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Ding Ding Ding - Last call for train departure to the sky - Ding Ding Ding


anders
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Questionable graph... Probably doesn't adjust for changes in accounting during the period and doesn't adjust for the shift from dividends to share repurchases. Should also be presented on a logarithmic scale imo.

 

Why would accounting changes make much of a difference?  I realise they matter, but they would simply cause a step change in earnings.  That might not be on the graph, admittedly.  But accounting changes won't affect the cagr, will they?  And they won't affect the fact that estimates assume earnings will continue up in a straight line.

 

As for buybacks, nothing on the graph suggests this is per share data so would buybacks matter?

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Yes, logarithmic would be preferable... But the underlying point.. What analyst today would dare to risk his career by reversing earnings estimate..? and what does that do to the voting machine..?

 

Still lots of retail cash on the side line.. QE will continue until it sucked everybody in imo...

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The scary part of this graph is that every time it hit the upper bound it nosedived to, or through, the lower bound. If the trend continues, we could see earnings fall by 50+% which would also likely result in a compression of multiples. We'd be looking at a correction on the magnitude of 60-75%....

 

This is what has me concerned the most - margin compression on top of multiple compression. I don't know the likelihood of it happening, but a 75% correction would change a lot of attitudes about the market even for some of the most stoic investment managers.

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This is what has me concerned the most - margin compression on top of multiple compression.

 

 

+1

 

I remember Grantham pointing out that the correlation between market multiples and margins should be -1 but it is actually slightly over +1.

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I guess technical analysis isn't just for individual stocks, eh.

 

Just a few thoughts. I'm not making a prediction - we could have a crash tomorrow, who knows - my point is that things aren't that easy to predict. You can't eyeball a chart and say "oh, see, things moved like that, so they're bound to move like that again".

 

Thinking that everything stays the same is just as bad as thinking that everything is different.

 

For example, consider that for most of the past couple centuries, businesses paid out a lot more of their earnings in dividends than they do now. Now a lot more is reinvested internally. That has to change growth rates, right?

 

Also, consider that what you're looking at is an index. Is that index static? No. What changes? Well, maybe now there's more things like services, pharma, software, etc. More business with very large international operations in faster growing economies rather than just national. Etc. Is that stuff higher margin than what was in the index in 1950 or whatever? Probably, right?

 

Markets are unpredictable. Animal spirits, feedback loops, black swans, etc. But also entrepreneurship, resilience, billions of people trying to do something constructive every day. Could go one way, or another, but over the long arc of time, things usually keep getting better. That's why I try to focus on quality businesses that sell things that people want, run by good capital allocators that will find ways to create values in all kinds of environments.

 

Otherwise, if you're eyeballing a few charts and ratios to make decisions, many would have been out of the market for most of the past 20 years, and where would that have gotten you? Buffett is buying a big business today, and he'd do more if he could, I'm sure.

 

And yes, all long-term exponential charts look crazy on the right compared to the left. Log would be better. Tell someone in 1965 that the Down would be 18,000 fifty years later...

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For example, consider that for most of the past couple centuries, businesses paid out a lot more of their earnings in dividends than they do now. Now a lot more is reinvested internally. That has to change growth rates, right?

 

Also, consider that what you're looking at is an index. Is that index static? No. What changes? Well, maybe now there's more things like services, pharma, software, etc. More business with very large international operations in faster growing economies rather than just national. Etc. Is that stuff higher margin than what was in the index in 1950 or whatever? Probably, right?

 

 

While reinvesting more of their cash back into the business would seem to generate higher growth per academia, don't you need to consider the demand side as well? Unfortunately, I have a feeling demographics (not just domestically; look at slowing growth rates in the higher fertility countries) is working against us with respect to longer-term demand growth across a range of industries.

