December 2006
Monthly Investment Commentary
In next month’s year-end commentary, we’ll do a thorough review of our investment strategy and give our views on the major asset classes (as we do at least quarterly). Since little has changed with respect to our portfolio allocations or our assessment of risks and opportunities, we aren’t going to spend a lot of time in this month’s commentary restating what we’ve already said in the recent past. Many of our readers wonder if we’re “leaning” one way or the other in terms of any portfolio or fund allocation shifts. We can report that this is not the case. In general, we still think market valuations are reasonable, despite the run up in stock prices, thanks to strong earnings. In essence, the market’s rise has in part simply helped prices “catch up” to higher earnings. We don’t think earnings growth will remain at the levels we’ve seen in the recent past, but it’s nice to have the valuation cushion that strong earnings have helped provide, especially given the broad, structural risks that exist. One concern we’ve heard some clients voice relates to the declining dollar. We’ve addressed this issue for quite a while, including our growing current account deficit, and our three balanced models include non-dollar bonds as a partial hedge against a declining dollar. We’ll talk about this more next month, but for now we can say that nothing material has changed with respect to our thinking on this issue. We still think hedging against a dollar decline makes sense, but that a dollar collapse is unlikely. Speaking of our growing current account deficit, our research partner, Litman Gregory Analaytics, have spent time this month interviewing Steven Vannelli of investment research and management firm GaveKal. His firm has some unconventional macro views (including on the current account deficit) that have stirred discussion in investment circles and that we think makes for an interesting read. The Q&A appears below. Q&A with Steven Vannelli of GaveKalEditor’s Note: Steven Vannelli is a partner in the Hong Kong-based research and money management firm GaveKal. Founded in 1998 by a French father-and-son team, Charles and Louis-Vincent Gave, GaveKal publishes global economic and investment research for clients in 35 countries. Their most recent book, Our Brave New World, has stimulated interest and debate in many investment circles, including mutual fund managers and analysts we regularly speak to in the course of our research. The conversation below concentrates on the ideas developed in this book. Litman/Gregory: What was the impetus to write Our Brave New World? Vannelli: The book was a down payment on a body of work that we’re continuing. Classical economics looks at things in a very linear manner and we think it is simply incapable of capturing what’s going on in the world around us. One of the themes of the book is that we’re moving from an industrial economy to a knowledge-based economy. The Western World, primarily, is leading that parade. But the whole world is moving in that direction. The book is written, of course, from the perspective of the “platform company,” because we feel that that’s the investable asset that will rise to the fore as the theme plays out in the world. Litman/Gregory: How do you define a platform company? Vannelli: The essence of a platform company is that it is a “knowledge” company. You have three functions that a company can perform—they can design, manufacture and/or distribute a product. More and more companies in the Western World are deciding that manufacturing that product is capital intensive. It’s labor intensive. It does not generate high returns. And so they’re focusing on the design and distribution—the knowledge portions of that activity. Ultimately, the cost of capital for a platform company should go down, because they’re committing less capital to long-term assets. They’re generating higher productivity, which is the real key. The returns on intangible assets—the returns on knowledge—are higher than the returns on physical capital. With the activity in China and Asia and other low-cost parts of the world, the returns on physical capital are rapidly falling to the cost of capital around the world. The returns on knowledge capital—or the returns on intangible assets—are rising. They’re sustainably above the cost of capital for companies. So, platform companies in essence are monetizing those intangible investments. They’re shifting their asset mix to more intangible assets from tangible assets. Litman/Gregory: Can you give us an example? Vannelli: One of the companies we own is a company called Furniture Brands. They’re a company on the East Coast that produces furniture. Over the last handful of years, they have gone the way of the platform company. Litman/Gregory: By definition, intangible assets are hard to see or measure. How are you measuring them to identify platform companies? And how many platform companies are there? Vannelli: An intangible asset can be anything that has value in terms of generating subsequent cash flows. That can be basic science, applied science, brand building, employee training, or compensation schemes that incent employees. It is estimated that in the 1930s, 70% of the assets a company had were physical assets, 30% intangible. Estimates today are 70% of the assets of a company are intangible. The universe that I watch is the S&P 900. From the get-go, you eliminate things like utilities. A regulated monopoly is not, can not, and will not be a platform company. You eliminate things that are commodity pass-throughs—energy, mining, a lot of basic chemicals. You eliminate things that are non-traded goods because the benefit of globalization and technology doesn’t play into that. So you eliminate things like homebuilding and cable. I also just finished a big project reconstituting 15 years’ worth