Bruce Greenwald's Talk at GuruFocus Value Conference Notes

Notes of Prof. Greenwald's sweeping presentation 'Value Opportunities in Today's Environment'

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Apr 29, 2016
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Bruce Greenwald: Channeling Benjamin Graham. He was not a traditional economist but proficient in the economy. At Columbia in the value community there has been one ominous development: In the wake of financial crisis, everyone has become an economist, in a fairly dangerous way. Typically, people have begun to adopt the part of economics that Ben Graham would have been least sympathetic to: forecasting.

The reason he would not be is he was not a great believer in forecasts. One of the pricinples of value investing is looking at what’s there. Earnings power that’s been well-established. Buffett-type stocks, competitive advantages, above average returns on capital and predictable growth rates. Not interested in doing forecasting. My students all have the forecasting disease. What’s going to happen tomorrow? Looking at changes in management, changes in macro, changes in industry. It’s not usually an enterprise that works well.

Today talking about eight years after the financial crisis, I'm going to talk about a particular view of what’s going on supported by 8-10 years of data, or longer. Hopefully point out how that translates into a general principle of valuation that doesn’t really involve forecasts that are difficult to make. Also will use an investment example that illustrates...

The dangerous part of the talk: This is the history of the Fed Reserve to forecast the future. White lines at the top are forecasts they made. The first big line is the forecast for 2010. What actually happened was the bottom heavy line. Systematically they’re wrong about direction, the future and don’t get much better at it. The line at the bottom is amazingly stable.

Associated with this real failure to forecast what’s going on is a failure to grasp what’s going on. Nothing is more depressing than a forecast than the discourse that surrounds it. These new business cycles, new since 2007-2008, are something different. They are a financial crisis and they are balance sheet cycles. The problem with describing it as a new development is in the 1960s in a qualitative sense and in late the 1960s and '70s there’s a large literature in which Ben Bernanke, the story has been that all cycles are financial market cycles. They’re all balance sheet cycles. That they start with a demand or supply shock that comes as a negative to businesses. They don’t adjust immediately. They continue to invest, build up inventory, accumulate capacity. Meanwhile revenue sales are deteriorating. Just cash outflow results. They keep cutting back sales without cutting back costs. Here is where the informational problem comes in: What would standard theory tell you they should do? They may finance these unwanted investments with debt because they can do it quickly but immediately. The opposite happens: Equity issues from the firms quickly evaporate.

Imagine I gave you the chance to bid for the money in my wallet. The auction will be peculiar. If I don’t like your bid, I’ll turn it down. How much do you expect to make in that auction? Question: nothing. Why is that useful? Because that is exactly the way public management works. Every day the stock market makes a bid for the amount of money in the wallet. Who decides to sell? It’s the management of the company. That’s exactly what investment bankers say: If you sell under these circumstances, you’re going to knock the price out under the stock. That’s why you see no equity issues in recessions.

Why not? The firms go on and continue to produce until they realize the reality of what’s going on and then cut back very sharply. For about 6-9 months, they lay off workers, cut inventory, stop investing. They go from cash flow positive to cash flow negative. They restore their balance sheets, when done, the equity base is restored and debt gotten rid of. Suddenly we have an improvement. Has happened for century.

What’s striking is there are instances where this simple self-correcting story does not apply. Obvious case of that is the Depression. What does it look like. The second half of 1929 is bad. 1930 is worse. 1931 is terrible. 1932 is bad. And first part of 1933 is also disappointing and is a contraction. A four-ear contraction, not a short sharp contraction. Given the length you have to accept it is not self-correcting. There are major countries that have never recovered from the recession, e.g. Argentina.

There are shades of that now, in Europe, Japan. Not kind of self-correcting cycles you are used to seeing. So the question is: What is going on that accounts for long-term cycles that look very different from stories people are telling about present circumstances. Going to start with the Depression.

In the Depression a major sector of the economy to which government and societies is deeply attached for historic reasons, collapses. It’s agriculture. In 1930 about 90 percent of the country is based on agriculture. In 1922, farm balance sheets are in good shape, and farmers are able because they have assets to move off farms. The correction in 1922 is a huge outflow of farm population. When 1929 price collapse starts to occur, you have a situation where the farm families, services businesses dependent on farm families, are all of a sudden starting out poor and become impoverished. They are stuck on the farms. They do what they always did is they continue to work. Difference is farm productivity is 5%, demand is growing at at 2%.

Price collapse deteriorates further and really can’t move. 1929-1932 is where migration from the farms essentially stops. Farm incomes fall by about 80%. One-third of populations are marginalized by these trends. It's not their fault; people couldn’t eat their way through the food excess. It's not a way to go. Get transition to broader economy. Agricultural demand collapse outweighs benefits of lower food prices. Countries try to export their way out of the problem. Argentina and Australia devalue really early. Recover from the Depression quickly.