 

Good point on the composition of indices (and the general economy) over time. I would agree these asset light businesses certainly tend to generate higher margins and ROICs over time. I still struggle with how sustainable that is, since in theory asset light removes a significant traditional barrier to entry, and therefore could make these margins and ROICs less stable. Of course, we're seeing more "network effect" type businesses with substantial barriers almost irrespective of capital, but those tend to be winner take all situations. I suppose we're seeing that these days with the FBs of the world. That probably gets into a different discussion of wealth (in)equality.

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For example, consider that for most of the past couple centuries, businesses paid out a lot more of their earnings in dividends than they do now. Now a lot more is reinvested internally. That has to change growth rates, right?

 

 

Wrong, if it is a) being malinvested which is sadly quite normal when money is this cheap or b) being spent on buybacks (which obviously grows per share earnings but not earnings per se).

 

Agree re mix changes in the index, but I think (although cannot prove) that every time period has had its fast growing industries.

 

Overall, while I agree that no chart provides a perfect prediction tool, it's not hard to say that things might be dangerous when margins are high, multiples are high, and expectations are really just extrapolations of both.  That's a recipe for danger.  Not that I expect a crash soon given all the free money - I just think we're asking for trouble at some point.

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For example, consider that for most of the past couple centuries, businesses paid out a lot more of their earnings in dividends than they do now. Now a lot more is reinvested internally. That has to change growth rates, right?

 

Wrong, if it is a) being malinvested which is sadly quite normal when money is this cheap or b) being spent on buybacks (which obviously grows per share earnings but not earnings per se).

 

You think that the world's entrepreneurs and businessmen all lost any ability that they had to invest capital when they reduced dividends on average? I mean, sure lower interest rates can lead to some stupid things taking place, but plenty of stupid stuff happened in the 60s, 70s, 80s, etc. It's just one factor. When you almost have deflation in many places because people are still deleveraging from the last crisis, high interest rates aren't exactly required to cool things down...

 

I don't know. I look at all the things that I have in my life that didn't exist, or weren't nearly as good a few decades ago, and I read a few articles about all the things going on around the world, and the hundreds of millions of people getting out of abject poverty over the past few decades, and I'm thinking we're not wasting all this capital (or 'malinvesting' it, to use the ever-pessimistic Austrian terminology).

 

Agree re mix changes in the index, but I think (although cannot prove) that every time period has had its fast growing industries.

 

Sure, but some industries are inherently higher margins and scale better than others (software), and things like globalization and the internet make it a lot easier to reach more customers quickly. Facebook was barely a dorm room project a decade ago. Youtube was founded 10 years ago. Heck, the modern smartphone didn't exist 10 years ago (iPhone came out in 2007) and look at the size of that industry now. There's fast growing and fast growing.

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Two trends that seem as if they could hold asset prices up for a while are low interest rates and instability around the world.  As long as interest rates stay low, I will not be surprised if risk assets hold up or go higher.  Everyone is desperate for yield.  As Howard Marks said the mentality goes, "If I can't get safe yield, I'll just have to get unsafe yield."

 

Further, I've read that lots of foreign money continues to pour into the US because it is seen as a safe haven throughout the world.  Ongoing capital flight from Russia has been well reported.  I'm sure anyone with money in the middle east has taken action to get it out of there.  And lots of concern continues to surround Europe, particularly the southern countries. 

 

I keep tabs on Shiller's CAPE ratio and market cap relative to GDP.  Both are very high from a historical perspective.  But I always remind myself that just because assets are expensive, it doesn't mean they can't get more expensive.  That's what's interesting about markets, there are really no "rules" like there are in science.  Really crazy things can happen for a long time. 

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While reinvesting more of their cash back into the business would seem to generate higher growth per academia, don't you need to consider the demand side as well? Unfortunately, I have a feeling demographics (not just domestically; look at slowing growth rates in the higher fertility countries) is working against us with respect to longer-term demand growth across a range of industries.