of income statements and balance sheets. For example, one of our models takes a company’s R&D investments and capitalizes that. We’ve come up with some new measures and some new calculations and a whole new screening process. We got down to a list of 530 companies out of the S&P 900 that are potential platform companies. Litman/Gregory: Ultimately do you expect all U.S. companies to go through this transition? Is GM or Ford going to be a platform company? Vannelli: They are going to have to become a platform company, in that the movement to intangible capital and knowledge capital is a response to the returns on physical capital dropping to the cost of capital. I might add that Ford and GM are numbers 1 and 3 of the top five R&D spenders in the world. The auto companies will become platform companies. It is just a matter of going through the political and social transformation process to get from here to there. Litman/Gregory: Does this transition mean that 20 years from now, there will not be any manufacturing jobs in the U.S.? Vannelli: I think that manufacturing will stay in the U.S. for products that are high-value added, with a lot of intelligence and a lot of knowledge in them—for the simple reason that they can’t be produced anywhere else right now. Jet engines. MRI machines. There are any number of products that we produce that are very high tech and very high-knowledge-embedded products. Litman/Gregory: How do platform companies’ increased use of intangible assets translate into profit margins and actual earnings? Vannelli: A company used to say, “Well, I’m going to produce a million of these things, because I need to cover my fixed costs. Let’s try to sell them.” It just doesn’t work that way any more. Companies are choreographing the global supply chain so there is better knowledge as to the supply and demand for products. Prices are made on the margin, because products are in a just-in-time model. The customer will file an order and then a company will go make the product. That means you get rid of the big price swings in the economy—which were largely a function of inventory swings. When you take away a lot of those price swings, you take away a lot of the volatility of business. And it leads to very high profitability. You hear everybody saying, “We’re back to peak profit margins of the 1960s and margins are a mean-reverting data series and they’re set to revert.” We sit back and say, “You know, that’s just absolutely not true.” The late ’60s was the last gasp—or when we wrung the last bit of efficiencies out of a physical capital economic model. The new era began in the early 1980s and we have a long way to see that play out to ultimately higher and higher profit margins. There has been a structural upward drift to cash-flow margins for the last few decades. That’s a function of the transition to a platform company model. The economy is becoming less volatile. Not as many people lose their job at the bottom of the cycle. You don’t have as many jobs created at the top of the cycle. Litman/Gregory: Even with reduced volatility in the economy, the book says greater income disparity is a necessary part of what you call a knowledge-based economy. That sounds like there will be a lot of former factory workers who don’t partake in the rewards of that economy. Vannelli: An environment where income disparities are allowed to persist and grow through time is an environment where everybody prospers. It may be more beneficial to the people doing the most work and earning the highest returns but it’s beneficial for everybody. The more a society seeks to redistribute wealth and minimize income disparities, the more it reduces the incentive for people to become rich. It reduces the incentive for work and production. In the last 100 years, we created more wealth in the U.S. than in every century combined previous to that. That’s hard to appreciate when somebody on TV is bemoaning the loss of their factory job and now working at Wal-Mart. The fact of the matter is that you can go to Wal-Mart and literally buy a five-gallon jug of mayonnaise for about $3. The fact of the matter is, with these platform companies and with the transition of the economy, it really has never been so cheap to be poor. Litman/Gregory: What about the countries that have taken on our manufacturing? If returns on physical capital are falling and low-cost producers in Asia are getting squeezed, how is the platform companies’ emergence going to benefit Asia? Vannelli: I would say that that is a refinement that we’ve made in our thinking since we wrote the book. At first, we thought that as the U.S. exported the volatile part of its economy, then a foreign economy would take on that volatile part. What we’ve come to realize is that while that’s true, that’s relative. Agriculture is the most volatile type of economic activity. Industrial activity is next and services [or knowledge economy] last. So to the extent that we are moving a lot of our manufacturing to China, China is becoming less volatile as they move their population out of agriculture. We believe that Asia will benefit from what we call a triple-merit scenario: a rise in the currency, a fall in interest rates, and a rise in the stock markets. That’s largely a function of an economy getting to the point in its maturation where it has overcome a lot of its initial tendencies of poor policies—monetary, fiscal, or otherwise. China’s a perfect model to look at. Multinational U.S. companies are the first investors that go in. They want to own the factories themselves and produce there and take advantage of cheap labor. The products they create are low capital-intensive but high-labor. Textiles would be a great example. As the economy matures, more and more global investors and producers want to commit to more capital-intensive manufacturing activities. So the country can