Global problem here: When you add up countries, the tariffs and currency manipulations don’t solve it. How do you get out of it? There’s a lot of mythology. The Keynesian mythology is demand from WWII put all those people to work. There's a problem with the story. in 1944-45 two Keynesian economists run around saying the Depression is coming back. Government demand goes away, in same situation. And they were wrong. Why? It seems to me that WWII is inadvertently in industrial policy. Finances movement of everyone off the farms into war industries, industrial sectors where the jobs are. No longer isolated. Forced savings during the war moves transition. You get 40 years of prosperity. Except Argentina and Brazil that do not participate in WWII. They don’t transition to industrial. What you are seeing is structural transformation that is hard to advance in conventional markets. Today, the argument is productivity and low demand manufacturing is collapses globally. Has been very extended. In the U.S. deindustrialization happens in 1970 and 1982. Net income of male high school graduates falls by 40%.

Japan, Asia crisis made worse by increases in manufacturing capacity. New land being brought under the plow. Transition into broader economy, people find it hard to transition. Income is undermined. Then you see international competition. No one is saying let’s make the transition to services. They’re all talking about saving jobs, but they’re not going to be able to do it.

The transition now doesn’t look anywhere in sight. It’s going to be a long-term problem and has already been around for a long time.

I'm going to channel Ben Graham in those terms.

1) Japan always wanted to have a net surplus. Find themselves committed to big manufacturing sector that’s export dependent, not changing any time soon.

2) Germany has a powerful industrial sector. Was inhibited by rise in mark. Since the EU they are feeding off other countries with the euro. No signs of them abandoning the base.

4) China committed to large surplus.

3) Korea.

4) Saudia Arabia.

Just as in the Depression, the structural problem is international imbalances. Shows up as financial market imbalances. The Chinese have a problem finding people that will run deficits. They also have another amusing problem: Talk about how they’re going to get rid other dollars. Lots of luck with that. If you run a surplus that would destroy manufacturing you destroy it with deficit. They have to do fixed income investments. Spending on capital account is mirror image, so you have foreign money flooding the U.S. What you get is chronically low interest rates. China gets upset. They’re not happy at low yields. Stupid money looking for opportunities is what Wall Street is constituted of.

The financial imbalances are driven by international imbalances, not vice versa. Either run deficit of buy U.S. dollars. If they try to buy the euro, it won’t devalue. Those countries have very few choices.

For the U.S. it’s more a tightrope. There’s a continued dollar-goods exchange and continued macro deflationary pressure.

In the U.S. there is a series of things necessary to offset external deficits. Internet boom that turns out to be a mirage. Housing boom with much more serious consequences. What has to happen is U.S households have to not save. Now at a negative saving rate in 2005: -0.4. Problem with that: top 20% have at least 40% of income, and savings rate is 15%. To get to a zero savings rate, bottom 80% have to be saving just 6% a year, but they have 6% of the income. That’s the situation prior to the crisis, and that was obviously unsustainable. People couldn’t go on spending 110% of their income forever. When the gravy train ended, you have serious consequences.

In Japan the discussion has little to do with reality. You hear about demand problems, demographic problems. Pre-1990, Japan hours work growth was 1.5% ours in the U.S. Post-1990: The relative hours worked growth rates are the same. Big difference: Post-1990, half a percent below the U.S. That's a 3-3.5% change. It’s not a demand problem; it’s productivity problem. Manufacturing sector in Japan: run into situation where they can’t get rid of the workers fast enough. it’s a dying sector; they’re sending all resources too. It’s the wrong place to do it, at exactly the wrong time. Again, it's a structural problem.

There are wonderful things about services. Non-financial corporate profits as fraction of national income. In recent years, income inequality. When did that start? Back in the 1990s, when the U.S. deindistrualized. Because if you think about profits, they come from two sources. Standard BG and WB: Second source is barriers to entry. It's easy to measure the width of a moat although Buffett will never tell you. Minimum scale that a viable entrant has to attain. In manufacturing markets you can survive on 2% share. But in local services market like cell phones, Coke, servicing rather than manufacturing. Local market by local market you need 20-25% share to be marketable and that’s a lot harder to get. Because services in local market services purchases tend to be much more frequent than manufacturing and get more customer retention. They can dominate and keep others out. Corporate profits keep rising, from 8.8% to 13.9%. Not likely to reverse.

Also, in a protective market, if you invest $100 million in growth and pay 10% to people who provide the growth, what will you earn on the investment? In a competitive market it’s 10%. If you make 10% and you pay 10%, the net value is zero. Growth has no value in competitive markets. But in local franchise businesses where you earn above growth creates value for people who own businesses.

