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Commentary:   April  2019

Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel

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    of all guest columns written by Dennis C. Butler, CFA                                                        

APRIL  2019

I

n a remarkable turnaround, on March 27 the German government sold — into heavy demand 2.4 billion euros of ten-year bonds yielding their purchasers negative 0.05%, a guaranteed loss. The first such sale since 2016, it is indicative of the change in sentiment in the fixed-income markets just since the end of 2018. In the U.S., Federal Reserve action in short-term securities and market adjustments in longer-term debt led to rate increases over the course of last year, and heavy liquidation of fixed-income funds, especially among the lower quality sectors. This year has witnessed an about-face in market outlook for rates and bank policy action. Fearing that overly-aggressive central banks were risking a slowdown in the global economy, many investors fled to the perceived safety of sovereign debt (and in the case of the U.S., to higher yielding securities), resulting in the re-appearance of negative yields, as seen in the German issue. The stock of debt in the world sporting negative yields expanded once again and now stands at over $10 trillion. Significantly, even a few corporate issuers have managed to raise debt capital with negative yields, which is surprising given the fact that so many corporations have debased their capital structures during the low interest rate environment of the past decade, in many cases issuing debt in order to buy back their own common stock at ever-higher prices. In fact, such corporate capital account-shifting has contributed mightily to the rise in the equity markets since the financial crisis.

One consequence of the renewed interest in fixed-income was a rapid decline in U.S. mortgage rates, which generally track the yield on ten-year treasury notes. During the final week of March, average rates on standard thirty-year mortgages dipped nearly one quarter of a percentage point to 4.06%, the largest weekly decline since 2009. So far this year, thirty-year rates have averaged 4.37%, down from 2018’s 4.54% average, showing economic self-correcting mechanisms at work. Evidence of a slowing economy drove money into the perceived safety of bonds, thereby lowering borrowing costs across the economy. Eventually, this drop in borrowing costs will act to stimulate the economy in general, and, in particular, housing construction (one of the largest economic sectors) as the cheaper mortgages increase demand for homes.

In contrast with the gloom prevailing toward year-end 2018, stocks, too, enjoyed a remarkable rebound in the first quarter of 2019. Following the worst December since the 1930s, stocks had their best start to a year in three decades. January alone saw the S&P 500 index jump 7.9% the biggest rise for that month since 1987 making the first quarter of 2019 the best for that index in ten years.  “As goes January, so goes the year,” says the old Wall Street maxim a hopeful thought to many traders whipsawed by last year’s final quarter but just as 2018’s year-end market gloom did not provide an accurate foretaste of things to come, we should take the predictive power of this year’s initial euphoria with some skepticism.

1987 is best remembered for October’s “Black Monday” crash. Few remember the strong run-up in prices during the first nine months; January 1987 saw a gain of 13.2% in the S&P. Also, stocks gained 6% in January of 2018, while they declined for the year. Such a record certainly put paid to the reliability of old Wall Street wisdom, at least the kind that promises to foretell market direction.

Not that any of these market foibles matter very much over the long term, engrossing as they may be at the time. Stocks soon rebounded from the Crash of 1987. The downturn of the early 2000s proved fleeting as well, and the recovery in the markets after the much more severe collapse of 2008-2009 has been rapid and long lasting. Stock prices recouped their losses, and now stand near all-time highs. Profit margins of U.S. businesses have been at record levels for several years, and a few companies have reached market values in excess of $1 trillion. Society’s wealth has expanded, its uneven distribution notwithstanding. Through widespread holdings in pension and other retirement vehicles, equities have played an important part in this wealth accumulation something that anyone can participate in if done properly. The late John Bogle, Vanguard Group founder and long-time exponent of low-cost index fund investing, once said “the stock market is a distraction from investing.”  As long as one remains true to investment, as opposed to speculation or gambling in securities, one increases the chances of benefitting to the furthest extent possible from our society’s engine of wealth creation.

Financialization

We have long been interested in the impact that an emphasis on financial factors has on business, investing, and our society at large, because it seems to play a role out-of-proportion to what is needed to make the wheels of commerce run efficiently. The business of finance has always been an important part of U.S. industry; for example, the proportion of total stock market capitalization comprised of financial firms has not changed much over the past century (about 20% in 1900 and 2018, with ups and downs). Financial shenanigans of various kinds, and corporate structures set up with purely financial aims in mind (pyramids in the 1920s, for example), have always been with us, but finance and financial goals seem to demand an inordinate amount of attention in modern business. Wall Street, once a relatively small cottage industry, dominates business news. Many corporate executives obsess over their own company’s share price and feature stock quotes on their desktop computer screens proving that the stock market can also be a distraction from running a business.