 

Demography is hard. Makes my brain hurt when I think too much about it. In a way, a lot of the extra growth that comes from higher population growth only goes to create jobs and stuff for those new people being added, right? So if they aren't there, growth being lower doesn't necessarily make things much worse per capita (the pie's a bit smaller, but there are fewer slices, so maybe the surface area of each slice doesn't change that much).

 

And since a lot of what people are spending on now tend to be more intangible and qualitative (media content, IP in things like smartphones, telecommunications, services, better foods, better cars, etc), it's a lot easier to keep increasing consumption per capita than back when most things that people spent on where physical and about sheer quantity of stuff (you reach a hard limit on how much crap you can consumer faster).

 

But I don't know about demography. It's outside my circle, for sure. Certainly seems like you'd rather want fewer healthier and richer people than more poor unproductive people (birth rates falling rapidly in poorer countries as they get richer and more educated aren't necessarily negative for global businesses selling to them). So that's good. As for the US and such, I don't know. Immigration seems like it still has a long runway, and what truly matters is per capita anyway, so this goes back to my first paragraph above.

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While reinvesting more of their cash back into the business would seem to generate higher growth per academia, don't you need to consider the demand side as well? Unfortunately, I have a feeling demographics (not just domestically; look at slowing growth rates in the higher fertility countries) is working against us with respect to longer-term demand growth across a range of industries.

 

Demography is hard. Makes my brain hurt when I think too much about it. In a way, a lot of the extra growth that comes from higher population growth only goes to create jobs and stuff for those new people being added, right? So if they aren't there, growth being lower doesn't necessarily make things much worse per capita (the pie's a bit smaller, but there are fewer slices, so maybe the surface area of each slice doesn't change that much).

 

And since a lot of what people are spending on now tend to be more intangible and qualitative (media content, IP in things like smartphones, telecommunications, services, better foods, better cars, etc), it's a lot easier to keep increasing consumption per capita than back when most things that people spent on where physical and about sheer quantity of stuff (you reach a hard limit on how much crap you can consumer faster).

 

But I don't know about demography. It's outside my circle, for sure. Certainly seems like you'd rather want fewer healthier and richer people than more poor unproductive people (birth rates falling rapidly in poorer countries as they get richer and more educated aren't necessarily negative for global businesses selling to them). So that's good. As for the US and such, I don't know. Immigration seems like it still has a long runway, and what truly matters is per capita anyway, so this goes back to my first paragraph above.

 

Good points - certainly the missing component from my original comment was the higher quality of life and increases in GDP per capita enabling people to "buy more stuff." But to petec's comment re buybacks, I think we've seen plenty of corporate cash used to retire shares at uneconomic prices over the last 15 years. One view on why that occurs is increased indexing (reducing shareholders questioning logic of rubber stamped buyback programs), and seeming general consensus that buybacks are always good. Think about buybacks in 2006-2007. That cash would've been far more valuable on corporate balance sheets to make massive investments in 2009-2010. I'm not holding out hope management and boards will become disciplined in their capital allocation strategies, but I do think that arguing lower dividend payout rates (particularly when at the expense of buybacks) does much for longer-term corporate growth rates.

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You think that the world's entrepreneurs and businessmen all lost any ability that they had to invest capital when they reduced dividends on average?

 

Not all, but I fear a lot did, yes.  I think the combination of high taxes on dividends, low taxes on cgt, stock options, and buybacks is a potent incentive to redirect quite a lot of corporate value from shareholders to senior managers.  And the clear positive correlation of buybacks with stock prices tends to support the idea that capital is not being well allocated.

 

I should be clear here: I'm sure a good proportion of capex is being well allocated.  But capex is not where the dividend money has gone.  It's gone to buybacks.

 

When you almost have deflation in many places because people are still deleveraging from the last crisis, high interest rates aren't exactly required to cool things down...

 

 

I agree entirely and I am not arguing for high rates (although I don't think much of QE).

 

But I would argue that deflation isn't just because of deleveraging.  In fact, the world is still leveraging and added debt worth ~40% of GDP from 2007 to 2013.  Deflation is at least in part because of malinvestment: too many factories making too much stuff, hence PPI deflation in China. 