Same with cost reduction. Profits go up, potential entrants see it, enter and drive up fixed cost, and profits go away. Barriers to entry, get to enjoy the benefits of cost reduction because you don’t have process of entry. Post-2000 when profit levels are high, the services businesses of manufacturing become dominant. Profitability growth accelerates. Period from 2011 is period of best performance because we are the best at services since WWII. Grim economic pictures and get ready for your kids to live at home till they’re 45. But for owners and management, this is a valuable opportunity.

You also get pricing power. Striking picture you won’t hear about. GDP deflator more telling than CPI. In period of chronic access capacity and slow growth, growth in prices has been 1.5% throughout the crisis. Evidence of pricing power and result of local service monopolies.

Basic elements of value: franchise businesses where growth matters. Have to invest to support growing income screens. Operating at competitive disadvantage may make 5%, but it will be value disruptive.

Competitive advantages look like: easy to calculate the width of moat. One is economies of scale, like Coca-Cola (

KO, Financial). Sustainable monopolies tend to be natural monopolies. They are increasing with the transition to services.

How to look at businesses: market by market. Forget global markets. They're not where you’re going to make money. In the PC industry, people who made all he money are not Apple and IBM or Japanese that did everything. It is the specialist. Microsoft (

MSFT, Financial), Google (GOOGL, Financial), Intel (INTC, Financial), Adobe (ADBE). In service businesses it’s ones like Wal-Mart (WMT) that are geographically focused. They only want to operate where they dominate. Not like ATT (T), Sprint, Texas Instruments. Local companies like Verizon (VZ, Financial) and pharmaceuticals. When they go international they don’t make money.

When valuing, it turns out you can’t put a value on them. When introduced, Charlie was overly kind about my value investing book. We have to do a second edition because it’s not a good book. If buying a book, buy a different one I wrote.

It didn’t do a good job valuing growth. Very hard to put a value on a growth stock. A lot of the value is out there in the future. Hard to know what will happen in the future. Can look at trajectories. Return space. If I buy this stock today at the growing price, what return should I return in the world just described going forward. You want to concentrate on returns. There are a fair amount of opportunities.

John Deere (

DE, Financial) you want to take a long-term view. No question there are short-term headwinds. Sustainable margin is 10%, revenue is $30 billion or a little below that. The tax rate is a third. Sustainable income after tax of $2 billion. Market cap is way below $30 billion today. Better bargain. Finance subsidiary worth $6.5 billion. 8% return. Going to do this in return space because it’s a growth stock. Of 8% return, 6% has been distributed in the past and likely to continue in the future.

Where the nature of the business matters: They used to sell seeders and cost of machinery was 80% of cost of package. Today there are four service components to the business that far outweigh manufacturing: Farm equipment is more valuable when you can fix it in an hour than when it lays for time. Deere has learned to concentrate on local places. At the moment, Brazil. If you are in the area where 90% of the tractors are Deere. Second: Financing is a big factor. Bob Willers: Profitable banking is local banking. If Deere is 90% of agriculture equipment buyers in the market, they know if you are a good risk or not. If Deutsche Bank comes in and makes an offer, Deere is going to match it and keep them every time.

If it’s a bad offer, Deere will call them in and say sorry, and Deere will get them all the time. With tobacco Deutsche Bank had 90% bad loans.

Third: second-hand sales. Tractors are more durable. Second, sales are more important. Local markets are important there too.

Increasingly nobody works in those tractors. Programmed for local agricultural conditions. Deere writes a lot of software, writes a lot of programs based on GPS for running tractors. They're probably 20% manufacturing now. Other companies can’t break monopolies by cutting prices. Kubota (

TYO:6326, Financial) is almost beyond reform. AGCO (AGCO, Financial)  has retreated to Europe. Kubota has naturally gone to Asia. If they are three monopolies, it's an extraordinary profit opportunity.

Deere has a 13.5% return. with interest rates at 1% is a pretty great return, with low risk. In the long run success depends on: whether story about Deere continues to apply (now have 10 years of evidence and longer for whole econpmic period in the U.S.) and second has to do with long-term growth rate. Is agriculture automation going away? Obviously not. Going to be replacing, lots of people still farming, going to be replaced by equipment for many years to come. Above GDP growth. Average four-person family farm is heading to 10-20 thousand acres. That's 20 square miles. Global world waiting outside to do that.

When you dominate your market like Deere, when there is a recession you don’t get price competition. From 1999-2003, you have a small drop in demand and profits go to zero. In 2008-09 sales fall 20% and profits stay positive at slightly over half of previous profit rate. Seeing that in face of larger reduction of demand where has been profitable through whole transition.

This is my story channeling Ben Graham: When you do economics, be careful out there. Don’t forecast. Look for well-established trends from a broad range of global data. Not a one-size-fits-all positive or negative story. Unemployment numbers are completely phony. Five percent more of the 16-65 more than there are today. The number of people working part time that want to work full time: at 12% compared to the 5% rate in 2006. Macro economy in terms of growth and employment is not going to get better until you see global trends.

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