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    Monday
    Dec262016

    PerfectCompany Update 12/26/16 and Why Random Walk is Wrong

    A few dear readers have asked about PerfectCompany this year. Some have even said they have enjoyed reading the newsletter, which has not been published in 2016. Here is an annual update.

    Some of our companies have continued to perform well. If you did nothing but hold last year’s portfolio through this year, you would be up 32% versus 11% for the S&P 500. 

    Below are charts from Etrade for my wife’s and my retirement portfolios. As of the close on December 23, one is up 46.5% and the other 49.6%; the S&P was up 10.8%. The difference between holding last year’s portfolio and our actual Etrade accounts is that, in practice, I sell losers, keep winners, and buy companies with better potential. For instance, I believed in IBM’s Watson initiative, but concluded that IBM was not the company to capitalize on Artificial Intelligence, so I sold IBM and bought NVDA, a company that has become the darling of that investment trend. Keeping winners is also counter to general portfolio practice since the winners come to dominate one’s portfolio. Does Jeff Bezos wonder, “Gee, Amazon is too big a piece of my portfolio – should I sell it?” I like winners that make sense.

    Note the difficulty at the beginning of 2016 when we were significantly under the S&P 500. This is when investors are manipulated into panicking, so that they rarely experience significant profits. Much has been written by psychologists and economists about people’s greater concern for loss than profit: as a group, we would far rather not lose than win, which is one reason why the “random walk” theory is wrong. The not-lose tendency exacerbates both ends of a stock’s run by driving down values in the extreme when prices decline and by driving up values in the extreme when people feel they are missing out. Investors who can tolerate frequent losses because they know the overall effect is a superior return call these periods opportunities to “buy low” and “sell high.”

    The other exaggerators of trends are index funds and programmed traders. Index funds are blind to value, and programmed traders, which make up a majority of trades, trade so quickly that they do not have time to reach out to the real world to see facts: they play a game against other programmed traders and weak investors, so they naturally exaggerate any real value trends by piling on or by temporarily pushing value in the opposite direction to flush out weak investors before further exaggerating the trend.

    Random walk is wrong because most trades are made by automatic trend exaggerators, and the only actors who can make value judgments (actual investors) are frightened by their own psychology, and have limited access to data that could provide them with comparative values.

    The other attribute of this market is that it is mostly run by professional investors who believe they can predict earnings. The data show that earnings predictions are wildly inaccurate after just three months, and anyone who has ever run even a small company knows that environmental factors, large sales, and animal spirits can easily inflate or devastate profits, which, after all, are only a small percentage of sales. Young MBAs who believe they can – from the outside and with persistent questioning – predict next year’s earnings of complex organizations are deluded at worst and ambitious at best. One of them told me that “everyone knows that stock values are correlated to earnings.” This is wonderful news if you have ever had an original thought: 15,000 hedge funds are operated by people who mainly think the same way and follow each other, so they are yet another group of value exaggerators. Buffet moved from New York back to Omaha to get away from this group think.

    To be fair to analysts, if each analyst handles 30 to 80 companies, first, they cannot possibly understand them and, second, they are overeager to find something good to write about in their tiny universe. If you are looking at the investable universe, you are throwing away 80 companies by the handful in an attempt to find truly excellent candidates.

    For the few people interested in doing the work and thinking at all originally, the opportunity to invest in a market with so few original actors is certainly easier than starting companies and selling products. You can ride other people’s successes, and, if you make a mistake, cut your losses quickly. What could be easier?

    Why I stopped writing this year

    I stopped writing for three reasons:

    1. Performance doesn’t matter.
      A friend summarized the PerfectCompany blogs in three pages of his Princeton newspaper at the end of 2015. I thought this might produce some interesting opportunity, but there was little feedback. It dawned on me that the real business of money management is aggregating money, not making money.
    2. My data sources dried up.
      My approach is top down: I seek to find the best values among thousands of companies, and then I wait for those companies to grow and be discovered. It appears to me that – even among professionals – the most prevalent selection method is whisper-down-the-lane. Consider an investment if you see it in Barron’s, or if you hear about it from multiple sources. Good data that you can load into your own spreadsheet is surprisingly hard or outrageously expensive to get. Data companies want you to work within their systems, or they omit simple data points like enterprise value and dividend rates. This is public data, and everyone but public employees is now responsible for managing his own retirement, so it seems to me that this data should be free. It is far from free. The very limited distribution of this data en masse so that it can be analyzed is another reason why random walk is wrong: all the information is not really in the market – in fact, few people have access to data that allows them to compare values or look beyond bogus indicators like PE ratios. To remedy this, I have hired a company to develop a web-scraping program that I hope will deliver the data in 2017.
    3. I have been busy this year.
      I dropped out of social activities, and worked this year on various projects. One of these – the BillionDollarArtGallery – is described below. It was a labor of love, but one that might appeal to readers of this blog.

