Market Commentary First Quarter 2015
During the first quarter, the major U.S. stock market indices had a mixed performance; the S&P 500 and NASDAQ Composite gained 1.0% and 3.5%, respectively while the Dow Jones Industrials lost 0.3%.
Interest rates declined slightly as some weaker economic data implied a rate increase from the Federal Reserve Bank, previously expected this summer, may be somewhat delayed. The yields on 10-year and 30-year Treasuries ended the quarter at a miniscule 1.95% and 2.55%, respectively. The European Central Bank began a program to reduce rates in the Eurozone, in contrast to the Fed’s recent language which suggested a rate increase in the US is likely in the next 12 months.
The last few years have given investors and consumers a front-row seat to incredible innovation that is rapidly changing the way we do many things. Some of the changes are obvious and others require a bit more thought to understand the drivers. Quick! Where is your nearest video rental store? What? You can’t name one? Most of us haven’t stepped into a video rental store in 5 years or more. Video stores have largely been eliminated by alternatives such as Redbox, the operator of automated DVD rental machines, and by DVD-by-mail and video streaming services offered by Netflix. Such economic Darwinism is often referred to as “creative destruction”, a phrase first used by Austrian economist Joseph Schumpeter in his book published in 1942 titled Capitalism, Socialism, and Democracy. Creative destruction can be a painful and joyous process with the commensurate emotion depending on one’s position in the cycle.
In each cycle there are winners and losers that emerge. In the case of video stores, local store owners and large franchises such as Blockbuster were forced out of business by more efficient alternatives and the associated jobs were lost. Owners of commercial real estate were hurt as the high traffic video stores shut their doors. The benefits to consumers were lower prices, a massive increase in selection, and far more convenience. The investment required by Redbox and Netflix to serve a local community is a fraction of that required by their brick-and-mortar ancestors.
If not hindered by regulations or public policy, creative destruction can bring increases in productivity, new products and services, better jobs, and often higher living standards. The unavoidable cost, however, is the elimination or reduction of jobs tied to the products and services that were eliminated. It is natural for us to lament such changes as they’re occurring and focus on the impact on lives immediately before us. Stores close, incomes decline, individuals and families are forced to adapt. The desire to protect incomes is an admirable one, but when it comes at the expense of the progress brought by creative destruction the benefits can be short-lived. This is especially true in the global market place where companies now compete. To continue our analogy, if steps had been taken to protect video stores from Netflix and Redbox, these types of companies may have emerged in other countries and ultimately introduced their services in the US. The result would have been a “stay of execution” for video stores for several years but the end result would be the same and much of the value created from these new enterprises would have been lost to the US. In the US, consumers would have spent more of their money on video entertainment and less on other items. In countries where regulatory burdens are high and labor is protected, innovation is less prevalent. Entrepreneurship and innovation can be even more risky or almost impossible in such environments. We have researched more than a few companies that purposely avoided entanglements with manufacturing in European countries because of labor laws that made changes to operations difficult. The avoided assets continued to decline with low demand and less innovation while job creation suffered.
A more dramatic example of creative destruction that few would turn back if given the choice is transportation. Steam power emerged in the US in the nineteenth century and waves of change followed for decades. Railroads were built and the US became more connected, which led to expanding markets for a great number of products. Shipping costs declined dramatically and all consumers benefited. The internal combustion engine brought automobiles, still lower shipping costs, and massive increases in agricultural productivity through farm machinery. In 1920, more than 2 million people, roughly 2% of the population at the time, were employed by the railroads. As automobiles became less costly, more families could afford them and travel by train declined. Today, barely 100,000 people are employed by railroads.
The changes before us today seem even more dramatic than those experienced in the last century and we cannot forecast the size of the subsequent waves but shall make an attempt nonetheless. Some of these dramatic changes include digital exchanges, 3D printing, and electric cars.
“Digital exchange” is a phrase we introduce to describe an entire genre of businesses that have emerged because of the Internet and mobile communications. Digital exchanges largely work by matching a demand with a supply, much like the stock market, but for various goods and services. Transactions occur under a known set of rules designed to give the buyer and sellers confidence in the transaction. Some well-known examples include EBay and Uber. EBay is certainly not new but it’s a prime example of a digital exchange. When it emerged, EBay owned no inventory, rented no floor space, and operated no fleet of trucks but it was a full-fledged retailer. It was a hub for buyers and sellers. It connected them and protected transactions through various measures in order to attract still more buyers and sellers. Compared to operating a physical store, the benefits of EBay’s model are massive; a classic “asset light” business. EBay served as a platform for many consumers to become proprietors of their own virtual stores and earn additional income with little capital commitment on their part, an obvious societal benefit.
