to check out my post connecting Europe today to the Articles of Confederation USA entitled The Answer to the Eurozone Crisis was Written in 1787).

I “left” the conference having learned of several very intriguing ideas that are queued up for immediate further inquiry, but maybe even more importantly, I “left” feeling like I made important strides in continuing the evolution of my own investment philosophy.  In this blog post, I would like to share some of the more macro ideas from the live sessions on day 1 of the conference, including perspectives on the European markets and some important philosophical points on value investing in this present environment.  Anyone who finds these ideas remotely intriguing would extract considerable value from attending these online sessions at

Guy Spier, Managing Partner, Aquamarine Capital

The live portion of the event kicked off with Guy Spier’s keynote address on “Investing in Europe in the Face of Crisis and Uncertainty.”  Spier started his analysis with some very informative charts on the debt-to-GDP ratios of the various EU entities, including a breakdown between public, private and corporate debt.  There were some interesting observations on the charts, including just how troubled Greece is from a public debt perspective, how much greater Ireland’s aggregate debt burden is compared to the rest of the EU and US, and how much actual private wealth exists in Italy.  Obviously we all know about Greece’s woes, but I think in valuing investing circles, the troubles of Ireland stand in stark contrast to conventional wisdom, and Italy’s wealth is often overlooked (this is something I’ve covered on my blog in the past in a post called Why Italy Doesn't Worry Me).

In my opinion, one of the more important points Spier made off of these charts is that “fear-mongers try to make money off of selling fear, but the globe has a whole lot more wealth than is ever talked about.”  This is exactly how crises go.  People get caught up in the negative emotion and willfully look past some crucial realities. 

We then turned to a chart on the odds of a country leaving the EU, which has greatly decreased since ECB President Mario Draghi’s aggressive late summer statements and actions.  This segued nicely into how Guy in the recent past thought the Euro would in fact break up, however, politics, not economics paved the way for Draghi to bypass the rules in practice, and keep the currency union together.

Next Spier broke down the two lenses through which people view this crisis: the Anglo Saxon vs. the Continental.  Anglo Saxon countries are more individualistic and place a greater degree of value on personal freedom, whereas the Continental lens is more collectivist.  This creates a dichotomy whereby those who adopt the Anglo Saxon perspective view the crisis through an economic lens, while Continental people take the political view.  Each perspective has its own unique consequences; however, it’s clear that today the Continental approach is winning. 

Spier himself asserted that he has moved his understanding in the Continental direction.  This then evolved into a discussion on how the crisis itself is a catalyst for further integration to the point where without crisis, integration itself stagnates.  That raises the question of whether crisis is desired amongst those integrationists like Draghi, for without it they cannot continue the mission of Jean Monnet.

Please note: Spier then gave some very interesting investment ideas, but again, my focus here is to outline the European perspectives and what I learned philosophically about value investing.

Charles De Vaulx, Chief Investment Officer and Portfolio Manager, International Value Advisers

Right off the bat, De Vaulx continued on this theme of an Anglo Saxon/Continental divide: “Investing has always been an Anglo Saxon endeavor…it’s mostly those countries that have relied on capital markets to advance capital formation, while other countries saw their capital formation financed in other ways.”  De Vaulx then launched into a great history of value investing, and how it had predominantly been an American, and then British phenomenon.  Starting with the early 1990s recession, great American investors like Tweedy Brown and Michael Price ventured into global capital markets for value, mainly Europe.

Why did these investors turn to Europe? De Vaulx argues that this is due to some of the competitive advantages offered by European reporting.  Before the adoption of international account standards in Europe, man companies made it easier for some equities to get mispriced, or they ended up undervalued due to very conservative accounting practices (the opposite of many other places in the world).  In many of these cases, true economic earnings were thus understated.  Likewise, many companies had hidden assets on their balance sheets that were booked at historical cost, rather than present value.

