USA Inc.

Since 2009, I have been blogging on the macro picture and overall equity valuations. In my real investor life, however, when it comes to equity portfolio management, I am mainly a stock picker, trying to find companies that can provide mid-to-long term capital appreciation almost regardless of the economic environment. For long-term investments, the research task essentially boils down to management, management, management.

If picked right, management will do the bulk of the job for me as long as I bought and held the shares at reasonable valuation levels. If picked wrong, management will offset many of my previous good picks, hence the need to simply discard any company with doubtful management. For me, any reasonable doubt is enough.

Warren Buffett once said that he always seeks companies with management having demonstrated intelligence and integrity, the latter being the most important of the two since “without integrity, an intelligent management will kill you”. So true, but it often takes time for the “killing” to actually happen. In effect, experience has shown time and again that stocks of companies run by rogue management often flourish before reality eventually sinks in. (rogue: “An unprincipled, deceitful, and unreliable person”)

For all kinds of corporate and personal reasons, analysts and commentators are generally mute on such management if and when they see or suspect one. Thick skin short sellers are often the first to publicly denounce but are quickly loudly accused of talking their book, are often sued and are generally publicly and disrespectfully dismissed by management as stupid unaware people forging stories and twisting numbers for their own benefit.

How to spot potentially dangerous companies: character investigation.

• The first time I look at a particular company, I initially read the annual report backward, starting with the Notes to the Financial Statements, more specifically, the Accounting Principles used by the company. When a company adopts mostly very liberal accounting practices, clearly favouring short-term profitability at the expense of transparency and sound balance sheet management, I look elsewhere. Not because it necessarily means bad or questionable management, but it displays a basic character of the organization that leaves the door open to sub-par management and manipulations. I shun these potential time bombs.
• I then look at the depth and quality of the organization, starting with the board of directors and the background of each director, importantly with the Chairman and the CEO: they pick their board and management teams to fit their own character and they are the ones who will define and run the company. Any past integrity problem eliminates the company for me. Any doubt does the same. I also scrutinize the CFO’s background as he/she controls the books.
• I look at stock ownership of management and the board. I am not comfortable with people taking risk with only other people’s money. I want officers and directors to share the risk with me. Stock options don’t count: all upside, no downside.
• I read the Chairman and/or CEO Message to Shareholders: more informative or more promotional? Factual?
• I read or watch recent investor presentations: more informative or more promotional? Factual?

A good case in point: in September 2000, I was attending an investor conference in NYC. By coincidence, Enron was having a luncheon presentation in the same hotel that day. Being free for lunch, I sat in, curious to see this glorified management (the stock had jumped from $35 to $90 in less than a year) even though I was then not responsible for U.S. equities. What a show! Good for Vegas. Really entertaining, but no substance, featuring highly creative definitions for revenues and profits and several unverified and unverifiable numbers. All meant to awe the audience. Back at the office the next day, I simply told my colleague managing U.S. equities that I would not touch this stock with a 15-foot pole.

Why am I writing about that here and now?

Because, for some strange reasons, the current CEO of “USA Inc.” made this remote period of my life pop back up. I wonder if there is a connection and if we should all worry about our U.S. investments.

This CEO, for reasons of his own, early on took measures and/or adopted policies that quickly boosted the economy and the stock market but were often considered economically and financially bold and highly debatable. There were apparently little, if any, internal discussions or other form of due diligence as the CEO and his team found highly dubious ways and means to bypass all normal decision-making processes meant to ensure thorough analysis and mid to long-term impact evaluation. To wit:

• limiting immigration right when the country needs more labour;
• slashing taxes and boosting government spending right when the country’s resources are stretched;
• increasing the deficit right when prudence would dictate to reduce it given the strong economy;
• raising the country’s debt beyond what is reasonable and manageable;
• using blatantly illegal methods to upend treaties governing trade and commerce;
• bullying anybody and everybody criticizing his decisions, actions and generally twisted facts;
• isolating the country, politically and economically, even antagonizing old trusted allies;
• dividing people;
• degrading the moral fabric of the nation, acting in such ways that make people believe that anybody can act any which way he/she wants, however unethical or disgraceful.

