How we measure inflation

Traditional inflation measures have been looked at from the perspective how much a basket of goods cost today compared to last year. However this approach fails to measure the output or the use of this basket of goods. The question I am asking is: do we garnish the same utility of that basket of goods or do we yield higher output with the better technology?

As technology progresses, consumption of anything is yielding higher utility of use as things are becoming more efficient, last longer, use less energy,...etc. Aside from using more of things, the cost per unit of consumption should have gone down over the years with increase in efficiency, innovation and productivity of things. Lets look at energy as an example. Please note that the point I making here is only valid over multi-year periods, decades maybe as technology does not progress overnight.

We have always seen the graph of energy cost over the years going up and up,

as seen in graph here. Whether on inflation adjusted or in nominal terms, cost have gone up. But is dollars per barrel the correct measure to gauge cost of energy over time? I say maybe this is not the right way to look at inflation.

The oil put into our cars now allows us to travel much longer distance than say 20 years ago. When you went from point A to B in the 1970s, you consumed more energy than travelling the same distance now. The energy consumption per mile traveled has gone down. See the second graph which illustrate that each mile traveled is costing us less and less in term of energy consumption as measured by BTU per mile traveled. Drivers most certainly realized improved output by increasing the number of miles per unit of energy used. So the question is the cost per mile traveled have gone down?

A barrel of oil produces 5,800,000 btus, a measure of energy. Then if I divide the historical cost of a barrel of oil by that factor I would get an approximate cost of the passenger mile. The result show that there is still inflation in figures but at much lesser extent, see graph 3. Oil prices from 1960 has gone up 21 folds while cost per passenger mile has gone up some 14 folds.

The same concept can be applied to the basket of goods that we measure inflation with. Electricity can be analysed in the same manner.

The cost of production and technology would have declined resulting in higher output per unit consumed. Off course on the aggregate we are using more of everything compared to 20 years ago. We are driving more, using more lights, using more electricity...etc So our total use of energy and electricity has gone up. But the cost per per unit of energy used has not gone up as high as we think.

This is me thinking out loud, I may have missed some critical issues in my analysis as I am no expert on the economics of inflation. Well, may be I am, I can't be more wrong than anyone else.

Internet: Destroyer of Profit Margin

I have discussed how Internet disrupted or continuing to destroy software business models. So lets look at one of those Internet application companies and how they are "thriving" in the age of the Internet.

Salesforce.com is the poster child of the new Internet company that offers Software-as-as-Service applications, or Customer Relationship Management as a service. The application is really good, we use it at our company and we are happy with it. But does this model can translate to sustainable competitive advantage or at least a viable business?

I reason, NO.

After using Salesforce for few years and being happy with the value we got, competitive alternatives are being offered less costly. Competition, although may not be mature yet, but getting there quickly, are offering similar solutions. Competition have huge advantage over Salesforce, being able to use cheaper and more advance technologies. In this industry it does not pay to have a first mover advantage. Salesforce will not chug its infrastructure but a new entrant to the industry will pick the most efficient platform to launch its service. Competition is everywhere for someone like Salesforce with less costly operating structures, prices for these offerings will continue to go down overtime and eventually they will become free.

Google applications market place is one platform for companies and start-ups to develop on a free platform and data centre. Sure it is yet to mature to offer business ready solution but it will get there. Others will offer similar solutions. Actually salesforce offers something similar but its drawback is it has to be developed on their platform, limiting flexibility.

In order for Salesforce to keep its growth it spends heavily on sales and marketing. Actually, 50% of Revenue is spent on marketing and sales annually to continue with its growth. But how long can you continue with such spending before investor want to see some returns?

If we look at their margins they are very depressed. Actually, there are no margins after some 10 years of operations. Sales and Marketing expenditure

will continue to eat at their profitability to ensure they compete and sustain market share. They have generated cumulative earnings of $42 Million from cumulative revenue of $3 Billion, since they went public. And I do not think that will change in the future.

Salesforce sports a very high multiple, in fact 102 x earnings. Investors are bidding these shares up for the prospect of growth in earnings. I am afraid the growth will come but Salesforce and many outfits like it will not benefit. The market for Software as a service(Saas) will grow like crazy but, profitability will be scarce. Why? Free is the name of the game on the Internet.

This is a good candidate for a short:

• one product company with the promise of growth.
• extreme valuations.
• no earnings after some 10 years operations.
• tough market dynamic and getting tougher.
• the accounting is open for games as they book of revenue from deferred customer contracts, which can be messy, I have not analyzed it carefully but it is something I would look at very carefully.
• Something does not add up about there subscriber base:
• based on their financials revenue per user should be around $18,733, based on published users of 60,000.
• however the highest revenue per user is $250 per month or $3000 per year. The two figures are vastly different.
• The discrepancy between the two figures tell me that they may have few large customer that skew the average higher, while the majority of their users are small (1 user) customers.

Would I short? No. People can continue to believe in future growth longer than I can remain solvent.