Previously, the abundance of family owned and controlled businesses had been thought of as a risk in Europe, yet on further analysis, it became clear that these families were true stewards of investor capital, with their risks aligned in an advantageous way.  Further, many were open to the idea of takeovers and/or mergers as a means through which to realize value. 

Right now, International Value Advisers has 10% of the fund invested in France and only 0.4% in Germany.  This sits in contrast to much conventional wisdom, which holds that Germany is the safest, and France’s regime will crush capitalism.  Many companies across Europe, and particularly in France are in actuality global businesses, with a plurality of income generated overseas (De Vaulx used Vivendi and Total as examples here).

Over the course of the Euro Crisis there has been a big distinction in stock performance between the quality businesses and the cyclical ones.  Right now, many of the high quality businesses have performed very well, and thus are not cheap, while the cyclical businesses have become increasingly depressed.  Because of this contrast in performance, De Vaulx has been selling some quality businesses and allocating more capital towards the cyclical ones.  Because of this dichotomy, if you look at Europe in aggregate, the markets look very cheap; however if you want to buy quality you have to be willing to pay up.

Interestingly, De Vaulx had two impactful statements which contrast with typical value investing theory: first, he said that “gold has a lot to do with value investing and has a lot to do with Europe” as a hedge against problems; and second, he said that “buy and hold should not be part of the value investor’s vocabulary right now” due to the heightened volatility, which will be with us for a while.  This is an interesting adaptive change for a long-time value investor. 

Alvaro Guzman de Lazaro Mateos, Managing Partner and Portfolio Manager, Bestinver

Bestinver is a long only, no derivatives value investing group that follows macro, but doesn’t invest it.  Guzman de Lazaro focuses much attention on the reasons why a security has become cheap, and when an answer is readily identifiable, he invests so long as the reason for cheapness are acceptable.  In Europe, much of their attention is focus on family owned companies, companies with weird share structures, long-term projects and under-the-radar small caps.

Guzman de Lazaro observed that by and large, “Europe is a less efficient market” and in my opinion, this is music to any value investor’s ears.  For without inefficiency, there cannot be value, and the greater the degree of inefficiency, the greater the opportunity.  Guzman de Lazaro continued that in the US there is far more competition amongst the various value investors, and competition drives down return.  With European family owned businesses, there is a unique opportunity to engage with the families in order to develop a synergistic relationship over the course of years.  These families start to see their big investors as partners, and take their input in capital management.

Typically, Bestinver will look for companies with high barriers to entry, trustworthy management, little or no debt, and the stock already down quite a bit, all the while value itself should be growing.  What they prefer is a stock to drop solely due to concerns about the European Union itself, and not the fundamentals of the business.  Guzman de Lazaro emphasized the importance to their margin of safety of the increasing of intrinsic value while the price either stagnates or drops lower.  This creates a situation where over time the company has gotten cheaper.  Because a breakup of the EU cannot be taken off the table, Guzman de Lazaro models each company accounting for a 40% devaluation in their respective domestic businesses. 

Guzman de Lazaro also presented two excellent ideas, one of which is now on my immediate research list, and I urge you all to check out the European Investing Summit to learn more.

Jochen Wermuth, CIO and Managing Partner, Wermuth Asset Management

Jochen Wermuth is an investor focused on Russia and his presentation was appropriately titled, Russia: Klondike or Eldorado?  I went into the presentation disliking Russia and wanting to dislike it more.  Everything we hear about the country is of government and corporate corruption alike, with a near dictatorial leader imposing his well as he sees fit.  While there is certainly much merit to these complaints, Benjamin Graham certainly would still invest in a cigar butt were the valuation cheap enough, with little regard to the quality of the business itself.  And it does seem like Russia has some impressive numbers working in its favor, and we’re talking verifiable, not corruptly skewed numbers here too.

