It’s surprising this hasn’t garnered more media attention. Several quarters ago, the financial press fluttered to the top of the cage over the relatively unimportant news that AAPL market capitalization had surpassed MSFT. The earnings news is far more competitively substantive, yet goes unreported.

The usual business case for Microsoft depends on the idea that “Microsoft always eventually wins” — it has a long, if recently corroded, reputation as a brutal competitor, based on the following linchpins:

• “Network effects — everyone needs Microsoft to interoperate with each other.” This is still absolutely true among businesses and governments.  But in consumer devices, Apple now has the network effect, through iTunes.  Apple’s tightly integrated multi-device platform for managing and viewing content creates ever-stronger lock-in as users develop a content collection managed through iTunes.
• “Microsoft has more resources.” This is no longer true. Apple now wins any pure resource contest, other things equal.
• “Windows PCs are cheaper.” This is no longer true. Though Apple still has small market share, it also has a very narrow product line, resulting in huge scale economies on a per-product basis.  The result: Apple is more profitable at any price point than traditional PC firms.  This is particularly clear in newer product categories like tablets, where Apple is generally recognized as the low-cost producer.

Conclusion: MSFT can very likely ride out at least a few more years of gains on its business/government customers alone.  It has been a tremendous bargain in recent years, delivering double-digit EPS growth while trading at 8 to 12 times earnings — because of this, I own MSFT, have done well with it, and am not selling yet.

As an investment, Apple has always been too expensive (I don’t pay any premium for growth).  Meanwhile, as a business, the presumption has generally been that Apple will eventually stumble, since consumer markets are fickle.  Though true, this may undervalue Apple’s own increasing network effect in consumer content.  And unless such a stumble occurs soon, MSFT will be rendered unable to win significant new computing markets, not just due to sclerosis, but also simply a lack of scale.

—

The longer-term economic consequences of a currency breakup affecting 600m people will likely be bigger than that of a few failed investment banks.  Yet, when the day finally comes that we wake to learn France and Germany have let the Mediterranean nations swing, we Americans may face no threat of US financial collapse on the scale of 2008, for the following reasons.

1. US firms are better prepared now.  The financial system and indeed most public companies at least appear better capitalized than in 2008, and exposure to the euro is likely well anticipated.  Our case for inevitable breakup (previous post) is not simple, but certainly not rocket science, and the collapse is happening slowly and in the open.  So we suspect there has been adequate time for financial firms (outside Europe, at least) to limit the damage.  In contrast, Lehman came as a surprise, because all banks had presumed the U.S. Treasury understood their interlocking exposure well enough never to permit an outright bankruptcy;  anticipating rescue instead of bankruptcy, other banks never guarded against the prospect of cascading failure.
2. Thanks to our newfound collective sensitivity to loud noises, the breakup is also better anticipated by investors, and thus better incorporated into price.  Shares are already much cheaper relative to earnings than they were then.
3. Because the euro is not the global reserve currency, a crisis may be more geographically contained.
4. The US Treasury and the Fed have been on full alert now for three years.  Again, Lehman was more of a surprise, requiring more time to put together a policy response.  Not so here.  The Fed stands ready, firehose of cash in hand, ready to extinguish the faintest wisp of smoke. Presumably it will step in instantly to rescue systemically important domestic firms that failed to manage euro risk.  Short-term credit then remains intact, and we settle into an orderly global recession.

None of this is to say that it won’t be bad;  but not, perhaps, as bad as we think.

—

Readers may notice I am writing about eurozone breakup as a certainty;  for at least 16 months I have considered it inevitable, based on this reasoning:

1. Europe can be considered to exist in three potential states of economic integration:  trade union (no tariffs), currency union (common currency and central bank), or fiscal union (common treasury and taxation).
2. It is currently in the second state, monetary union without fiscal union.
3. This is an inherently unstable transitional state between trade union to fiscal union. With a common currency, members cannot devalue vs other members, so persistent uncompetitiveness or financial shocks cause big current-account imbalances;  without fiscal union, these imbalances are not easily corrected by transfusions from other members, and so instead become ever-increasing debts.  Since these debts cannot be inflated away by devaluation, they must end in either rescue or default.
4. This appears to have been understood from the outset by at least some EU framers.  The intent, or at least the hope, was always to move forward to fiscal union.
5. But EU-wide fiscal union is politically impossible.  Differences in culture and legal systems prevent uniform taxation.  Popular majorities rejected the euro currency (Maastricht Treaty) — a far less drastic measure.
6. The benefits of a common currency are lower than in the past, and falling.  The original political goal of the EU – to guard against postwar threats like fascism and communism — is no longer relevant.  The information revolution makes foreign currency transactions fast and cheap.  So the EU today captures most of the economic benefits of total integration by its trade union alone, without resorting to the extremes and risks of monetary and fiscal union.
7. Because there are so many risks and so few benefits, it stands to reason that the parts of the EU that cannot go forward to fiscal union must, then, go back to mere trade union.
8. Sovereign nations eventually act on self-interest, and the current euro area is no longer in the self-interest of some member states.  Greece’s main benefits from the euro — greater buying power and cheaper credit — are waning fast. Germany’s main benefit from the euro — artificially depressing the cost of its exports to other EU countries by preventing devaluation against the mark — is increasingly counterbalanced by the cost of ever-larger bailouts, with no end in sight.

The above argues that breakup is only a question of when, not whether.  Franco-German talks last month on the subject of common taxation suggest they hope to lay groundwork for a common currency between them, advancing to fiscal union, albeit over a smaller region.  The others then may regress to trade union.  Though a short-run financial shock, this is actually a stabilizing outcome in the long run, in my view.

But what are the implications for investors, other than the prospect of insanely cheap holidays in Santorini?  See next post.

(Above photo by Nesster.)

It’s a supposed truism that in such industries, perfect competition leads to forever low profits, and thus every company in such industries makes for a bad investment. This is generally right, but as investors, we make money not where things are generally right, but instead where they are occasionally wrong. When faced with a generally accepted rule, the curious and enterprising investor naturally asks, “when is this not true?”  In investing, the money is often hidden in the exceptions to received wisdom.

In commodity industries, one big exception to the no-profits rule is that, in the real world, a few companies do gain sustainable cost advantages;  in these rare situations, the same features that make the industry profitless for others can actually benefit the low-cost producer.

The situation is easiest to see in pictures. Imagine an industry with 3 competitors.  In the graph, each colored block represents a company.  The height of each block is that company’s average marginal cost per unit, while the width is the company’s maximum unit capacity. In the real world, even in a commodity industry, each will have slightly different marginal costs.  We will exaggerate those differences here to make a point. Superimposed over them is the hoary supply/demand curve from Econ 101.

In this imaginary example, we start with equilibrium (what could be more imaginary than real-world economic equilibrium?). The market is exactly cleared by the combined capacity of the three companies (the width of the three boxes is their aggregate capacity, which adds up to the market-clearing number of units). Red has gross profit of zero — its marginal cost is exactly the same as the market-clearing price (dotted line).  Yellow makes some profit, and green makes a lot.

Now, imagine that a recession shifts the demand curve down as shown in the second graph (right). Everything else is the same. Green continues to make money.  Yellow scrapes by with gross profit near zero.  Red is in a world of hurt, running below capacity and losing money, on average, with every unit.

Red may survive for a while by closing its highest-cost plants, which simultaneously reduces its capacity and average cost.  If successful, the new equilibrium might look something like the third graph (right).

What if Red figures out how to copy Yellow, cuts costs further, and matches Yellow’s cost structure?  Graph 4 (right) shows the result:  supply curve is shifted down, price falls to the new, lower marginal cost, someone (we’ll say Red) steps in to satisfy increased demand at that price — but Red still makes no money, and now Yellow makes no money either.

Through all this, Green makes money, because everyone’s selling price is the same (commodity industry), and that price cannot fall below Red’s costs.  So Green always makes money. Theoretically.  In practice, this is rare, because it’s hard to have a cost advantage that other cannot copy.  But this is the source of advantage for most of the companies that defy the odds in commodity industries — Southwest Airlines, POSCO, and so on.

As an investor, one might look at commodity industries, estimate cost per unit for each supplier, and buy a consistently lower-cost producer (only when cheap, of course).

There is a second, less powerful, but also less obvious and less rare type of competitive advantage for commodity producers: balance sheet strength, which confers advantage mainly during shocks, and thus is not given the price premium it deserves.  More on that in a future post.