    Trends in 2016

    One main trend is upending business and politics: the optimization of everything and the reduction of jobs. This has predictable consequences: 

    • The desperation of relatively unskilled workers whose jobs are going away not just to China, but forever: drivers, clerks, cashiers, warehouse workers, middle managers and many others
    • Unimaginable wealth for people who control the tools of optimization:  in a recent period, the most valuable 10 stocks were all tech stocks.
    • No pressure on wages because jobs are constantly being reduced
    • Continued low interest rates because governments want to encourage risk capital that might create jobs. If you think last week’s rate increase was important, look at the historical perspective:
    • The piling up of cash in hyper-efficient companies, which, by the way, are unconcerned about interest rates
    • The concentration of industries and the reduction of competition as cash-rich companies buy their competition, and further reduce jobs
    • The proliferation of entertainment options to fill time for people who work less or not at all
    • The election of previously unthinkable outsiders because so many people are seriously frightened about their prospects.

     

    I spoke about this at length in Philadelphia in July.  See How Technology is Upending Money, Politics, and Religion

    Perfect Companies in 2016

    PerfectCompany has benefited from the trend toward machine intelligence and ultimate optimization of business processes. We bought Nvidia (NVDA) when its chips were beginning to be used in artificial intelligence or pattern recognition devices like IBM’s Watson. It’s up 393% since we first bought it on 4/27/15, and now has a market cap of $59 billion. I have long thought that Intel (market cap $175 billion) should buy Nvidia because Intel is reaching the end of Moore’s law: it is getting harder to increase profits by jamming more transistors on a chip. We shall see. I was pleased to learn last week that one PerfectCompany reader bought 1000 shares in the the $20s, so he has made about $80,000 on that investment.

    I like WSTG, which pays a 3.7% dividend and continues to grow nicely. Insiders have been net buyers in the last 12 months. The company has no debt, plenty of cash, and steady, profitable growth. I would like to see a clear vision that might enable phenomenal growth. For instance, an expert system that would enable WSTG’s vendors to provide low-cost, high-value support for the technical products that it distributes. Though I’m not aware of anything that might enable explosive growth at WSTG (barring an acquisition by Amazon), it’s a good company with a decent dividend.

    LOAN continues to grow by making hard-money loans to developers in New York City. LOAN pays a 5.6% dividend. It seems to me that people with money all over the world want to establish a connection to New York. If the world goes to hell, people will still want to come to New York – maybe more.

    IDWM is a special situation. The stock is thinly traded, and is controlled by a handful of shareholders. One of the shareholders wrote a well-reasoned letter to sell the company in late 2015.  Read it here.  I suspect that that shareholder sold shares in early 2016, which depressed the price. However, almost every lull in IDWM has been a buying opportunity. This company is following Marvel’s playbook by developing stories in comic books, and rolling them out in TV shows and movies. Wynonna Earp is a good example of a comic book turned TV show that has earned IDWM credibility. The company also pays a 1.3% dividend, which is better than you get at your bank. IDWM has a $153 million market cap; Marvel sold to Disney for $4 billion.

    OLED is the Qualcomm of screen technology. They license their patents for low-energy, high color screens to LG, Samsung, Apple and others. OLED screens are coming, and the company is getting into lighting fixtures next. If you have seen the incredibly bright LED flashlights, you have some idea about how lighting is going to change. I would not be surprised if Qualcomm or another tech company bought OLED. The near term is murky, but the long-term is very promising.