Wermuth started with the assertion that valuations are extremely depressed, and the reasons are twofold: the perception issues cited above, and a dose of truth.  The government has been increasing its share in the economy, and extracted significant value from the oil sector in order to build a substantial sovereign wealth fund.  To that end, there have been rollbacks in the pace of privatizations, and more dangerously, people in the country have been deeply upset by corruption to the point where they want to leave.  As a result, the country’s equity risk premium now sits at 17%--all-time highs, and a 36% discount to its average PE over time, and a 58% discount to the rest of the BRICs.

That starts us on the good stuff—the country is priced for the worst case scenario.  Importantly, government debt, as it stands right now, is at 10% of GDP and the country has zero debt denominated in foreign currencies.  This is in stark contrast to many other countries around the globe.  Plus, Russia has $520 billion of its own FX reserves, the 3rd largest stash on the planet.  This is a very different Russia than the one which defaulted in 1998.

As it stands right now, market infrastructure is not very developed, with foreign capital the primary “bid.”  Pensions in Russia are small and cannot invest in equities, therefore the market really just moves along with the flow of international capital.  When the tide rides in, valuations rise, and when it leaves, they decline.  Further, speculative flows focus on only a few sectors (i.e. the love for emerging market consumers) to the point where there are substantial valuation gaps between the sectors.  Liquidity (or the lack thereof) compounds these problems, are brokers only push their international clientele into the most liquid vehicles, not the cheapest, best investments.

John Gilbert, Chief Investment Officer, General Re-NEAM

Although this was dubbed the European Investing Summit, John Gilbert focused his really thorough presentation on the present state of the US economy and its implications for long-term investors.  Gilbert posted some outstanding charts highlighting the state of the economy today and how it has changed over time.  One of the first observations was that both household net-worth to disposable income and household net worth to debt have both improved since the crisis began, albeit not very much overall.  Plus the savings right, while higher now, has to potential to get even more elevated.

Financial sector debt-to-GDP has risen from “virtually zero” in 1952 to a peak of 120% of GDP in the bubble days, back down to about 90% now.  Deleveraging has been particularly rapid in this sector of the economy, but it “may have considerably further to go.”  Leverage in the shadow banking arena (mortgages, ABS and other) is greater than in the traditional financial sector now, and this can be attributed to the financialization of the economy.

Gilbert then asked rhetorically, “how far along are we on deleveraging, and how much further do we have to go?”  In 2011, the Bank of International Settlements presented a paper at Jackson Hole called the “Real Effects of Debt.”  The BIS outlined how in each of the 3 sectors, levels of 85-90% of GDP correlate to slower subsequent economic growth.  We are still in this danger zone.

Many optimists point to the debt service as a percent of disposable income in order to say thing are getting better, and the Fed does this too (for my Twitter followers, you know I’m guilty as charged here too…see the chart for yourself here).  Gilbert says “it is quite encouraging” and certainly has some merit, and says the reasons behind this are the Fed’s zero interest rate policy (ZIRP) and what that has done to create low mortgage interest rates.  However, Gilbert would caution that the balance sheet itself remains quite stressed and this leaves the household sector vulnerable to any subsequent shocks.

Historically, the largest source of deleveraging has been from increases in nominal GDP, most specifically inflation.  While there are no imminent signs of inflation, this is a good template through which to expect future deleveraging to take place and its worth looking at where inflation might come from.  Plus, the aid of inflation in decreasing debt burdens can be quite large even when the overall inflation rate is low.  Policymakers are aware of this, but there problem is that it’s tough to get inflation started in the short run. 

Housing is typically a good source of inflation, although it “won’t surge anytime soon.”  It is clearly off the bottom today, and we’re heading in the right direction.  Single family rental rates (or the bond equivalent value of owning a home) has diverged sharply from the price of actually owning a home.  This makes renting more expensive relative to housing and pushes would be renters into homeownership.  This is a good positive for housing.