ADDENDUM 5/23/11:  An astute reader and fellow Caltech alum points out that in practice, sustainable advantages in commodity industries are often non-scalable.  For example, since bricks are heavy and low-priced, shipping is a big percentage of unit cost, so plants have a sustainable cost advantage in selling to nearby customers, but cannot extend this advantage to other markets.  As a result, there is no opportunity for internal compounding, i.e. the company cannot productively reinvest in itself.  This is absolutely true — the cheap, high-quality business with long growth runout is more attractive.  By contrast, low-cost producers in commodity industries, as above, are appealing either as medium term investments (if mispriced) or as reliable yield engines (as long as the company is either paying dividends or buying back shares at rational prices).

1. Buffett expects a turnaround in its residential construction-related units as soon as the end of 2011.
2. He bet on the Australian dollar last year, because it has, relative to major currencies, more hawkish monetary policy and stronger export base (due to mining).  He also bet on one other, unnamed currency — I suspect the Canadian dollar, given his reasoning for Australia.

These two facts underscore Berkshire’s current position on everything:  bearish on the dollar, but bullish on the real economy.

And if we must discuss the media frenzy over the Berkshire/Sokol/Lubrizol affair, I do have an opinion that is different from anything I’ve seen elsewhere.  From all that was said at the Berkshire meeting Saturday, the most logical inference is that Sokol’s insider trading was not to make money, but to impress Buffett that he was a good enough investor to one day run Berkshire.

One of the first rules of investing is to check everything yourself.  Get ideas from anywhere you like (preferably Spinoff & Reorg Profiles), but then follow up with your own due diligence.  Yet it appears as if Sokol, who worked at the world’s most famous investing institution, hired Citigroup to do everything for him, did none of his own work, then hid that fact from his boss, presenting the work as his own.  The insider trading was simply to bolster the impression that he had done his own work, by implying he had long owned Lubrizol.

In short, the Sokol situation resembles office politics, or perhaps plagiarism, more than it does the usual insider scam.

—

Once listed, these two would seem excellent opportunities for a performance-compensated fund manager, if he were unabashedly sociopathic.  Zimbabwe’s recent inflation rates, which reached 231 million percent in 2008, practically guaranteed nominal equity returns well over a thousand-to-one every year.  Suppose the manager is compensated as a percentage of nominal Zimbabwean dollar returns.  He simply puts 100% of assets into MIKM or its spinoff;  shares go nowhere, or even fall in real terms;  but they rise, say, a hundred thousand percent nominally;  the manager collects a 20% override on the gain.

In effect, he transfers almost 20% of his partners’ wealth to himself every year.

This reductio ad absurdum illustrates a potential moral hazard in performance-based compensation under conditions of high price inflation.  Investing to keep up with inflation is vastly easier than investing to beat it;  thus, from a return-on-effort perspective, when inflation is high, the portfolio manager with a performance incentive and a fixed hurdle is well paid just to do the minimum, easily clearing the compensation hurdle without increasing his partners’ real wealth.  Sometime in the next several years, we may have a chance to see what ensues under such conditions.

Last Thursday [11/20/08], the S&P 500 marked a dubious milestone, surpassing the 1973-4 and 2000-02 slumps to become the biggest U.S. broad index crash since the Depression (although, to rival the 1929-32 crash, it would need to fall by half again).

This naturally leads to the question of whether the broad index is now cheap. The answer seems to be, “slightly.”

The 125-year U.S. index price/earnings record compiled by Yale economist Robert Schiller implies long-term mean reversion to an index PE10 ratio of about 16, where PE10 is defined as current price divided by the average of inflation-adjusted earnings over the past 10 years. With relatively high reliability, 20-year investment returns tend to be better when PE10 was well below that level at purchase time; returns tend to be worse when the purchase was made well above that level.

Mean reversion oversimplifies, by ignoring the relationship between earnings yield, interest rates and inflation; however, it is a useful long-run rule of thumb, reflecting reasonable expectations of current net earnings yield on volatile but growing assets.

