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Modern Creative Destruction, Banks Post Good Earnings, and De Tocqueville!

The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process.  Joseph Schumpeter

Creative destruction describes the deliberate dismantling of established processes in order to make way for improved methods of production. The term is most often used to describe disruptive technologies such as the railroads or, in our own time, the Internet. Over the course of our lives, at any particular moment, there are specific instances of creative destruction potentially taking place. Right now, the most obvious one is the question of electrification in the transportation and power markets. The transition to electrification in the automobile market hasn’t been rapid, with electric cars having a total market share in 2019 of 1% (entire market) with 2.6% of global sales. Year over year sales increased 40%, according to the IEA. Investors believe electric and hydrogen based vehicles will displace the incumbent, internal combustion based automobiles, and do so in a short period of time. Current market prices for those segments, especially Tesla and others, reflect this idea, as do the values of traditional automotive manufacturers. Oil and gas providers and their depressed stock prices are also evidence of this thesis. The important consideration for investors is the accuracy of this prediction, will it take place, and if so, how rapidly? Given the amount of capital at stake, and the conclusions many have already drawn, creative destruction requires serious thought and analysis. Let me share a real life example and what has to be considered.

A few years ago, a high profile startup in Silicon Valley was considered the leading contender in the health care area of diagnostic testing. The existing public companies in the diagnostic area were sold off on the thesis that the startup had superior technology. The startup had a charismatic founder, partnerships with leading pharmacies and retailers, and plenty of media attention. Our holding is a leader in the industry, with thousands of existing laboratories and millions of tests conducted daily. The question to consider was the legitimacy of the startup. It was based on the idea a multitude of tests could be assayed off of a small amount of blood. It turned out the technology was, shall we say, not fully vetted. Our holding continues to churn out millions of tests per day and is a vital part of the health care system, holding up pretty well during the Covid-19 crisis. What can be learned from this? First, the rush to declare victory by emerging companies with new technologies should be evaluated on the basis of relative competitive threat within that industry. Applying this to electric cars, apparently the experience is like driving an Ipad. The current generation, and future ones, finds this appealing, along with the environmental benefit. Just as important is the price of these vehicles, and their competitiveness with internal combustion ones. One must also consider the ability to create enough infrastructure for these cars, like battery recharging stations. The infrastructure component might be the biggest hurdle. The second point is the strength of incumbency in markets is a very large advantage. Generating millions or billions of dollars in cash flow, having relationships with millions of customers, and existing distribution are enormous barriers to those competitors trying to displace them. The new technology must remake the customer experience for buyers or the existing entities probably will continue their leadership. In sum, creative destruction is an ongoing part of the investment universe and these questions will continue to show up in different areas. Duly noted.

In the market last week, the largest banks reported earnings which were dismissed by the investment community. Banks with large deposit bases, JP Morgan Chase, Bank of America, Citigroup, and Wells Fargo, face the problem of minimal net interest margins and a Federal Reserve committed to not raising rates for the foreseeable future. The investment banks, Goldman Sachs and Morgan Stanley, without deposits and an absence of loans, were helped by strength in trading and underwriting in fixed income. All have seen lower transaction advisory fees from reduced merger and acquisition activity due to the pandemic. Many see this area picking up when we get into the new year. Elsewhere, Delta Airlines suffered a brutal quarter while VF Corp raised the dividend, as did Walgreens. Charles Schwab closed their acquisition of TD Ameritrade, and Bank of Mellon New York slightly surprised. Next week will bring a deluge of more reports, including those from Coke, Tesla, AT&T, and Netflix.

In the political world, Twitter and Facebook reminded us this week why Alex de Tocqueville was such a brilliant forecaster. Alexis traveled the country in the mid eighteen hundreds and wrote brilliantly about our fair land. In his writings, he espoused the importance of a vibrant and free press for democracy. With the details of Hunter Biden’s emails emerging from a NY Post article, Twitter and Facebook decided to shut down the story for public consumption. The largest technology companies have clearly been biased in how they apply their publishing standards during the current political season. Their 230 exemption for liability protection should be evaluated at because of their repeatedly biased actions over the last year. De Tocqueville wrote about the importance of a free press to prevent the tyranny of the majority. In the current case of Democrats, who many believe have a chance to control the legislative and executive branch of government after the election, Facebook and Twitter have potentially helped aid the minority to become the majority. Of course, so has the vast majority of our cheer leading media. Alexis saw it coming over a century ago, and his wisdom should be strongly considered by whichever side emerges victorious from the 2020 campaign.

Thank you for reading the blog this week, and if you have any questions about investing, please email me at information@y-hc.com.

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Yale Bock, Y H & C Investments, its clients, and the family of Yale Bock have positions in the securities mentioned in the blog,  Investing in securities involves risk and the potential loss of ones principal.  Past performance is no guarantee of future results.  All investment decisions should be considered with respect to ones risk tolerance, return objectives, liquidity needs, tax considerations, and one’s overall financial situation.  The fact that Yale Bock has earned the right to use the CFA designation does not mean Y H & C Investments will outperform broad market indexes.