As for Fed policy, QE3 is different from its predecessors both in terms of conditions in advance (they’re a bit better now) and in the way it’s done (open-ended purchases of MBS instead of fixed amounts of Treasuries).  This marks an important “cultural change in the Fed” that is moving towards unanimity in the dovish direction.  We can see this in how certain members have changed their positions to align with Chairman Ben Bernanke.  Since QE3 is tied with the Fed’s goal of “maximum employment” we must then examine what that term means.  Gilbert defines it as “the rate when the economy is at potential and not exerting pressure on inflation.”  The problem is that this rate shifts over time, and is not observable.  It therefore “must be inferred from the condition of the labor market.”

One way that policymakers try to figure out “maximum employment” is through using the Beveridge Curve.  This plots the unemployment rate against the job opening rate.  There are two problems with this analysis: the natural employment rate is subject to error, and there is a big spread between the real-time data and revisions down the road.  Right now it’s too early to form any strong opinions about the labor market, as to whether there has or has not been structural change in the economy.  The Fed is inclined to say there is not; however, Gilbert is a bit more skeptical and wants to wait to make any judgments.

Everyone today is looking for more yield, but it’s important to remember that these are troubled times and more yield involves more risk.  We are approaching tight corporate bond spreads on high quality stuff, but not quite yet on high yield.  There are many anomalies in markets due to this chase for yield, including: electric utilities trading at their highest P/E relative to the S&P ever, the Schiller CAPE/Tobin Q are not all that cheap right now; Gold has outperformed the S&P despite not being a good long-term investment in its own right.  Gilbert elaborated on gold saying that once in a while it acquires option value, but doesn’t pay off very often.  It is “only in the money when people lose faith in the existing monetary standard” and considering that faith has not broken, gold “is a candidate for a bubble.”

In conclusion, Gilbert explained that it’s too early to say whether there has been a permanent behavior change following the recent crisis, but it’s significant that most people alive today have never seen anything other than credit inflation.  Lehman itself upended 200 years of lender of last resort behavior, and this in and of itself could have far- reaching consequences down the road, leading people to take on less debt for a long time, and/or possibly inducing central banks to be more aggressive than they have been.

I had the opportunity to ask a question, and I asked: “you referenced the connection of maximum employment to NGDP and the Fed’s new form of QE2 as a more forceful push towards maximum employment.  Do you then view QE3 to be the fed’s adoption of NGDP targeting?”  Gilbert answered that it’s not quite there, because there are technical problems with targeting NGDP.  He does however expect the idea of NGDP targeting to get more attention, because it would allow the Fed to let inflation rise without actually saying so. 

Gilbert continued to explain that If we end up in a world where the US is not a real growth economy, but a 2% real GDP growth state, and you set an NGDP target of 5%, this lets your target inflation rate rise from 2% to 3% without actually doing anything.  Further, he said that it’s hard to see QE3 having the transmission mechanism to support such a substantial change in their targeting.  They’re solely resorting to increase the quantity of money right now, rather than the cost of money, which is what NGDP would do.  For that reason, the Fed might have to take more radical steps were they to actually adopt NGDP targeting as its policy.

The Answer to the Eurozone Crisis was Written in 1787

When I last focused on the EU in this blog, I took a look at why Italy doesn't worry me too much.  I omitted Spain from this analysis purposely, because what placated me with regard to Italy just did not exist in Spain despite Spain's lower overall stated sovereign debt-to-GDP ratio.  Since that time, the Eurozone had calmed down, but during my blogging hiatus things once again flared up.  Now, I think it's time to take a much deeper look at the EU and what it all means, because this has become far bigger than an economic question.  More specifically, I am firmly in the camp that sees the Eurozone crisis as a constitutional crisis, not an economic one.  

Since World War II, the European Continent has moved towards a unified economy, without unifying any of the institutions necessary to manage and enforce a centralized currency.  As a political philosophy guy, this is seriously fascinating stuff, as we are witnessing history in the making, while as an investor it's skewed to the scary side of things.  The uncertainty is great, however, for you history buffs out there, the clearest parallel to Europe's present predicament is the United States under the Articles of Confederation.  