    If anyone can survive at retail – and I’m not sure anyone can – it is likely to be FYE (a unit of TWMC), which has been rolling out its new store format over the last year. Store employees say that it’s going well, and insiders are buying heavily. If you’re reading this, you probably wouldn’t buy any of their chotskies, though they are the kind of movie and game-related merchandise that young people buy on impulse. You might buy used CDs and vinyl records on TWMC’s secondspin.com  TWMC paid $75 million for etailz in October, 2016. They expect results to be accretive in the first quarter of 2017.  This company had a lot of cash and insiders were buying. They have now used that cash to buy etailz, so the future rests on their new investment. I have not had a chance to fully evaluate etailz.

    My biggest mistake in the last two years was buying NMM. The numbers looked good, and the management has been excellent. It paid an extraordinary dividend and had long-term contracts. I did not know that the Chinese were dumping ships onto the market to keep people employed and to take over ship-building. In July, the seventh largest shipping line, Hanjin, went bankrupt, stranding $14 billion of goods at sea.  It appears to me that Navios is following a kitchen-sink approach to this period that will strengthen it for the future. As long as the news is bad, they are throwing every bit of bad financial data in that they can can. In Q3, depreciation and amortization jumped from $19 million to $38 million. The company makes the case that it is paying down bank loans, and shoring up its cash flow. PerfectCompanies make money, so I would not buy NMM now, but I am prepared to jump on it at their next profitable quarter.

    I like ATNI a lot. These guys are good at buying networked systems, improving them, and selling them. VIVO is a medical testing company that pays a 4.5% dividend. I think someone will buy them.

    Trends in 2017: rumors of wars

    • The war on jobs
      Uber is now making clear its plans to kill off drivers. Google wants to make automatic programmers. Like so many things that could never happen, these and other job-killers may come to pass. Disability is picking up clients dropped by welfare.  Universal Basic Income may be on its way.  
    • The war on fixed assets
      The sharing economy reduces, at least in the short term, asset purchases. Private plane manufacturers are finding that the greater utilization of private planes by sharing companies is driving down sales. Who wants to park money in assets?
    • The war on sugar
      We’re getting fat and going diabetic. Addictive industries are profitable and have powerful lobbies, but I detect an interest in reducing refined sugar in our food.
    • China’s economic war
      China’s debt is 250% of its GDP. If the U.S. had the same ratio, we would have $47 trillion in debt. China uses debt and state-owned companies to take over entire industries. It’s great for U.S. consumers: I bought a metal slingshot with three latex bands from Alibaba Express for $2.70 including shipping. China’s three state-controlled airlines are now setting up cheaper routes around the world, and reducing the profits of U.S. carriers. China is the world’s second-largest economy operated by a single political party. It feels like they’re building a death star over there. I stay away from Chinese companies because they operate by different rules.
    • The war on carbon
      Renewable energy is getting cheaper. (Solar, which essentially an inverse transistor, should benefit from Moore’s law.) Battery technology will improve. We will continue to offer cheaper carbon fuels than our enemies until we can’t give away carbon. I think ATNI will participate in this.

    It seems to me that Trump is setting up for a Reaganesque, capitalistic free for all. Infrastructure will be built, which will generate jobs and a feeling of can-do excitement. Technology will be further deployed in defense. Public debt will increase, so interest rates will stay low. The rich will get richer, and coal jobs will not come back to West Virginia.

    I will look into more companies in the new year with my new data source.

    One of my projects: The BillionDollarArtGallery

    About a year ago, I was wondering about what kind of images we would want to see if we had cheap screens everywhere, so, to the dismay of my wife, I bought a 50” UHD TV and mounted it in the living room. We tried family photos and Internet feeds, but they weren’t very compelling. Then I started to notice the Economist’s articles about museum exhibits around the world, and began adding images of paintings. My wife, who loves art, took an interest, and added more. I found that I wanted to know more about the paintings, so we changed the file name to the name of the painting, the name of the painter, the year it was painted, and the museum where you could see it. I began to learn about art, and, to my wife’s delight, we began going to museums.

    Now we have assembled 500 paintings on a memory stick in an etched wooden gift box called The BillionDollarArtGallery for $25 or five for $100. As a gift, it’s about 1000 times better than a wine bottle. People are mesmerized by the paintings. You can buy it here.

    All the best,

    Glenn

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