Today [remember, this excerpt was written in Nov. 2008], the S&P 500’s PE10 is about 14 — below the long-run average, but well above the bottom of previous crashes. PE10 went below 10 in 1974, and below 6 in 1932. So while the market today is rather cheap by historical measures, it has occasionally been 30% to 60% cheaper, relative to this particular average earnings measure. [We now know that the S&P did fall another 15% from November 2008 to the 2009 trough.]

This argues for a good, if unspectacular, long-run prognosis for the index as a whole. By contrast, the earnings streams of many individual stocks are now for sale far below traditional prices, with excellent long-term promise for those who can afford to wait.

The predictable exposure is recession; the more complex exposures are in three interrelated areas, all with unpredictable volatile outcomes.

Dollar stability – The dollar is supported by central banks in nations now entering sharp recessions. They have domestic incentives to continue support, but if a retreat did begin, there would likely be a multinational race for the exits, resulting in dramatic dollar decline.

Inflation – Not only is price stability unlikely, but experts even disagree about the direction. Commodity-driven inflation has abruptly given way to deflation. Next year, we will see intensely, deliberately inflationary fiscal stimulus, with certain trillion-dollar federal deficits. The result could go either way.

Long rates – Fiscal stimulus will be financed by offshore lenders, with their own problems, and without infinite capacity or patience. As borrowing greatly increases, the stage may be set for Treasury auction revolt and further loss of control over long-term rates.

The best path through this minefield appears to be cheap companies with substantial foreign earnings, competitive advantage (ability to raise prices, often exhibited by high return on employed capital), and low debt. These features partly inoculate against dollar instability, inflation, deflation and high interest rates. A fourth necessary feature is investor patience, since even the best firms will likely see a wild ride in coming months.

Among spinoffs from recent years, Coach (COH) is perhaps the best fit for these conditions, and quite appealing just now.

Coach has more than tripled since that day, which is gratifying, but that’s actually not the most important message here.  The critical thing is that our downside was protected.  If credit had remained impossible to get, Coach could have financed itself from cash, even as indebted rivals like Bulgari might well have failed.  If the dollar had collapsed, Coach’s US production for export to Japan and China would have worked out fine, even as the “Chimerica” offshore production model would have collapsed.  If inflation had taken off, Coach’s strong brand and low capex would have helped sustain margins.  At that price — it was under 10 times earnings — Coach was what we like to call an investment battleship, all but impervious to whatever storms the global economy might bring.

—

Over the meal, Warren asked what kind of investing he was doing.  The investor answered with embarrassment, “Well, nothing fancy.  For want of something better, I’m just sifting through Value Line for the lowest-P/E companies that still have an investment-grade credit rating.”

Buffett answered simply, “Yeah, that’ll work.”

Since then, that investor’s portfolio not only beat the S&P handily, but suffered only two down years in over three decades. He now runs a 9-figure investment partnership.

This wasn’t rocket science.  As mentioned at in an earlier post, it was a game of long-term, low-rate compounding, and the self-discipline to stay on that track.

There has been talk since late 2009 among value investment managers about shorting long-dated Treasuries — especially after well-regarded value investor Charles de Vaulx (manager of the International Value Advisors funds, protegé of SoGen Funds manager Jean-Marie Eveillard, and a self-described lifelong long-only investor) revealed he had 1% of his IVA Funds in ProShares Ultrashort 20+ Year Treasury (TBT).

The speculation makes sense — the Fed must eventually wind down intervention in that market — but it is disconcerting to see value investors stray so far, buying instruments with no measurable book value or direct yield, and which hedge poorly against “armageddon,” in that they depend upon financial counterparties that may fail under just the extreme conditions in which they should pay best.

This illustrates the box into which investment managers — especially bigger ones — are painted. Demand, prices, credit and currency exchange rates all remain unusually unstable and unpredictable, compared to the pre-2007 world. The S&P’s price ratios are again at the high end of their historical range, with yet little evidence of sustained industrial recovery.

Moreover, value investors continue fear a macro wipeout: hyperinflation, protracted deflation, stagflation, currency collapse, etc. No one agrees which one, and it is difficult to judge conditions by public data when the global financial system is increasingly intertwined with government (for example, how do we judge the residential mortgage market when nearly all new loans are federally subsidized?). Under such conditions, the fundamentals respond as much to political necessity as to economic logic.