As a refresher, the Articles of Confederation governed the United States in the time period between the American Revolution and the Constitution, where States existed as de facto sovereigns and no strong centralized power existed.  In response to growing economic and political failures, and rising social tensions, the leading intellectuals and political figures in young America gathered in Philadelphia to "form a more perfect Union."

Unfortunately, and contrary to the linear path with which history is narrated, the Constitution was not instantly greeted with excitement and acceptance.  As a result, the Founding Fathers had to go to great lengths to ensure its passage, especially in the "core" states of New York and Virginia.  Alexander Hamilton was a particularly important architect of our form of American Federalism and was a key emissary for the State of New York (in fact, he was the only New Yorker to sign the document).  To help get New Yorkers and Virginians to vote "yay" for the Constitution, Hamilton and James Madison wrote what are now known as The Federalist Papers under the pseudonym "Publius."  It's amazing how relevant these papers remain today.  

To be clear, I did not originally conceive of this idea of the EU as the pre-Constitutional US.  I first encountered the parallel in some of Bridgewater's excellent economic research available on the WWW.  Instantly the parallel resonated with me, and as a result, I started re-reading some of the relevant American History.  No one document struck me as more important today than Federalist #15.  It's as if Alexander Hamilton wrote each and every word directed at the powers that be in the EU today. 

Hamilton so adeptly incorporates the political, economic and ultimately the human emotional element into constructing a deeper understanding of the failures of a weak, centralized confederacy of interests.  Interestingly, Hamilton briefly gets into the history of failed attempts at confederation in Europe and their collapse at the hands of individual constituency interests.  Ultimately, he makes it abundantly clear why no sovereign interests can unite without unified institutions that have real powers of enforcement.

Below are a few excerpts from  Federalist Paper #15, entitled "The Insufficiency of the Present Confederation to Preserve the Union" but I urge all interested parties to read the whole thing:

In pursuance of the plan which I have laid down for the discussion of the subject, the point next in order to be examined is the "insufficiency of the present Confederation to the preservation of the Union." It may perhaps be asked what need there is of reasoning or proof to illustrate a position which is not either controverted or doubted, to which the understandings and feelings of all classes of men assent, and which in substance is admitted by the opponents as well as by the friends of the new Constitution. It must in truth be acknowledged that, however these may differ in other respects, they in general appear to harmonize in this sentiment, at least, that there are material imperfections in our national system, and that something is necessary to be done to rescue us from impending anarchy. The facts that support this opinion are no longer objects of speculation. They have forced themselves upon the sensibility of the people at large, and have at length extorted from those, whose mistaken policy has had the principal share in precipitating the extremity at which we are arrived, a reluctant confession of the reality of those defects in the scheme of our federal government, which have been long pointed out and regretted by the intelligent friends of the Union.


It is true, as has been before observed that facts, too stubborn to be resisted, have produced a species of general assent to the abstract proposition that there exist material defects in our national system; but the usefulness of the concession, on the part of the old adversaries of federal measures, is destroyed by a strenuous opposition to a remedy, upon the only principles that can give it a chance of success. While they admit that the government of the United States is destitute of energy, they contend against conferring upon it those powers which are requisite to supply that energy. They seem still to aim at things repugnant and irreconcilable; at an augmentation of federal authority, without a diminution of State authority; at sovereignty in the Union, and complete independence in the members. 


There is nothing absurd or impracticable in the idea of a league or alliance between independent nations for certain defined purposes precisely stated in a treaty regulating all the details of time, place, circumstance, and quantity; leaving nothing to future discretion; and depending for its execution on the good faith of the parties. Compacts of this kind exist among all civilized nations, subject to the usual vicissitudes of peace and war, of observance and non-observance, as the interests or passions of the contracting powers dictate. In the early part of the present century there was an epidemical rage in Europe for this species of compacts, from which the politicians of the times fondly hoped for benefits which were never realized. With a view to establishing the equilibrium of power and the peace of that part of the world, all the resources of negotiation were exhausted, and triple and quadruple alliances were formed; but they were scarcely formed before they were broken, giving an instructive but afflicting lesson to mankind, how little dependence is to be placed on treaties which have no other sanction than the obligations of good faith, and which oppose general considerations of peace and justice to the impulse of any immediate interest or passion.


