How Buffett’s business empire could unravel

Josh Brown had a terrific comment about the secret of Warren Buffett’s success. Buffett is unabashedly “permabullish” on America:

One of the hallmarks of Berkshire’s success has been its willingness to raise or lower its formidable cash hoard in response to the presence (or lack thereof) of viable investing opportunities. One of the other hallmarks of Buffett’s approach has been to tune out forecasts and de-emphasize the importance of them in general.

The one thing Buffett has never given up on is the idea that American productivity, innovation and economic dynamism will always lead to substantially greater prosperity in the future. And he’s been right for decades, through all sorts of setbacks, crises and challenges for the nation.

So if the choice is to be in the Buffett camp vs the David Stockman camp or the Peter Schiff camp, well, I regard that as no real choice at all.

Lastly, permabulls need not be blind to the possibility of market declines, economic catastrophes (real or imagined) and other momentary trials and tribulations. Buffett’s got these possibilities built right into his manifesto:

Charlie and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.

That formula has worked out well. Stay bullish on the belief of the dynamism of America, and buy good businesses when they become cheap. In a post-election interview with CNN, Buffett expressed confidence in the supremacy of the American businesses (click on this link if the video is unavailable).
 

 

There is much to be said about the Buffett formula. According to Credit Suisse, US real equity returns has been the highest in the world. Though the stock market has experienced serious losses, prices have always come back.
 

 

A value orientation, as proxied by a high price to book, outperforms the market. Buffett then couples the value discipline by buying companies with a moat, or a sustainable competitive advantage. The combination of buying value companies with a moat has been the secret of success.
 

 

However, we may be reaching an inflection point for Buffett`s brand of investing. In the Age of Trump, the tailwinds on Buffett`s value approach may be coming to an end.

The end of Pax Americana?

This chart from BCA Research (via Tiho Brkan) tells the story. Buffett’s successful run coincides with the era of Pax Americana and rising global trade. What would happen if the growth in global trade were to come to a screeching halt? What kinds of stresses would the global economic system face?
 

 

Value investing depends on valuation a mean reversion effect, or the tendency of cheap stocks to return to becoming more reasonably priced. What if mean reversion were to stop occurring? What would happen to some of those business moats if global trade were to start shrinking?

Donald Trump’s America First policies certainly raises the risk level. Politico reported last week that Trump wants to re-negotiate trade treaties upon a moment’s notice whenever the US gets into trouble:

Trump has said he wants to include a clause in trade agreements that would allow the United States to get out within 30 days if the other country balks at fixing any problem that occurs. Last week, White House trade adviser Peter Navarro upped the ante by telling Senate Finance Committee members that the administration also wants to include a provision that would trigger a renegotiation whenever the United States runs a trade deficit with the partner country, Morning Trade has learned.

WTF? This is the same Peter Navarro who dismissed analysis from Citigroup outlining how retailers would be losers under a Border Adjustment Tax (BAT) as “fake news” (via Business Insider):

CNBC’s Melissa Lee pointed to a Citigroup estimate that said this new tax would be a massive hit to company earnings. That means people working in retail would likely lose their jobs as companies try to cut costs.

Navarro immediately got defensive.

“Well, first of all, this is a false narrative and a fake study,” he countered.

Lee was a bit surprised. “Let me get this right,” she said, “Citigroup did a fake study?”

“Citigroup has no credibility,” Navarro said. He called the bank’s analysis, and analysis from the Peterson Institute for International Economics, “garbage studies and scare tactics” and compared them to media outlets like MSNBC and CNN.

“We are not backing off,” he said.

Lee pointed out that Citigroup isn’t the media — it’s research written for investors looking to find out if companies are healthy. Navarro ignored that point.

“Yeah, well, the Dow just hit 20,000, how you like them apples?” he said. “There are winners and losers.”

America First Protectionism = EM debt crisis

If the Trump administration is intent on going down that trade policy path in the name of “America First”, then the risks are rising very, very quickly. Here is one immediate problem that market analyst and Texas Republican John Mauldin is worried about:

Paul Ryan and House Ways & Means Committee Chair Kevin Brady know everything I just said and probably agree with much of it. They believe the BAT’s negative effects will disappear quickly due to currency flows. As the trade deficit shrinks, fewer dollars will flow from the US to the rest of the world. That trend will make the dollar rise against other currencies, thereby nullifying the higher prices we will pay for imported goods.

That’s the theory. In fact, most economists do agree that the dollar is likely to rise significantly if this proposal is adopted. So, the theory is that Walmart shoppers really won’t pay higher prices, at least in dollar terms. I do not think things will work that way in practice, at least not as quickly as they hope…

Here we see once again how debt constrains us from doing what might otherwise make sense. Emerging-market countries own massive amounts of dollar-denominated debt. A stronger dollar means they must somehow come up with more of their local currencies to repay their dollar debts. And they will have to do it fast, even as their exports are shrinking because US consumers are being encouraged to “buy American.”

It gets worse. To whom is all that emerging-market debt owed? Primarily to Western banks and bondholders, who are often themselves excessively indebted. The potential financial contagion is massive. Ambrose Evans-Pritchard of the London Telegraph describes it in his characteristically colorful style:

Yet getting there constitutes a global shock of the first order. “This will trigger a series of emerging market crises,” said Stan Veuger from the American Enterprise Institute. He estimates that the burden for companies and states in developing countries with dollars debts will jump by $750bn. Turkish firms alone would face a $60bn hit.

