David Fleer
Bristlecone Value Partners, LLC
12301 Wilshire Blvd., Suite 320
Los Angeles, CA 90025 USA
Work 1-877-806-4141

The Next Crash is Upon Us!

August 18th, 2017

Hardly a day goes by without an article predicting an impending stock market crash. As we reiterated in a recent commentary, now is not the time to chase hot investments. However, we do not profess to have any insights on the timing of the next crash, and we certainly do not advocate selling your stocks or stock funds. Since we are now 10 years removed from the onset of the last financial crisis, we’d rather draw a few lessons from history: Read the rest of this entry »


Oil Future; Increasing Allocation to Foreign Stocks

June 23rd, 2017

Oil Future
Total S.A., one of the world’s largest oil companies, was reported in a recent article as seeing its future in electricity generation, rather than oil production. This is a startling admission in our opinion and worth mulling over. Total is the 2nd company in the last 6 months announcing a surprisingly early peak in worldwide oil demand (Royal Dutch Shell has said oil could peak somewhere between five and 15 years, while Total thinks demand for oil will peak in the 2030s.)

The recent example from the coal industry should serve as a warning to investors in oil companies. After demand for coal peaked, a little over a decade ago, it took about 2 years for coal companies’ finances to start deteriorating. The downtrend has been relentless since then and investors who tried to bottom fish got burned. The main culprit was competition from cheap and cleaner US natural gas for power generation.

Oil has a much bigger footprint than coal in the global economy, and for this reason we do not expect it to become a stranded resource within the next decade.  Nevertheless, there are trends worth watching with potentially ominous long-term consequences for oil companies and oil prices. In the short to medium term, it appears that increasing demand from fast-growing economies around the world will continue to support demand for oil and its derivatives (plastics, chemicals, asphalt, etc.). But there is a very real possibility that demand could peak in the next 15 to 25 years, a scenario which OPEC, Exxon Mobil and other major oil companies do not anticipate.

Those forecasters predicting an early decline see it driven by an accelerated adoption of autonomous vehicles, greater fuel efficiency from increasing use of hybrid and electric vehicles in all types of transportation, and a surge in ride-sharing (see this article from the Wall Street Journal), as well as  a secular shift toward greater use of renewable energy. It is very hard to predict exactly when peak demand will happen, but it is a matter of when, not if.

Once oil demand starts declining, it will have far ranging consequences on a number of industries, some positive and some negative, but none will be more affected than companies that make a living from extracting oil out of the ground. As investors, our valuation models implicitly rest on our ability to project within reason a company’s future cash flows beyond just the next few years. We find that the range of possible outcomes for oil companies to be too daunting to have a high enough degree of confidence in our estimates. We decided to place these companies in the “too difficult” pile for now and sold our last remaining investment earlier this year.

Increasing Allocation to Foreign stocks.
A number of commentators have made the case that today’s market in the US is expensive, possibly very expensive, and is reminiscent of 1999, when the valuation of technology stocks (remember AOL?) and built-in expectations were very high. There are different ways to measure valuations but none indicate a historically cheap market today. The chart below tracks a measure of Price-to-Earnings ratios adjusted for inflation and averaged out over 10 years:

What should investors expect? First, it is important to remember that the key drivers of stock returns over time are corporate profit growth and changes in interest rates. Historically, stocks have been good investments, delivering real returns of about 7% annually, even if the ride has often been  rocky.

Discussing stock valuation does not mean that we are attempting to predict what the market is going to do over the next 1,2 or even 3 years. As the great economist John Maynard Keynes once said: “The markets can remain irrational longer than you can remain solvent.” Sooner or later though, valuation counts, and there is a strong relationship between future long-term returns and starting valuations.

If interest rates remain low, high valuations may be justified. The US stock market has indeed seen higher than historic valuation levels for the better part of the past 10 years. Not surprisingly, during the same period, returns have also been below historical standards, and this is our point. Even in a scenario where interest rates remain low, we would expect below average returns over the next 5-10 years for US stocks.

As for corporate profits, this is what they’ve looked like since the end of WWII as a % of the US economic output:

Clearly, they are also on the higher end of history and have been for the past decade. It is possible, and some have argued, that profits will remain at a permanently higher level for a long-time. The argument is that profits today are dominated by tech companies that are monopolies and therefore are facing less competition. Another factor might be that US companies are capturing a higher proportion of worldwide profits. Again, in this scenario, it would mean that profits will grow at the same rate as GDP, and the risk is that they might grow slower.

So where does that leave us for US stock returns over the next decade? We think they are very likely to be in the 3% to 5% range before inflation. This would translate in returns of 0% to 2% after inflation. Again, remember that this is an average, and year-to-year returns will be anything but.

These low returns are a real problem for US-based investors: for instance, when drawing an investment plan for retirement, most people depend on their portfolio growing at a much higher rate to be able to reach their goals.

What could an investor do to increase the odds of improving future long-term returns? Currently, high quality bonds are paying 2% to 3% and won’t help. Because the issues discussed previously, valuation and profit growth, do not affect foreign markets, including emerging markets, as much, we believe that most US investors would be well served by investing more in the shares of foreign companies. Models like the one we just used to estimate future US long-term returns yield numbers in the 4% to 6% after inflation for international stock markets.

Depending on the data you look at, the US economy is about 25% of the world economy, and US stocks represent about 50% to 60% of the world investable universe today. Our average client portfolio is already diversified globally but we recently made the decision to bring the proportion down a notch further and rebalance away from US stocks (individual circumstances vary and will impact the actual proportion).

Increasing exposure to foreign stocks brings up the question of currency risk. In any given year, an adverse move in the dollar could offset the benefits from rising international markets. Therefore, some fund managers might hedge this risk, particularly when making investments in countries with volatile currencies. At the overall portfolio level though, academics studies have shown that, despite the added currency component, diversifying globally pays off for long-term investors. Although increasing foreign exposure might potentially increase the overall volatility of our clients’ portfolios, we feel that it’s a risk worth taking over the next 5-10 years.


Berkshire Meeting, Baumol’s Cost Disease, and Amazon

May 17th, 2017

Berkshire Hathaway’s 2017 shareholder meeting was held on the first weekend in May.  The Wall Street Journal carried a helpful live-blog with notes from the lengthy Q&A session with Warren Buffett and Charlie Munger (the event’s main attraction).  One of Mr. Buffett’s more interesting points—particularly in light of current partisan debate on the subjects—concerned the relative impact of taxation versus health care costs for U.S. businesses. Read the rest of this entry »


Berkshire Hathaway: In Praise of Synthetic Leverage

March 22nd, 2017

“Life is like a snowball. The important thing is finding wet snow and a really long hill.”

–Warren Buffett

A few weeks ago, Warren Buffett published his annual letter to shareholders of Berkshire Hathaway–one which we read with interest each year.  The letter’s opening page contains a performance table tracking the annual percentage change in Berkshire’s per-share book value, compared to the return of the S&P 500 Index. By this very basic performance measure, Mr. Buffett’s track record is remarkable, outpacing the S&P 500 by an average of 9.3% per year over the past 52 years!   Read the rest of this entry »

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