Government implies the power of making laws. It is essential to the idea of a law, that it be attended with a sanction; or, in other words, a penalty or punishment for disobedience. If there be no penalty annexed to disobedience, the resolutions or commands which pretend to be laws will, in fact, amount to nothing more than advice or recommendation. This penalty, whatever it may be, can only be inflicted in two ways: by the agency of the courts and ministers of justice, or by military force; by the COERCION of the magistracy, or by the COERCION of arms. The first kind can evidently apply only to men; the last kind must of necessity, be employed against bodies politic, or communities, or States. 


There was a time when we were told that breaches, by the States, of the regulations of the federal authority were not to be expected; that a sense of common interest would preside over the conduct of the respective members, and would beget a full compliance with all the constitutional requisitions of the Union. This language, at the present day, would appear as wild as a great part of what we now hear from the same quarter will be thought, when we shall have received further lessons from that best oracle of wisdom, experience. It at all times betrayed an ignorance of the true springs by which human conduct is actuated, and belied the original inducements to the establishment of civil power. Why has government been instituted at all? Because the passions of men will not conform to the dictates of reason and justice, without constraint. 


From this spirit it happens, that in every political association which is formed upon the principle of uniting in a common interest a number of lesser sovereignties, there will be found a kind of eccentric tendency in the subordinate or inferior orbs, by the operation of which there will be a perpetual effort in each to fly off from the common centre. This tendency is not difficult to be accounted for. It has its origin in the love of power. Power controlled or abridged is almost always the rival and enemy of that power by which it is controlled or abridged. This simple proposition will teach us how little reason there is to expect, that the persons intrusted with the administration of the affairs of the particular members of a confederacy will at all times be ready, with perfect good-humor, and an unbiased regard to the public weal, to execute the resolutions or decrees of the general authority. The reverse of this results from the constitution of human nature.


All this will be done; and in a spirit of interested and suspicious scrutiny, without that knowledge of national circumstances and reasons of state, which is essential to a right judgment, and with that strong predilection in favor of local objects, which can hardly fail to mislead the decision. The same process must be repeated in every member of which the body is constituted; and the execution of the plans, framed by the councils of the whole, will always fluctuate on the discretion of the ill-informed and prejudiced opinion of every part. 


In our case, the concurrence of thirteen distinct sovereign wills is requisite, under the Confederation, to the complete execution of every important measure that proceeds from the Union. It has happened as was to have been foreseen. The measures of the Union have not been executed; the delinquencies of the States have, step by step, matured themselves to an extreme, which has, at length, arrested all the wheels of the national government, and brought them to an awful stand.


Why should we do more in proportion than those who are embarked with us in the same political voyage? Why should we consent to bear more than our proper share of the common burden? These were suggestions which human selfishness could not withstand, and which even speculative men, who looked forward to remote consequences, could not, without hesitation, combat. Each State, yielding to the persuasive voice of immediate interest or convenience, has successively withdrawn its support, till the frail and tottering edifice seems ready to fall upon our heads, and to crush us beneath its ruins.

Why Subsidize Speculation in Commodities?

If you follow me on Twitter @ElliotTurn, you know that commodities have been a big point of interest of late.  I’ve been spending some time trying to distill whether the driver of the commodities bull market for the last decade has been US monetary policy or China’s rapid acceleration in growth.  The answer to that question has significant implications for several different types of investments today, and is really just an interesting and important point in understanding today’s macroeconomy.  But today, with commodities a hot-topic and tax day quickly approaching, I want to take a glimpse at commodities through a different lens entirely.  With oil prices rising quickly in the face of our largest build in crude oil inventories since 2008, there are obvious questions being raised about the impact of speculation in commodity markets (see here for a good look at the question).  After all, how can something go up in the face of an overabundance of supply?  Rather than try to answer the question of how much of a premium in commodity prices is driven by speculation, to this too, I want to take a different angle altogether.