 

I totally agree life is generally getting better and new products are exciting - and that some money has always been malinvested.  I just think that when money creation is at record levels, and seems to be going into asset prices not real demand, it's fair to assume that a higher than normal proportion is being wasted!

 

Sure, but some industries are inherently higher margins and scale better than others (software), and things like globalization and the internet make it a lot easier to reach more customers quickly. Facebook was barely a dorm room project a decade ago. Youtube was founded 10 years ago. Heck, the modern smartphone didn't exist 10 years ago (iPhone came out in 2007) and look at the size of that industry now. There's fast growing and fast growing.

 

Absolutely.  I think we're going through an amazing period of change.  I'll be very interested to see how it gets reflected in earnings though.  All these industries are massively disruptive.  Facebook, for example, provides targeted advertising.  Less targeted channels will likely lose a lot of revenue to them.  Technological improvements ought to drive productivity and more rapid GDP growth, but a) that's not new and b) I'm not sure how much of that GDP growth will accrue to existing SP500 companies in earnings.

 

Edit: speed of going global is a good point.  Not sure how much of SP500 earnings it applies to though.

 

I'm basically a big bull on general progress in the world, but I do think that graph tells of excessive bullishness amongst equity analysts.

 

P

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Not all, but I fear a lot did, yes.  I think the combination of high taxes on dividends, low taxes on cgt, stock options, and buybacks is a potent incentive to redirect quite a lot of corporate value from shareholders to senior managers.  And the clear positive correlation of buybacks with stock prices tends to support the idea that capital is not being well allocated.

 

I should be clear here: I'm sure a good proportion of capex is being well allocated.  But capex is not where the dividend money has gone.  It's gone to buybacks.

 

Are buybacks so different from capex when it comes to measuring the growth of the SP500 or another index, though?

 

Say the index is 500 businesses, a composite of their share prices. If buybacks help increase earnings per share, and stock prices go up, all else being equal, the index goes up too, right? If that money had been paid out in dividends, maybe some of it would have been reinvested in stocks from the index, affecting the supply-demand balance, but not all of it for sure. So buybacks, like capex investments in more capacity or productivity, should make the index go up more on average than if they hadn't taken place.

 

If buybacks are made at bad times, like at market peaks, the effect might be a lot weaker, but is it weaker than if the money had just left the system via dividends? In other words, the buybacks might have been a bad deal for shareholders, creating only, say, 70 cents of value with a dollar, but that value still accrues to the stock (fewer shares to divide the earnings by) rather than leaving the system via dividends. Is that so different from mediocre capex that creates only 70 cents of value per dollar invested (it's not like that doesn't happen all the time)?

 

Again, it's not something we want. But if we compare it to dividends, I think we can see how it would have a different effect on the index price over time.

 

I agree entirely and I am not arguing for high rates (although I don't think much of QE).

 

But I would argue that deflation isn't just because of deleveraging.  In fact, the world is still leveraging and added debt worth ~40% of GDP from 2007 to 2013.  Deflation is at least in part because of malinvestment: too many factories making too much stuff, hence PPI deflation in China. 

 

I totally agree life is generally getting better and new products are exciting - and that some money has always been malinvested.  I just think that when money creation is at record levels, and seems to be going into asset prices not real demand, it's fair to assume that a higher than normal proportion is being wasted!

 

Could it be that people and businesses are deleveraging but governments are leveraging up? It would be interesting to see the breakdown of that new debt. It could certainly have a deflationary impact on the economy overall since government going in debt because of, say, lower tax intake, isn't something that will stimulate the economy the same way that spending on more stuff would.

 

 

Absolutely.  I think we're going through an amazing period of change.  I'll be very interested to see how it gets reflected in earnings though.  All these industries are massively disruptive.  Facebook, for example, provides targeted advertising.  Less targeted channels will likely lose a lot of revenue to them.  Technological improvements ought to drive productivity and more rapid GDP growth, but a) that's not new and b) I'm not sure how much of that GDP growth will accrue to existing SP500 companies in earnings.

