The Wonderful Wizard of Omaha
Berkshire is too Big, Apple has a China Problem, and NIRP is the next Big Short
by Jeffrey Miller, Partner, Eight Bridges Capital Management
May 1st, 2016
Pay no attention to that man behind the curtain.
The Wizard of Oz in The Wizard of Oz, 1939
So that was neat. I’ve always wondered what the hype is all about regarding the annual pilgrimage to Omaha for Berkshire Hathaway’s annual meeting. Since traveling to Omaha, Nebraska is not on my bucket list, and I can think of better things to do with half a week than wandering around a convention hall looking at booths from companies that have actual stores near home, I’ve never gone. So it was great that this year the meeting was webcast for all to see, because now I realize that I wasn’t really missing anything.
Were there some interesting moments? Most definitely. I spent a large portion of my Saturday glued to the webcast. Buffett has created a lot of wealth for a lot of people and built a very stable company. There are worse ways to spend a Saturday. But I was left wondering what all the hype is about, simply because for 99% of the people in attendance, who spent decent money on flights, hotels, restaurants, etc., they have zero chance of replicating, even poorly, what he has done. Especially since the only real investment advice he seemed to dispense was that most investors should simply put their money in an S&P 500 index fund and go home. And he’s probably right. Most people don’t have the time or the ability or the desire to spend most of their waking hours investigating potential investments and then waiting patiently for their thesis to come true (or not). But they flock there anyway to sit in an arena and listen to him talk for a few hours when the real lessons they want to learn are available in his annual letters, books that have been written about him, and myriad other sources that are basically free. Who says people are rational?
The most interesting part was when he was asked why Berkshire had changed from investing in companies with high returns on capital and no-or-low capital requirements to those that require massive amounts of capital, like railroads and pipelines. His answer: because Berkshire is too big now to invest in those great low-capital businesses (even though they are superior to what he is buying recently and are what created the track record of which so many are envious). My takeaway: smaller is better in asset management, because it opens up many more opportunities that are unavailable to investors that grow too large – like Berkshire Hathaway. Buffett hesitated before he answered, because the answer revealed an uncomfortable truth – that Berkshire is no longer able to maximize returns for its shareholders, but Buffett is unwilling to return the capital to them to go and find other investments. Ego? Probably. When everyone who you come in contact with is always telling you how great an investor you are, it makes it hard to think that someone else could do a better job than you with shareholder money. But when the alternative is to keep buying large, slow growing, capital intensive and economically cyclical businesses, maybe it’s time to pull back the curtain on the Wizard.
Coroner: [singing] As Coroner I must aver, I thoroughly examined her, and she's not only merely dead, she's really most sincerely dead.
The Wizard of Oz, 1939
We are about two-thirds of the way through the first quarter’s earnings season, and so far the results have been decidedly mixed. Last year’s darlings, the cohort known as FANG (Facebook, Amazon, Netflix, and Google) have had a poor start to the year, although this week both Facebook and Amazon reported better than expected numbers, sending their stocks soaring. Netflix was fairly bad, and the stock got hit for over 15% as a result, while Google was fine (note: my fund is long Google). But the stock of the week was clearly Apple, which fell nearly 10% after reporting really lackluster earnings on falling iPhone sales. We wrote about the issues facing Apple back in November, detailing how its products were becoming hard to distinguish from its competitors, and how its future reminded us of the once-great company Sony, another consumer electronics manufacturer that was known for great design but missed a few product cycles and fell into a long slow decline. It appears to us that the time when Apple is a “must-own” stock is “really most sincerely dead.”
Why? Because Apple has a weakness that most investors aren’t talking about, but which I believe has a significant non-zero chance of happening. What’s the weakness? Its substantial sales in China combined with its unyielding stance on encryption during its clash with the FBI over unlocking the San Bernadino bombers’ iPhone. While CEO Tim Cook’s unyielding position of putting Apple’s customers’ privacy ahead of the government’s interest in protecting its citizens from terrorism may fly (sorta) in the U.S., it definitely won’t in China. And no one is talking about that. So what happens to Tim Cook’s moral outrage when China demands that Apple make its phones accessible to the Chinese government? Does he maintain his “high” ground? Or does he capitulate because he wants the business? And what happens to Apple’s stock when this debate happens? To me, this is not a question of “if”, but “when.” Don’t think it’s gonna happen? From the New York Times: “Last week, the company’s iBooks Store and iTunes Movies services were shut down by a Chinese regulator, just six months after they started operating. The rare about-face by China suggests that Apple could face further pressure as the Chinese government increases its scrutiny of American companies’ operations within its borders.” Don’t say you haven’t been warned…
Google already doesn’t operate in China. Neither does Facebook, or a host of other companies. But Apple gets about a third of its iPhone sales from China. So being banned there, or even just getting into a no-win fight with the Chinese government, will leave a mark. And by the way, growth in the overall market for smart phones in China is expected to slow to under 5% this year, down from 50% in 2014. So even if they don’t end up in a battle over privacy, they don’t have the big tailwind from market expansion that they used to have. Maybe that’s what Icahn was referring to when he said he sold his whole Apple stake because he was worried about China. Those still holding should be too.
Scarecrow: I haven't got a brain... only straw.
Dorothy: How can you talk if you haven't got a brain?
Scarecrow: I don't know... But some people without brains do an awful lot of talking... don't they?
The Wizard of Oz, 1939
I was fortunate enough to attend a long dinner with Vincent Daniel of The Big Short fame this past week. Besides reminiscing about our days as research analysts at Keefe, Bruyette & Woods, where we both used to work (although at different times), we spent some time discussing our favorite long and short ideas for our respective funds and the craziness that is happening in central bank board rooms around the world.
The world’s central bankers like to do a lot of talking, but they don’t seem to have a lot of brains. I suppose this is what happens when you spend your whole career talking only to other career economists and bureaucrats instead of actually doing something – like holding a real job, or building a business. Why our world’s policy makers are uniformly uninformed individuals who all believe more in their models than in rational thinking and problem solving is beyond dumb, but that’s the hand we’ve been dealt. You can’t invest based on “what should be,” only on “what is.” And right now the “what is” is crazy.
We both agreed that while the insanity that is negative interest rate policies (NIRP) will end badly, the problem is that neither of us know when or how it will happen. My fear is that NIRP in say, Japan, will cause depositors to flee if they are charged for holding money at the bank. If they do, and the outflow reaches a tipping point, it could easily cause a liquidity crisis. Or will NIRP cause dislocations in overnight lending markets in Europe? In money market funds? Will it create distortions in sovereign bond markets that violently unwind? There are many potential outcomes. I just can’t think of one that ends well for someone holding a negative yielding bond, so the trade is probably to short negative yielding bonds in relatively strong economies if you can, since you are guaranteed a small profit if you can hold the short to maturity and a potentially large one if rates suddenly spike higher on a flight from “safety.” I’d also continue to avoid equities in general where the situation is so dire that central bankers feel the need to engage in negative rates, because when the big unwind happens, stocks are not going to be where you want to be, unless you’re short.