Whether one agrees or disagrees with speculation being a factor in commodity markets, I think we can all agree that such activity should not be subsidizes no matter what.  Yet, that is exactly what our tax code does—it incentivizes speculation in commodities over speculation in any other market.  Even more, speculation in commodities is a great way to guarantee a lower tax rate than the general income tax, when compared to any other profession in America.  There is a hot debate over carried interest, yet this loophole is at least as egregious. 

Broadly speaking, we are in a state of heightened global macroeconomic volatility, and that alone does yield way to increased volatility in demand and pricing for resources; however, that does not explain some of the radical swings in commodities ranging from oil to palladium to gold in recent times.  Since the 2003 Bush Tax Cuts, long-term capital gains are taxed at a 15% rate, while short-term capital gains are taxed as general income, at a 35% rate.  These capital gains apply to most forms of investment income; however, they do not apply on gains in futures contracts–the principle way in which commodities are traded.  Futures contracts, as prescribed by Section 1256 of the tax code, are taxed with a blended rate of long and short-term gains: 60% long-term capital gains and 40% short-term.  The blended rate results in an effective tax rate of 23% on income derived from futures/commodity trading (check out this site for more information on trading taxes).

In essence, the tax code promotes short-term speculation in commodities markets, and it does so in several ways.  People who are speculating in commodity future markets are inherently short-run, and care far more about the discount on the short term capital gains tax rate than they do the increased cost of long-term commodity ownership.  Whereas a short-term equity speculator is taxed at the general income rate, a commodities/futures speculator is taxed at 23%.  The consequences of this are two-fold: first, there is an economic incentive for speculators to ply their craft in commodities markets as opposed to equity markets, and second, speculators desire volatility in the short-run in order to maximize their capacity to make money, such that there is a serious misalignment of incentives between speculative market participants and the purpose of commodity markets. 

The goal of commodity futures markets is to provide a venue through which buyers and sellers of raw materials can share some of the risks in price fluctuations and both can secure some sort of certainty for longer-term budgetary purposes.  Fundamental commodity market particpants are not necessarily trying to make money on each transaction, but rather their aim is to gain security in price on both sides of the equation in order to more efficiently plan and manage their business.  Because this is the existential purpose of commodity markets, it should be noted that volatility poses dangerous risks to the players who need smooth functioning in these markets most. 

Meanwhile, short-term transactions that result in realized gains in commodity markets are not done with the intention ever taking or giving delivery of the underlying goods themselves.  Rather, these transactions are done for the purpose of realizing a gain off of changes in price.  These transactions require inefficiencies between supplier and buyer PLUS volatility in order to generate a profit.  In seeking volatility, such transactions promote yet further volatility.  Because of this fact, volatility and market dislocations lead directly to more opportunities for speculative gains.  Pushing such actors into commodity markets creates a situation where volatility becomes a self-fulfilling prophecy for the benefit of a significant portion of market participants, but a detriment to society at large. 

Speculative traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities; however, there is no reason for the government to provide a direct subsidy in inducing speculators to prefer commodity rather than any other market.  And there’s really no reason that speculators who engage in these markets for a living should pay a lower tax rate than any other hard working American.

Since markets like these are zero-sum, where one actor must inherently make money at the expense of another, there is unquestionably at least some coefficient of a speculative cost in the price of commodities.  No one these days is seriously concerned about a lack of liquidity in commodity markets, if anything we as a society acknowledge the abundance of this liquidity between the proliferation of commodity-based ETFs.  While we can’t necessarily weed out all speculation from these markets, we can realign the incentive structure to be symmetrical with every other profession in our country.  This is a question to which both Democrats and Republicans should be able to find some common ground.