It does not end there. Studies by the Bank for International Settlements show that a rising dollar automatically forces banks in Europe and the Far East to shrink cross-border lending through the mechanism of hedge contracts.

A dollar spike of anywhere near 20pc would send the Chinese yuan smashing through multiple lines of psychological resistance. The People’s Bank (PBOC) is already intervening heavily to defend the line of seven yuan to the dollar. Ferocious curbs would be needed to stop the Chinese middle classes funneling money out of the country if it crashed by a fifth.

Junheng Li from Warren Capital says the China’s exchange regime is more brittle than it looks. Official data overstates the PBOC’s fighting fund by $1 trillion, either because reserves are “encumbered” by forward dollar sales or because they must be held in reserve as a “fiscal backstop” for Chinese firms at risk of default on dollar debts. She expects the system to snap at any time, and without warning.

I strongly doubt whether the Trump-Ryan axis in Washington has any idea what could happen if they detonate a debt-deflation crisis in China, or if they ignite a short-squeeze on $10 trillion of off-shore dollar debt with no lender-of-last-resort behind it. Nor do they care.

A surging USD from the imposition of a BAT could spark another emerging market currency crisis. This time, the world won`t have the benefits of rising global trade to cushion the blow.

When confidence cracks

The blogger Jesse Livermore at Philosophical Economics wrote an insightful post last weekend about the interaction of valuation and cash in a low yielding world:

A useful way to estimate that value for a security you own is to ask yourself the question: what is the most you would be willing to pay for the security if you couldn’t ever sell it? Take the S&P 500 with its $45 dividend that grows at some pace over the long-term–say, 2% real, plus or minus profit-related uncertainty. What is the most that you would be willing to pay to own a share of the S&P 500, assuming you would be stuck owning it forever? Put differently, at what ratio would you be willing to permanently convert your present money, which you can use right now to purchase anything you want, including other assets, into a slowly accumulating dividend stream that you cannot use to make purchases, at least not until the individual dividends are received?

When I poll people on that question, I get very bearish answers. By and large, I find that people would be unwilling to own the current S&P 500 for any yield below 5%, which corresponds to a S&P 500 price of at most 1000. The actual S&P trades at roughly 2365, which should tell you how much liquidity–i.e., the ability to take out the money that you put into an investment–matters to investors. In the case of the S&P 500, it represents more than half of the asset’s realized market value.

Much of the valuation of equities in the current environment depends on confidence:

Now, here’s where the parallel to banking comes into play. As with a bank, a market’s liquidity is backed by a network of confidence among its participants. Participants trust that there will be other participants willing to buy at prices near or above the current price, and therefore they themselves are willing to buy, confident that they will not lose access to their money for any sustained period of time. Their buying, in turn, supports the market’s pricing and creates an observable outcome–price stability–that reinforces trust in it. Because the investors don’t all rush for the exits at the same time, they don’t have a need to rush for the exits. They can rationally collect the excess returns that the market is offering, even though those returns would be insufficient to cover the cost of lost liquidity.

When the network of confidence breaks down, you end up with a situation where people are holding securities, nervous about a possible loss of access to their money, while prevailing prices are still way above intrinsic value, i.e., way above the prices that they would demand in order to compensate for a loss of liquidity. So they sell whatever they can, driving prices lower and lower, until confidence in a new price level re-emerges. Prices rarely go all the way down to intrinsic value, but when they do, investors end up with generational buying opportunities…

The question comes up: in a low rate world, with assets at historically high valuations, offering historically low returns, what should investors do? Should they opt to own assets, or should they hold cash? The point I want to make in all of this is that to answer the question, we need to gauge the likely strength and sustainability of the market’s network of confidence amid those stipulated conditions. We need to ask ourselves whether investors are likely to remain willing to buy at the high valuations and low implied returns that they’ve been buying at. If the conclusion is that they will remain willing, then it makes all the sense in the world to buy assets and continue to own them. And if the conclusion is that they won’t remain willing, that something will change, then it makes all the sense in the world to choose hold cash instead.

Now imagine that global trade starts to unravel and EM countries experience a currency crisis, which morphs into a global financial crisis. What happens to confidence then?

If we want to get in front of things that are going to break a market’s network of confidence and undermine people’s beliefs that they’ll be able to sell near or above where they’ve been buying, we shouldn’t be focusing on valuation. We should be focusing instead on factors and forces that actually do cause panics, that actually do break the networks of confidence that hold markets together. We should be focusing on conditions and developments in the real economy, in the corporate sector, in the banking system, in the credit markets, and so on, looking for imbalances and vulnerabilities that, when they unwind and unravel, will sour the moods of investors, bring their fears and anxieties to the surface, and cause them to question the sustainability of prevailing prices, regardless of the valuations at which the process happens to begin.

Under that scenario, would buying the dip work? Could Berkshire Hathaway depend on the moats of these companies that Buffett purchased? How many of those moats would be breached if global trade tanks? Could you depend on the resiliency of a leaderless capitalist system when America is no longer willing to be its leader? What happens to the political systems of the leading industrialized countries in the world?

As per Credit Suisse, remember what happened the markets of major countries that underwent major political upheaval in the 20th Century:
 

 

Do you still want to bet on mean reversion and the sustainability of business moats under those kinds of scenarios?