This almost unprecedented uncertainty over macro conditions greatly amplifies the usual investor uncertainty about specific choices. Almost no tactic is simultaneously robust to inflation, deflation, currency fluctuation, broker collapse, credit crisis, etc. Even determining what to do with cash has been complicated — it now yields nothing, or less, yet is exposed to whatever currency it is denominated in, and to whatever financial institution to which it is entrusted.

For the investor convinced of an impending wipeout, but unsure which terrifying portent will prove true, one path through the minefield — surer than cash under some scenarios — is a stable, unencumbered, yielding asset whose yield is denominated in utility (in the economist’s sense), rather than currency. This may sound too general to be actionable, but actually describes the requirements fairly clearly:

• Low debt, so that yield is immune to shocks in the cost of capital.
• Low capital requirements, so that yield is immune to shocks in the price of plant & equipment.
• Stable demand, so that yield is immune to shocks in general economic activity.
• Sustainable competitive advantage, so costs can be passed on to buyers, rendering yield immune to wild swings in input prices.

It’s difficult to simultaneously satisfy all of these constraints except with a portfolio. Still, we keep coming back to tobacco firms — Lorillard (LO), Altria (MO), Philip Morris International (PM), etc. — as a good fit. While they are no longer cheap, and while debt is not as low as we would like, they do satisfy all requirements pretty well, and remain priced below the market’s long-run average P/E ratio.

—

Philippine President Benigno Aquino III intervened this month in efforts to restructure flag carrier Philippine Airlines (PAL.PSE);  managers were barred from spinning off inefficient ground operations or laying off workers, while labor was instructed not to strike until after Christmas.  PAL is reportedly near bankruptcy, despite its dominance in one of the more pricey, uncompetitive airline hubs in Asia.

This is interesting not for its direct investment potential, but as a microcosm of the sad trajectory of Philippine industry generally, and as a nation-scale illustration of the power of compounding.  For both the airline and the country, present travails contrast with a long and once-prosperous history, while populist meddling hobbles restructuring and may help explain stagnation.

Few now remember that PAL is the oldest surviving airline in Asia, operating continuously since the 1930s.  Almost as few will remember that just 50 years ago, the Philippines was east Asia’s third most prosperous country, behind only Japan and Malaysia in GDP per capita (this excludes Hong Kong and Singapore, which were still British colonies).  Today, as once-destitute neighbors like South Korea reach 1st-world prosperity levels, the Philippines has fallen to the bottom of the east Asian heap, and well below the average for sub-Saharan Africa.

Though surrounded by shining examples, and despite its strategic location, decent seaport sites, cozy relationship with the U.S., and the best English fluency in east Asia (again excluding the British city-states), the Philippines under Marcos missed the memo on export-led growth, and perennially lagged its neighbors.  For this and cultural reasons, its birth rate remained pre-industrial, and population tripled after 1960.  There are now more Filipinos than Vietnamese, Thais, Koreans (even if reunified), Germans, French, Italians or English;  in fact, with the highest birth rate in east Asia, they look likely to outnumber Japanese within 20 years.  For all that, the country remains relatively invisible on the world stage, because of slow industrialization.

There was no single moment of failure.  Though there were a couple of economic impairments along the way, the Philippines lost the prosperity race mainly through a small but consistent shortfall in GDP growth per capita, compounded year after year for decades.  How small a shortfall?  Since 1960, it has lagged the slowest Asian success story, Malaysia, by “only” 2.5% per year (nominal), and Thailand by less than 4%.  If it had instead delivered even Thailand’s per capita growth, it would today have aggregate GDP comparable to South Korea or Taiwan, and economists would visit Manila seeking lessons, instead of offering them.

From a Western perspective, the east Asian economic “miracle” appeared to emerge suddenly, but this is the usual misapprehension of hockey-stick exponential growth.  Asia’s success stories did not suddenly strike it rich.  They did not find oil or gold, or buy into the seed round of Facebook.  They instead exploited a series of low-risk tactics to compound at a relatively consistent 8-10% CAGR, without serious impairment, for decades.  That was enough.  Those who could not or would not do the same were left behind.

Like a Mandelbrot image, this principle appears the same at every scale, from individual investors all the way up to nation-states:  choose a series of low-risk tactics to generate consistent, slightly supernormal returns over a long period, without serious impairments, and you will win.  Food for thought.