begin to go from producing textiles and toys to more value-added items. That facilitates the development of that country. You see rising levels of disposable income. You see falling unemployment. You see greater productivity. You see infrastructure spending. So that’s why we look at that and say that the Asian economies should be on the cusp of that triple-merit scenario. They’re now at the point in their development where you would expect to see a greater employment of leverage with foreign outside capital. That gets back to platform companies outsourcing manufacturing. Everybody moves up the value chain, around the world. Litman/Gregory: One of the more controversial ideas in your book surrounds the sustainability of the U.S. current account deficit. Why do you think the calculation of the current account deficit is misleading? Vannelli: The current account deficit is calculated on sales—not profits. If you calculated the current account deficit on profits, you’d probably see a surplus to the U.S., not a deficit. I think that would change the visualization of money flowing out of this country. The numbers that I see indicate that a large portion of our trade deficit with China is accounted for by multinational firms. U.S. firms that have ownership of assets in China, that are then selling those goods back to the U.S. Meaning that we’re not necessarily buying a good from a Chinese company in the traditional sense of an export. But it is a U.S. company producing a good that is then exported from China back to the U.S., counted in our trade deficit, but not factually part of China’s production. Secondly, foreigners own about $2 trillion to 22.8 trillion out of our total $65 trillion stock of assets. Well, that’s very, very far from a picture of foreigners owning the entirety of our stock of assets. It gives us, at today’s value, $62 trillion worth of family silver to sell. The U.S. trade deficit is sustainable to the extent that there continues to be a positive return between the cost of capital and the return on capital. (See chart below.) The deficit represents borrowed money. If I borrow $10 and earn $15, I’m solid. But if I borrow $10 and earn $8, I’m sunk. As long as the return on capital is above the cost, leverage adds to my returns, but if my return on capital falls below my cost, leverage subtracts from my returns.
Litman/Gregory: Why are you confident that foreigners will be willing to continually add to their holdings of U.S. assets if Americans want to continue to borrow to import goods? Vannelli: We look at the Fed’s flow-of-funds household balance sheet as a measure of the wealth of society. We have about $65 trillion in assets, about $13 trillion in debt and about $52 trillion in net worth on that balance sheet. That net worth has been growing at about 6% per annum for the last decade and a half. At that pace, our net worth of $52 trillion will grow about $3 trillion this year. Of that, our trade deficit of $700 billion to $800 billion represented an increase in foreign claims on U.S. assets. That still means that there’s $2.25 trillion net that the U.S. earned. As long as that’s a positive number, there’s nothing unsustainable, mathematically, about the continuation of that trend. Were we to run into a trend for a period of time where the stock of foreigners’ claims on our assets rose $1 trillion and our net worth only rose $500 billion—well that would be unsustainable. At the end of the day, our stock of assets is growing at a relatively healthy rate. Litman/Gregory: All the considerations you’ve described—globalization, rising profitability for platform companies, rising wealth for both the Western World and Asia—lead GaveKal to the conclusion that we are in the midst of an investment environment you call the “deflationary boom.” Can you describe what that is? Vannelli: We base our four possible investment scenarios (see chart below) on variables used by Irving Fisher to dissect the reasons for the depression in the ’30s. In the equation MV = PQ, M is money that the Central Bank produces and provides to the economy. V is velocity—the extent to which the private sector multiplies that primary liquidity. On the other side of the equation, PQ is price times quantity.
In an inflationary bust, you have stagflation. So on the right side of the equation, you have rising prices, but stagnant-to-falling quantities in the economy. In a deflationary bust, money is accelerating but the secondary market is not multiplying that liquidity. You have both falling prices and falling quantities. In an inflationary boom, you have money and velocity rising on one side of the equation and both prices and quantities rising on the right side. The deflationary boom is unique in our shorter-term history but if you go back and look at the better part of the 20th century, the deflationary boom is what we called a natural state of capitalism. You’re in an environment of low volatility, [and] developed capital markets [have] access to capital and technological innovation. There is growth but fewer inflationary pressures. So, you have economic activity rising but prices falling. That’s really where we think we’re getting back to. Litman/Gregory: Potentially how long do you see this deflationary boom lasting? Vannelli: This should be about half-time of a 10-year economic cycle. So another five years. The last two expansions lasted about 10 years (and the U.K. and Australia haven’t had a recession since 1990). The stability of monetary policy, the prudence of fiscal policy, the proliferation of information technology, and the integration of the global economies are all reasons to anticipate another “elongated” economic cycle. I think one of the most identifiable trends of the last two cycles, and this one is shaping up the same, is the pre-emptive action of the Fed. In both the mid-1980s and [mid-]1990s the Fed