One of the things that many legendary music groups are able to do is to play a song that ends with free form riffing and morph the riff into the beginning of another song. The transition happens gradually such that in the free form riff the musicians will play a cluster of notes that are not definitively the melody of another song but are the basis from which the new melody can emerge. Then the next thing you know the music group is playing a different song.
In June of 2009, not long after what proved to be the stock market bottom we wrote: “The prospects for earnings growth in the S&P 500 have never been better, literally. There is a non trivial chance that earnings grow 22% in 2010 and 22% in 2011. We know that earnings for the S&P 500 have never grown by more than 20% for two consecutive years…” It is especially interesting to us that others are starting to note the unprecedented earnings growth that has occurred. (Side note: the lethargic economic improvement seems logically to preclude the revenue and earnings growth that occurred- yet another example of the irrelevance of economic forecasting) Other anecdotes are also signaling that a transition is coming. Small changes in your portfolio are harbingers that we are working our way into playing a different song. We are quite optimistic the transition will not be from “Trucking” to “Going Down The Road Feeling Bad”, a la The Grateful Dead.
China has been “Trucking” for a long time; however, it may have some really difficult challenges in the coming decade. It was stunning that Reuters reported that up to 3 trillion Yuan of debt (~$465 billion) may be shifted from local governments to the central government. Other reports suggest it is possible that bad debts total a third of the entire county’s GDP! Our general sense is that older Chinese have a hard line communist orientation while younger generations have strongly clashing entrepreneurial views. When my sister toured Tiananmen Square the guide told her that the massacre did not happen. Upon leaving the square the guide apologized that he could not tell the truth because the government had tight surveillance over the area and he would face hardship if he did not stick to the script. Such a culture is not especially fertile ground to spawn innovation. In fact, the only unsatisfied objective in China’s previous five year plan called for innovations in industries dominated by American companies like Emerson Electric and General Electric. A broad review of China’s most recent five year plan bodes well for innovative American companies.
Looking much further down the road, it seems that the world’s population growth may come to a crawl as educational and medical endeavors impact birth rates. A question for the coming century is whether inflation rates will be similar to population growth rates, but we digress. In a low growth environment, it is worth musing about the long term effects of share repurchase programs on the price of the stock. There are large companies repurchasing shares at a rate that if extrapolated imply that all the shares will be repurchased in a few decades. In a reduction by absurdity musing, the remaining share of a company with a market cap of $100 billion has a share price of $100 billion by definition- and some think that Berkshire Hathaway’s stock price is ridiculous. As a practical matter, after unprecedented earnings growth it seems there is likely to be a transitional period of mixed growth followed by low growth. The next song that we will be singing will have a verse about enormously profitable companies with low sales growth but high earnings growth per share due to share repurchases. There will be another verse about how critical innovation is in a low growth environment. Indeed, in a low growth environment there is no major tide to lift all boats. Individual stock selection will be of enormous importance. As always and more than ever, it will be important to “know what you own and why you own it”- perhaps a fitting title for the song.
Important Disclosures:
This blog is for informational purposes only. The statements contained herein are solely based upon the opinions of Redmond Asset Management, LLC and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This blog contains no recommendations to buy or sell any specific securities and should not be considered investment advice of any kind. Past performance is no guarantee of future results. In making an investment decision individuals should utilize other information sources and the advice of their investment advisor.