Good Week For Stocks, VP Debate Results, and Problems In Sports Viewing!

The Future Is No More Uncertain Than The Present. Walt Whitman

The definition of certainty is the quality of being reliably true. The investment world centers around the principle of cash flow, and discounting the value of the stream back to the present in order to come up with a value of an asset. Much depends on the reliability of the cash. How certain is it the cash flow will be there? Will it grow? Will it melt? How quickly will it grow? Could you lose the majority of it in a year? In a month? In a week? Will it double in a year? Triple in a year? Grow by ten times in a year? Ten times in a month? You see there is quite a bit of variability possible. Now, the variability can be eliminated with more knowledge. If the company producing the cash has generated a billion a year for the last ten years, there is probably a high probability it will do the same next year. If the entity just signed a lease last year and is in the retail clothing business, well, the cash generation capability will have a much higher degree of variability. Especially during a pandemic. I bring this topic up because of our existing macroeconomic and political environment. You see, my dear friends, we are in a time of considerable uncertainty. Why does that matter to investors?

It is important in terms of what one is paying for an asset. The more unpredictable the economics, the higher the risk. The greater the risk, the lower I should pay for the asset. The converse is also true. The higher the predictability of the income stream, the more reliable. The more certain, the more I will pay, especially if it is growing at an above average or high rate. We currently have a big dichotomy in the market in terms of reliability. Companies which have businesses which benefit from people staying at home are given massive multiples on their stock. If you haven’t been paying attention, Zoom is now as considered as valuable to investors as Exxon Mobile. Zoom is considered dependable, Exxon is believed to be melting. If you were to evaluate Pelaton, or Salesforce, Fastly, Datadog, Shopify, and others, the same principle is in play. The cash flow is certain, it is growing, and investors are paying up. Of course, the next pertinent question revolves around the economic environment. Let’s take a look at that for a moment, shall we?

The global and U.S. economy started having problems when the Covid-19 virus emerged in China around January, and then arrived here in the U.S. in March. The world is about a year into it, and possible vaccines may help the situation by year’s end, but probably in the middle of 2021. In the mean time, the US economy has recovered about half of the jobs lost since the beginning of the crisis- 11 out of 22 million. The damage remains centered in hospitality, travel, food and beverage, and entertainment. In conjunction with the crisis, and one could make a strong case for exacerbating it, is the current stage of the political cycle. With twenty five days to go before a tremendously heated presidential and congressional election, political issues at the state, local, judicial, and national level also are affecting what transpires in the economy. As such, there is a high degree of uncertainty about the outcome. High uncertainty should mean lower asset prices because of the lack of reliability. If there was ever a time which could be described as not dependable, now is that time. So, as an investor, we are forced to look at this and evaluate what you own within the context of the current situation. It is why predictability is good. Management teams with excellent track records, diversity of the industries, highly profitable businesses or enterprises which are positioned to grow for a long time, and unique models which are tax efficient. If taxes go up, no problem, what you own is already tax advantaged. It is a very uncertain time, and it is not going to change for at least a month, maybe much longer. Pay attention.

In the market last week, there were very few notable earnings reports. Paychex and Levi Strauss both beat estimates while Domino’s Pizza did not deliver. In the sports world, the NBA and NFL are showing huge drops in viewership, with the NBA Finals having the worst audience on record (nearly 70%) declines. If you are a network looking at those ratings, your going to be asking for big price concessions during the next contract negotiations, provided they don’t rebound. In the political realm, the Vice Presidential debate gave Republicans a glimmer of home that Mr. Trump will be able to use Mr. Pence’s template in the last debate to highlight Mr. Biden’s weaknesses. Probably the most uncertain question, and maybe the most important one, is what the American public really feels about what has gone on the last year. Polls show Biden ahead nationally, but by a much lower number in the swing states. Democrats feel very confident, while Republicans have their own points to give them some assurance. Just as crucial is the status of the Senate, which has about five very close races, including the one in North Carolina where some personal indiscretions of one candidate might have an impact on the outcome. Yes, we are living in a very uncertain time. Whitman would be pleased.

Thank you for reading the blog this week, and if you have any questions about investing, please email me at information@y-hc.com.

Get all Y H & C Investment blogs and monthly newsletters by sharing your information below-

Yale Bock, Y H & C Investments, its clients, and the family of Yale Bock have positions in the securities mentioned in the blog,  Investing in securities involves risk and the potential loss of ones principal.  Past performance is no guarantee of future results.  All investment decisions should be considered with respect to ones risk tolerance, return objectives, liquidity needs, tax considerations, and one’s overall financial situation.  The fact that Yale Bock has earned the right to use the CFA designation does not mean Y H & C Investments will outperform broad market indexes.

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