preemptively tightened early on in the expansion to curb any budding inflationary pressures. In each case, the Fed acted before wage inflation had taken hold in the economy, and by initiating a mid-cycle slowdown, they were able to stretch the cycle out and not have to get “ugly” for eight to nine years into the cycle. I see no reason this time is different. In fact, given the nature of the global economy, it may take even longer before the Fed needs to deal with embedded wage inflation in the latter stages of the cycle. On the other hand, given demographics, and the seeming paucity of available labor, it may happen a bit sooner. It’s hard to know. If Fed forecasts for sub-1% employment growth are correct, productivity will obviously have to shoulder a bigger portion of growth. At the end of the day, it is our hunch these factors will offset, and the expansion will continue for at least another five years. I think it is helpful to remember, expansion is the nature state of a well-functioning economy like the US, and it takes purposeful action to arrest the growth tendencies. Litman/Gregory: Why does it make sense to buy platform companies in a deflationary boom? Vannelli: In a deflationary boom, you want to own the companies that can monetize productivity. Platform companies produce a greater flow of incoming cash flow with a lower stock of assets. Their assets are lower-risk. Also, platform companies are especially advantaged as prices fall, because they sell products that have an elasticity of demand greater than one. So if the price of their product goes down, they sell more of it. To the extent that the price of a semiconductor, PC chip, or cell phone falls, they’re likely to sell more of them. Because platform companies are employing knowledge capital and not tangible capital, they don’t have a large marginal cost. By comparison, when the price of gold or oil goes up, we consume less of it. When the price of oil goes down, we don’t consume too much more of it. That’s largely the reason to sell gold and oil during a deflationary boom. Litman/Gregory: The book lists a number of threats to a deflationary boom: increasing taxes, increasing regulation, war, protectionism, and/or too-tight monetary policy. Is the deflationary boom you see at risk? Vannelli: I would look at monetary policy. Historically, if real rates on 10-year government bonds are above the real structural rate of growth in GDP, which is about 3.2%, then you have a headwind. Well, we’re not there yet. You could also look at it another way. If short rates get above the level of nominal GDP, then the cost of capital is above the return on capital. We’re not there either. So by those two measures, we would look at monetary policy right now and say, “It’s fine. It’s appropriate. It’s not restrictive enough that it would throw us into a recession.” There’s a difference between early-cycle inflation pressures and late-cycle inflation pressures. Early-cycle inflation pressures revolve around commodities and fixed manufacturing capacity. Late-cycle inflationary pressures revolve more around labor markets. When the labor markets get infected with inflation, then it has the potential to create the wage-price spiral. In the last couple of cycles, you’ve seen the Fed start raising rates early enough, when price-based indicators—gold, commodity prices, oil prices—are rising. We think that there’s enough monetary restriction to take the cream off the top of prices on the right side of the equation, and that’s kind of how you slide from an inflationary boom into a deflationary boom. You take away the fluff of prices and you keep quantities steady. That’s really the crux of a deflationary boom—really peeling off some of that initial price pressure. You’re in the exact same position as a period like ’95, when you had the mid-cycle slowdown begin. To us, you’ve got the sun, the moon, and the stars, lined up. As Charles [Gave] says, this is the most attractive environment he’s seen since 1979, where you have a cheap stock market, a neutrally valued bond market, and a cheap currency. Those three environments don’t happen very often in an investor’s lifetime. That’s why we’re so rigidly bullish on stocks. Litman/Gregory: Thank you for your time. — Stapp Financial Planning, PLLC This information is also available at www.stappfinancial.com, or you can download a PDF version. If you do not want to receive future e-mail newsletters from Stapp Financial, link to our subscription form, or send an e-mail to bstapp@stappfinancial.com. Before acting on any advice it is recommended to seek appropriate counsel applicable to your individual circumstances. |
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November was another good month for most asset classes. The large-cap S&P 500 gained almost 2% for the month, while smaller-cap stocks, as measured by the Russell 2000, gained 2.6%. Based on Russell indexes, value edged out growth in both the large- and small-cap areas. Mid-caps were the anomaly this month: their 3.6% gain was significantly ahead of both large- and small-caps, and growth beat value by 70 basis points (again, based on the Russell benchmarks). The foreign-stock Vanguard Total International benchmark was helped by a declining dollar, and posted a 3.7% gain in November. On the bond side, the Lehman Aggregate Bond Index was up 1.2%; high-yield corporates gained 1.6%, and developed markets foreign bonds climbed by 2.8%. Among our tactical asset class weightings, commodities gained 5.5% and emerging local markets bonds were up 2.2% (both positions are funded from an underweight to bonds). REITs, which we don’t own tactically, gained another 4.7%, bringing their year-to-date tally to a dizzying 37.6%. Our models performed well in November but still trail year to date. Over long time periods the performance record of our model portfolios remains strong.