Oftentimes, such management’s decisions initially appear smart and profitable to the mass as they can quickly boost growth. Oftentimes, the stock of such companies will perform very well, investors in general seeing apparent wisdom from the short-term boost, oblivious to the gangrene creeping up or confident that things will end up just fine with this controversial but charismatic and “evidently” successful leader.

Warren Buffett also said that it is when the tide goes out that we discover who’s been swimming naked. That holds for individuals, companies and countries as well. Look at Venezuela, Turkey, Argentina.

Rational investors should be able to recognize such artificially boosted situations and mark them down to compensate for the creeping risk, especially when monetary authorities are openly driving interest rates up to prevent economic overheating. But greed, well fed by the media, the sell-side and a good part of the blogging community, often wins over prudence and rationality, until the tide recedes.

Corporate USA is comprised of thousands of small, medium and large companies essentially operating independently and responsible for their own faith. But they are all navigating within a universe more or less controlled by a mother ship called the U.S. Federal Government which regulates and modulates the overall environment, presumably to promote efficient and smooth navigation for all.

The U.S. mother ship is now run by a highly controversial and maverick skipper determined to utilize its relative power to significantly change the rules governing how domestic and foreign corporations can navigate within and without the U.S. universe. His radical approach and ways and means are confrontational and often contrary to conventional, ethical and legal behavior. Many also doubt his management abilities and his knowledge and understanding of the complex interactions within and without the U.S. universe.

So far, however, the U.S. universe is strongly outperforming as recent policies have boosted corporate revenues and profits, even though they have resulted in a considerable weakening of the mother ship’s capability to weather adverse events and unforeseen future shocks. Furthermore, his approach to “business” has created a highly antagonistic and suspicious atmosphere with most other universes and showed a “different” way to run a mother ship which could potentially be more universally adopted in the future. Briefly stated, sheer economic power now justifies just about anything, anyway and anyhow.

While this is happening, foreign leaders are not standing still. Realizing that the USA is now a much different universe, there is a pressing need for every universe to reconsider the overall political and economic scene and reassess every possible options in order to achieve one’s particular objectives. This is happening at the macro level, as well as at the micro, corporate level (see AMERICA CURSED) and there is little doubt that the ensuing set up will be much different. Investors will need to catch up rapidly.

WHAT TO DO?

We know a few things for sure:

• Equity markets are not cheap. By many measures, they are actually historically expensive.
• Earnings growth slows down measurably in 2019, reverting to more normal growth rates absent a tax reform.
• Inflation pressures are ramping up but not too severe so far.
• The Fed is tightening, slowly but surely, hoping it will have enough time to recharge.
• Debt is very high, just about everywhere.
• Washington has no dry powder and his quickly shrinking its remaining options.

Given the coming earnings slowdown and ongoing monetary tightening amid a highly indebted and uncertain environment, rational investors should naturally reign in their risk exposure. Earnings multiples should thus be reduced, even more so given the longevity of this cycle and the numerous signs pointing to the end of the equity cycle: Here are just a few of these signs:

• Fed’s Powell Defends Pace of Rate Hikes to Avert Overheating

• Lenders Shunned Risky Personal Loans. Now They’re Competing for Them

The U.S. dollar can be seen as a proxy for the country’s overall health and attractiveness. This chart from Scotiabank (via The Daily Shot) illustrates a relationship which is likely to become dominant in coming years:

Other signs of near cycle end:

The leadership’s character generally trickles down the organization from mother ship:

• A Swamp Tour of Trump’s Washington The current administration is awash in government ethics violations, business conflicts, potential criminal acts, and flagrant lying.

• Five Trump campaign team members have now pleaded guilty to criminal charges

• A Former Big Tesla Bull Says Musk’s ‘Erratic Behavior’ Means Stock Is No Longer Investable

• Tesla Bulls Capitulate: Munster Sees Musk As “Jerk, Bully And Liar”;