A more recent and controversial example of digital distribution is Uber, the mobile taxi company. Uber started in 2009 and now operates in 200 cities worldwide. Uber enables individuals to act as taxi with their own vehicles while Uber’s mobile software connects them with others that need rides. The mobile app provided integrates the location of the ride-seeker, via smartphone, and of nearby drivers that are waiting for fares to produce short wait times. Uber handles all transactions by way of a credit card ensuring that drivers are paid. Drivers can work any number of hours they choose and different types of vehicles are allowed to charge different prices. In addition, prices are based on demand so a driver will be paid more around a heavily attended entertainment event than on a sleepy weeknight. Uber doesn’t own garages where taxis are housed and repaired or handle fuel services for its drivers. Similarly to EBay, it is an asset-light business that simply connects a demand for transportation with a supply of individual drivers. Some cities with heavy regulation of transportation have resisted or banned Uber while other cities have courted Uber openly to promote tourism. The benefits to individuals are a faster, in some cases cheaper, taxi service while the negatives include potentially lower wages for traditional taxi services.
3D printing, at first, seems like a process we may have first viewed in the old cartoon The Jetsons where a user presses a few buttons on a shiny box and then sees their desired product emerge moments later. The actual process is less magical. Traditional manufacturing, of a plastic handle for example, would involve construction of a mold into which liquid plastic would be poured. The mold would take days or weeks to create. Once the poured plastic cooled, the mold would be opened and the new handle would be complete. 3D printing of the same product involves an injector that pours out the material in very small amounts without a mold and builds up the product in layer after additional layer giving rise to its other name, additive manufacturing. For 3D printing, no mold is needed, just a 3D image of the item to be made. Production lines can also be switched very quickly to make a different product, unlike traditional manufacturing where line changes can take hours or even days. One US airline used 3D printing to produce replacement parts for toilets on older MD-80 planes because such replacement parts were no longer made. Currently, the time to make a single product is still much longer than with traditional manufacturing so mass manufacturing isn’t feasible. The benefits of 3D printing include short times from plans to complete product, increased customization, and greater flexibility of products in a single manufacturing facility. Such benefits should lower the cost of some products as a result and make new products possible that were previously too expensive to be economical. The negative effects will likely be slowing growth of traditional manufacturing and the possible elimination of craftsmen that generate highly customized items.
A final example of creative destruction that is interesting to watch is the introduction of electric cars. The top 2 selling models last years were the Nissan Leaf and the Tesla Model S. The most affordable model is the Nissan Leaf which sold over 30,000 units in the US in 2014 and costs $29,000 before $12,500 in state and federal tax incentives. The Tesla Model S, with a price starting at $70,000 excluding tax incentives, sold fewer than 30,000 units in 2014.
Outside of the positive impacts on air quality and the environment, the growth of electric vehicles like these will bring their own creative destruction. Gasoline-powered cars have thousands of moving parts which require regular maintenance. Electric cars have only several hundred parts which result in much lower maintenance costs. However, the battery packs are very expensive and cost $5,000-$13,000 depending on the vehicle and are expected to last 5-8 years or more. Vehicle maintenance is estimated to produce half of revenue at most car dealerships. As electric vehicle ownership increases, revenues for dealerships will decline and some mechanics will lose their jobs. Prices may even decline for maintenance on gas-powered cars as the supply of mechanics overwhelms the new lower demand. Owners of gas stations will see reduced traffic as electric car owners charge batteries at home and work. Producers of electric charging stations will see increased demand as owners of shopping centers and other commercial real estate install them to attract owners of these vehicles. We are already seeing a race for new battery technology as car manufacturers seek to offer the best vehicle range to their customers. At present, the Tesla Model S boasts the best range of 265 miles while the Nissan Leaf can travel an average of 84 miles on a full charge. Improvements in battery technology will make solar and wind power more feasible as batteries could store unused power generated during the day for use at night and on cloudy or calm days. The cascade of changes listed is by no means exhaustive but help illustrate what we might expect ahead.
How can we use this information for investments? Stock prices reflect a very long period of results. It is typical for the media and investors to focus on earnings for this year but all investments are ultimately valued based on expected future cash flows and a typical stock requires 20+ years of cash flows to justify its price. If an industry is expected to change dramatically, it will be reflected in the price of stocks in that industry. Our view of creative destruction does not indicate that will you see portfolios of stocks built on companies in 3D printing or electric cars in the near future. Periodically, we do purchase a few stocks that are more growth oriented and may include emerging industries. Typically, we invest with a value bias and prefer companies that are out of favor for reasons we believe are temporary and are often cheaper than the overall market. Brand new companies, such as those causing creative destruction, tend to trade at valuations that are much more expensive. We do, however, evaluate companies for potential negative impacts from the same phenomenon so our process may impact the companies that you don’t see in your portfolio. It is possible what appears to be a cheap stock may simply be a stock on the way to the graveyard of businesses eliminated by creative destruction; a value trap. Conversely, newer companies may not yet reflect their ultimate potential so understanding what’s possible for them many years ahead can aid investment decisions. We aim to work as a team to protect our investors from owning the video stores of tomorrow while finding great value in companies with longevity.
Stocks and bonds have not made large moves since we last shared our quarterly letter. By many measures, we still believe that equities are more expensive than their long term averages but with an accommodating Federal Reserve and modestly growing economy the slow march higher could continue for some time. Likewise, bonds are priced at levels that offer only modest yields. Yet inflation, which often drives bond prices lower, is nowhere on the horizon. We continue to invest in the best stocks and bonds we can find with a goal of managing risk, producing long term returns, and protecting principal.
As always, we welcome your thoughts and comments and thank you for the opportunity to be of service.
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