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Sometimes it’s good to get out and see new things. Well I recently took that to a bit of an extreme. There is nothing like a 3,000 mile RV trip with 4 kids, 2 dogs and 1 wife to remind you how big the country is – and how different parts of it are compared to where most of the readers of this letter live. Wyoming, South Dakota, and Montana are beautiful. If you haven’t been to Yellowstone, it is worth a trip. But there is something you should know – there are large areas that are completely devoid of cellular service. Or services in general. Driving a large RV with crappy gas mileage through remote parts of the country quickly gets you doing mileage calculations every 30 miles or so – and gets you checking the trucker guidebook we bought that lists all the gas stations at every highway off-ramp in the country to be sure you’ll make it. Relaxing? Not really. Informative? Most definitely.
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Jack McCall: Should we shake hands or something, relieve the atmosphere? I mean how stupid do you think I am?
Wild Bill Hickok: I don't know. I just met you.
Deadwood, HBO, 2004-2006
One of the places we visited was Deadwood, SD. Deadwood is famous for being where Wild Bill Hickok was shot while playing poker in the Number 10 saloon on August 2nd, 1876 (happy anniversary Bill?). Apparently, this is still one of the most interesting things that has happened in that town. In Deadwood today, you can see reenactments of it in the main street about every 2 hours, followed by a trial of his killer, Jack McCall, in the evening at the elks lounge. As entertainment goes in the towns we were driving through, this qualified as exceptional.
But the trip through Deadwood was educational for another reason. It made me realize how fleeting “success” is in business. A little history: in 1868, the U.S. Government signed the Fort Laramie Treaty giving ownership of the Black Hills to the Lakota Sioux nation. But when gold was discovered in the northern Black hills in the 1870s, the government reneged on the deal. Deadwood was established in April of 1876 and by summer there were well over 5,000 miners staking claims along Deadwood Gulch. But just as quickly as it rose up, it fell back, as better gold mines were found in other hills. By 1890 the population had declined to 2,366 people. The population today? 1,264 people.
Al Swearengen: Announcin' your plans is a good way to hear God laugh.
Deadwood, HBO, 2004-2006
Another stop on our trip emphasized the theme of impermanence. After a night in a less-than-memorable RV “park,” we toured Butte, Montana. Butte is another mining boom town that’s quietly gone bust. The Anaconda Copper Mining Company was formed in 1881. Anaconda’s owner, Marcus Daly, had the good fortune to own the largest known copper mine at the same time that electricity was being installed across the country – and electrical wires need copper. Anaconda was immense, and the wealth it created also immense. But mining became less profitable, and the mines were eventually shut down. From a peak population in the 1920s of over 60,000 people, today Butte is a neat little town of 34,000 people with the country’s largest Superfund site as its main tourist attraction. You got it, the country’s most polluted body of water (yeah!) is something people pay money to see. We skipped that and instead spent a morning at the really interesting World Museum of Mining – which is definitely worth the time for the underground mine tour and its replica of what the town looked like in the early 20th century.
At this point, if you’re still awake, you’re probably wondering what this has to do with investing. Well, it has everything to do with investing, because as this history of boom and bust towns shows us, a “sure thing” in investing can, and most likely will, eventually fade away. Gold in the late 1800s and copper in the early 1900s proved to be impermanent – just like companies in many other industries. History is littered with failed once-great companies (Polaroid, Eastman Kodak, and Blockbuster Video as some recent examples). GM went bankrupt in 2009, but the government bailed them out, so they’re still here for now. Other iconic companies that are struggling and one day could either quietly fade away or be acquired are P&G, GE, and IBM. Don’t think that’s possible? GE traded for well over $100 a share in 1983 – today it closed at $25.50. IBM traded for over $175 a share in 1987 before falling to almost $40 in 1993. It recovered to make new highs in 1999 before falling back to $54 in 2008. Today it closed at $144.45, but hasn’t grown revenue in years, and is at risk of obsolescence.
Al Swearengen: Sometimes I wish we could just hit 'em over the head, rob 'em, and throw their bodies in the creek.
Cy Tolliver: But that would be wrong.
Deadwood, HBO, 2004-2006
This cycle of boom and bust in corporate America may well be why dividends have historically provided so much of the stock market’s total return – because once you’ve been paid the dividend, it’s a permanent part of your total return. In other words, the past yield can’t go to zero. But the stock of the company that paid it can. In the almost 25 years I’ve been in the investing business, I haven’t been a big dividend investor. To me, what was important was the free-cash flow generating power of the company. Many great investments haven’t paid dividends at all (here’s looking at you, Berkshire Hathaway, Google, and Amazon). But…looking around Butte and Deadwood and other old mining towns, I’m thinking that getting the cash out upfront isn’t such a bad idea. In other words, hitting a company over the head, robbing it of its distributable cash and dumping the body in the creek maybe isn’t wrong after all. Because eventually, all good things come to an end.
I know what you’re thinking - surely today’s market darlings won’t disappear. They’re just too integral a part of the economy, too essential to our everyday lives, and too entrenched to be unseated from their place at the pinnacle of the economy. You know, just like Sears. Oh wait… According to a Crain’s Chicago Business article from 2012:
As both Sears and America flourished, the company's goods transformed those dreams into middle-class realities. Sears' best-selling Craftsman tools, Kenmore appliances and DieHard batteries built, furnished and ran the American household. By the 1960s, 1 out of nearly 200 U.S. workers received a Sears paycheck, and 1 out of every 3 carried a Sears credit card. By catering to prosaic daily needs, the retailer grew into a behemoth that defined not only the Chicago economy but American business.