 

I'm basically a big bull on general progress in the world, but I do think that graph tells of excessive bullishness amongst equity analysts.

 

P

 

As I said, I'm not making predictions, except maybe in the Buffett way of believing that over the long-term, things should get better and good companies should keep creating value.

 

My main point was that it's not as easy to predict as some people who look at a few convincing charts or ratios seem to believe.

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I don't fully understand the buybacks->eps growth->valuation chain as presented here and recently on the Philosophical Economics blog. If all companies reinvest their profits into buybacks EPS growth will surely be higher than a historical figure, all else equal. But you're also not getting those dividends and therefore your theoretical discounted payouts from now to eternity are pushed further out.

 

Say you own a widget making company that can reinvest profits in more widget making machines at 5% ROC. Also say you can find alternative investments that yield 5% if you receive dividends instead. Is the widget company worth a higher multiple because it decides to reinvest, grow earnings, and not pay out a dime (some tax efficiency aside)? Would it warrant a lower multiple if it retained no earnings and paid out all profits?

 

In aggregate aren't buybacks essentially this - investments that produce returns that will just equate with what investors in aggregate could/would do with dividends?

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I don't fully understand the buybacks->eps growth->valuation chain as presented here and recently on the Philosophical Economics blog. If all companies reinvest their profits into buybacks EPS growth will surely be higher than a historical figure, all else equal. But you're also not getting those dividends and therefore your theoretical discounted payouts from now to eternity are pushed further out.

 

Say you own a widget making company that can reinvest profits in more widget making machines at 5% ROC. Also say you can find alternative investments that yield 5% if you receive dividends instead. Is the widget company worth a higher multiple because it decides to reinvest, grow earnings, and not pay out a dime (some tax efficiency aside)? Would it warrant a lower multiple if it retained no earnings and paid out all profits?

 

In aggregate aren't buybacks essentially this - investments that produce returns that will just equate with what investors in aggregate could/would do with dividends?

 

Here's how I understand it:

 

If you're looking at it from the point of view of the investor, then yes. The value will be roughly the same (adjust for taxes and such) whether you get dividends or buybacks or a mix of both.

 

If you're looking at it from the point of view of the business/index, then there's a difference; dividends leave the system, capex and buybacks stay in it.

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Are buybacks so different from capex when it comes to measuring the growth of the SP500 or another index, though?

 

If buybacks help increase earnings per share, and stock prices go up, all else being equal, the index goes up too, right?

 

I think they are very different.  Capex builds an asset that adds to earnings.  Buybacks don't.  They add to earnings per share, but they also reduce the share count, and the market cap (of a stock or the index) is price x the number of shares.  So no, the index does not go up just because the stock price goes up.

 

Now, the P/E may rise because the buyback alters the supply and demand for shares, but clearly that doesn't actually affect the long run value of the companies, and it certainly doesn't affect the earnings, which is what the graph is showing.

 

Also in reply to your other post: buybacks do not 'stay in the system' because for every buyer-back, there is a seller.  That money leaves the market, at least temporarily.  And the value to the shareholder of a buyback vs. a dividend depends entirely on whether the buyback is done below IV or above it.  Below IV, a buyback is more valuable than a dividend, and above IV it is less so.  It is absolutely not the case that the value is necessarily the same.

 

If a company with a finite lifespan (and most companies have a finite lifespan) never pays a dividend, its NPV is 0, even if it spends all its FCF buying back stock, because that stock will turn out to be worthless.  I find that a sobering reminder about the value of buybacks!

 

That said, I totally agree with you about predictions and I'm not making one.  What I am saying is that when multiples are high, and margins are high, and growth expectations are high, future returns are likely to be low and risk is likely to be high!  Any value investor would think the same, no?

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