An article by Anat Admati of the Stanford business school (Journal of Economic Perspectives, Summer 2017) provides an interesting review of the history of “financialized corporate governance,” and its consequences. Admati points out that one of the chief characteristics of financialization in the U.S. has been the focus on “increasing shareholder value” as the overarching goal of corporate activity, with executive incentives tied to its achievement. This is actually a notable divergence from past practice. Prior to about 1970, only about 16% of U.S. CEOs of major corporations received “performance-based” pay with bonuses, stock awards and options being the typical instruments. This figure grew to 47% in the 1990s, and nowadays most CEOs receive stock market-linked incentive awards all with the stated intention of “aligning” the interests of executives with those of shareholders. Through these arrangements, it was claimed, the inherent conflict of interest between those with intimate knowledge and control of corporate affairs (managements) and those with limited knowledge and authority (shareholder-owners) the so-called “agency problem” would be resolved to everyone’s benefit. What has happened in practice, however, is that highly competitive and motivated individuals have found common ground with speculators, focusing on efforts to achieve short-term financial targets, including reported earnings, all in an effort to boost stock prices and with them the value of their compensation packages. As managements are fully aware, the investment community responds well to a nice record of steadily expanding profits. 

These practices can negatively impact the firm, its various stakeholders (employees and customers, as well as shareholders), and the larger society that it is supposed to serve as a good corporate citizen. The manipulation of reported earnings (often through perfectly-legal interpretations of accounting standards) presents a misleading picture of the actual earning power of a business (outright fraud, of course, has the same effect).  “Cost cutting,” a common tool used to boost profitability, works well as long as the business continues to invest in its future; however, the consequences of underinvestment are usually only discovered years later (recent sharp share price declines at a large consumer products company were attributed to a lack of investment in its brands). Increasing debt loads are often another symptom of short-term profit seeking (debt can increase earnings until a weaker economy or poor investments make it burdensome), as is increasing consumer prices to maintain profit margins. At some old-line industrial companies, an emphasis on finance and financial metrics has even come to dominate the original business (in one case creating huge, continuing losses in the process).

The ultimate cost of this system is born by individuals (hiding the harm from tobacco, for example) and society: increasing inequality can at least be partially explained as the result of those best positioned to manipulate the system deriving the most benefit from it. And the caustic politics in numerous countries in recent years can be tied at least to some extent to an increasing perception that the management of business entities the sources of much of our society’s wealth is rigged in favor of a small minority. Businesses eventually suffer as well, through higher funding costs, lower public trust, and, ironically, lower share prices.

                                

As investors, we have had first-hand experience with the effects of “financialization,” and one example stands out in particular. Some years ago we purchased shares in a relatively small industrial company in a cyclical business. We found it attractive because it was well-established, and nicely profitable in good times. It had an equally-nice balance sheet, with little debt and lots of cash to get it through tougher times. It paid a dividend, which, at the price we paid for the shares, represented a generous yield. We liquidated the position a few years back for a good return.

Recently we looked again at the company when its shares were trading at a fraction of the price at which we sold, only to find its affairs to be completely altered. The balance sheet was larded with debt; there was little cash; earnings were meager; and the dividend had been cut in half. On an earnings conference call, a member of the founding family, which still owns a significant position in the company, complained that without a big upturn in business the debt would never be paid off.

Yet here was a company that had done all of the things typically found in the financial engineer’s toolkit. It had made its balance sheet more “efficient,” adding debt (which should have increased profitability) and buying back shares (to increase that critically important earnings per share figure). It had made acquisitions, including that of a company in Europe, in an effort to boost its growth rate. But in the process it lost its way, forgetting the lessons of its own history in a highly cyclical, competitive industry that looks unkindly upon weak balance sheets and no cash cushions. We are saddened by the fate of this company, but this example is illustrative; it shows that investors should never be complacent about companies they own. It also explains why despite all of the incentives and interest alignment, so few businesses make it into the ranks of old age.

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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28).   "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:

Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695

Email: cscc@comcast.net
URL: http://www.businessforum.com/cscc.html


 

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