Been to a Sears lately? Yeah, me neither. Today, Sears is being stripped-mined for parts by Eddie Lampert’s hedge fund. Will it be a going concern in say, 10 years? Probably not. Again, a company that once employed 1 out of every 200 U.S. workers probably won’t be here in a decade, and today has a market cap of just $873 million.
Francis Wolcott: On my order, Mr. Tolliver, Lee will burn this building, mutilating you before, during or after, as I specify, or when he chooses unless I forbid.
Cy Tolliver: Oh, my full attention is at your disposal.
Deadwood, HBO, 2004-2006
So what does the likelihood that today’s winners will be tomorrows losers mean for investors? And how do you balance the needs of current shareholders versus those that want to be “long-term” shareholders and future shareholders? There are a few choices. If you’re small enough, you can sell outright for cash. This probably should be option A, especially if you see the prospects for your business starting to fade. But too many management teams think they are the exception, not the rule, and want to build a larger and larger company – probably because that’s how they’ll make more money. Boards should be the shareholders representatives, but often they are just there to rubber stamp what management wants to do. But if they faced the facts, that the odds are against them over the very long-term, I bet they would think differently. This may sound heretical, but I think boards should be focused on maximizing distributable cash and actually distributing it to shareholders as soon as possible. Continually reinvesting in what is likely to be an eventual failure is effectively burning money. If the company is at an optimal size, the board should be distributing all excess earnings, not holding and reinvesting it – or worse, just holding cash (yes, I’m looking at you Apple). If there are projects that show a clear path to a strong IRR, then by all means invest. But just sitting on shareholder’s money for some future, non-existent capital expenditure is just wrecking investors’ potential rate of return. Some have criticized IBM for issuing billions in debt to buyback stock at a time when its experiencing declining revenue, but when you think about it, that is exactly what it should be doing for its current shareholders. Will it eventually become so debt heavy that it is unable to service the debt, and will have to go into liquidation mode and close? Maybe. But that’s a problem for future shareholders, and the board represents the shareholders who own it today. If that means that some future, theoretical shareholders get left holding the proverbial bag, well, maybe that’s the right call. Corporate governance is tricky that way – is the proper role to preserve value for as long as possible, to create value for a future shareholder that doesn’t even own the stock today, or to maximize return for those that currently own it? I’d argue it is the last one, and I’d like to see the argument against it. Just like Butte was strip-mined for its copper and other assets, sometimes strip-mining a company is the best course of action. I bet Sears’ shareholders wish they had done just that when they had the chance.
Which companies are paying out most of their excess cash to investors today? Well, there is a sector that as a whole is doing it – banking. Want to learn which ones are the most attractive investments today? Sign up for Miller’s Market Matrix, and I’ll tell you. If you would like to receive it, just reply to this email, or email me directly at [email protected] and I will add you to the list. The next issue comes out this week. (Don’t miss it!) Also, if you would like to receive this newsletter directly in your inbox, simply subscribe by clicking here.
This week’s Trading Rules:
- A bird in the hand…
- Even the “greatest” companies eventually lose their edge. Be realistic and sell before it happens.
- “On a long enough time line, the survival rate for everyone drops to zero.” ? Chuck Palahniuk, Fight Club
We ended our last few letters with, “The market is fully-valued and is priced for Trump to get what he wants. We’re holding cash in case he, and the market, are disappointed. Now we’re also fully hedged and short high yield bonds. Can markets continue to power higher? Of course. But with hedging costs still very low, valuations extremely stretched, credit weakening in China (and in the U.S. in auto loans), at the same time the market structure is particularly fragile, not hedging would be irresponsible. Do the right thing. Get some hedges on.”
Since then, U.S. equities have continued to set new records, volatility has fallen to all-time lows, and Treasuries are signaling that inflation will remain low for the long-term. Peace and quiet prevails. U.S. retail investors are now more fully invested than at any time in over a decade. FAANG continues to do no wrong. Etcetera, etcetera. Investors I respect are extremely cautious and raising cash, while friends outside the business regal me with stories of how much money they are making in Apple and Tesla. I am thinking of taking an Uber just to see if the driver has any tips for me. I’m not saying a crash is imminent, I’m saying that all the preconditions for a sharp pullback are in place. As I look out my window at a downtown Portland that is engulfed in smoke from forest fires in British Columbia, I’m reminded that just a like a dry, tinder-laden forest that gets hit by a random lightning strike, it won’t take much of a sell-off to set the U.S. markets on fire.
SPY Trading Levels:
Resistance: We’re right in it at 247/248. Not much above here.
Support: 245, small at 242, then a decent amount at 239/240, followed by a lot at 233/235. Long-term support is 210.
Positions: Net neutral stocks (both long and short stocks). Short SPY, HYG and other ETFs. Long put options on SPY and other market ETFs.
Replica of the main bank in Butte, Montana, at the World Museum of Mining
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Article by Jeffrey Miller, Partner, Eight Bridges Capital Management