Short vs. Long: Kettle meet Pot

Those who short are no different than longs. In fact shorting is much harder than being long on so many levels. Shorting require more skill, research and discipline than being long. Actually I can argue that dedicated shorts are better investors than longs.

Sometime shorting is lumped incorrectly with trading and speculation. To short stock based on valuation or speculation is to make a bet on market conditions. But proper short is to short fraud, hype and bad management. These things require a lot of fundamental analysis to uncover.

Shorting is no different than going long. You do the research, more of it actually. Uncover unsustainable business models and bad management. Recognize hype from what is logical and sustainable. Once you complete your process, usually longs pull the trigger at this point. However shorts, do that process over and over again until there is no i left undoted. Then you wait and wait until you the perfect time and here is the art of short selling is when to pull the trigger.

A successful short has to master two things, timing and selection, while the long side can live with selection only. A long investment that depreciate in value hurts performance but does not pressure you to sell, as time can make you whole again. However a short does not have that luxury. A short position that moves against you, require more margin and more capital to hold. How long can you continue holding is a function of how much capital can you come up with.

I recommend reading a book about short selling called "The Art of short selling". It is not much about short selling rather than fundamental analysis. You will be surprised how detailed shorts can be be.

Commercial Real Estate: Some Observations

I have taken a beating on my commercial real estate holdings (CRE). So it is time to reevaluate my position on the sector.  

My original buys of these names were in late 2008 on the premise that unlike previous down cycles in CRE, office real estate is not overbuilt and will not experience any thing close to late 1980 collapse in prices. I guessed that the market had overreacted to CRE and the market though a repeat to the  collapse in residential housing will occur in CRE.  I expected cyclical down pressure on their operation to be mundane. You can see my earlier views here:  post 1, post 2, post 3, post 4.

What is the status of CRE, here are few observations:

• Credit underpins the valuation in all capital markets, including commercial real estate. To that extent lack of credit have downward pressure on CRE prices. The fact that CRE did not overbuild dampen that downward pressure.
• As deleveraging occurs, credit for CRE will not be available. Private equity and investors are not rushing to pour money into CRE.CRE upleveraged and needs to deleverage, while debt value are constant it follows that asset values came down so equity is wiped out.
• As property owners have no equity in their holdings they have no incentive trade or sell their assets. They will hang on in hope of something to happen. For example, GGP did not want to trade with Simon Property even in bankruptcy because they do not gain on these sales, so they will hang onto their properties in bankruptcy in hopes of something happening.
• No transaction will occur for few years so valuation will not be visible. Valuation will decline but will be mundane at least in what is reported in indices. 
• Transaction will occur in two instances:
• loans come due and the majority will occur in 5- 8 years. Lenders will extend loans rather take loses.
• transactions will occur when there is growth prospects of leasing, rental agreements..etc. so far the prospects of performance is not visible so highly likely no transactions to occur.

• The 20% drop in values are for small properties and not indicative of values in CRE space. publicly traded CRE companies have gone some 55-60% may be that is more accurate for CRE values.
• REITS that have announced equity sales have gone up and when completed have gone up even more. These REITS Ent. value has expanded as it reduced its debt/ equity ratio. Raising more equity will increase value rather it will dilute ownership as earning are decompressing.
• office will hit hard as unemployment will be high for few years so demand will go down although no overbuilding happened. 
  

Am I to abandon the space? I think not. But I will reduce some exposure as I take advantage of this rally. There are interesting development in some areas that can lead to opportunities especially on debt and distressed debt front. Still my preference is to buy long term assets in supply constrained markets, Like Brookfield Properties and Boston Properties. 

PE Valuation Cycles

I tend to view markets in PE cycles rather than most widely used price cycles of bear and bull markets. This means I follow PE expansion and compression cycles. Why? As investor and I look at valuation to allocate capital rather than price. Moreover, capital appreciation or return is made up from two sources: PE expansion and earning growth. So it follows that PE trends should determine bear and bull markets rather than price action. 

For the purpose of this post there are two cycles an PE expansion cycle and PE compression cycle. There has been 8 secular cycles, including this one, measured from PE trough to peak, throughout the period from late 1800. There were 4 PE expansion cycles and 4 compression cycles, including this one from 2000 to date. 

I used Prof. Robert Shiller data for my analysis and the most interesting findings are in the following table:

Here are few observations:

• There are secular cycles lasting many years from PE trough to PE peak and vice versa.
• 10 yr Yield peak and trough coincide with PE cycles; rising yields does impact valuation. So the prospect of rising yields in today's market will negatively impact equity valuation.
• Average PE compression cycles is some 13 years; we are 9 years in this cycle.
• Average annualized returns associated with PE compression cycles is almost double the upside move in the PE expansion cycle, -17% vs 10%.

Here are some valuation implications, if I use typical cycles averages to the current PE compression cycle:

• According to the data, the long term average of PE of 16.34x, it seems that at the current market levels the S&P is fairly valued at 15x.
  
• Given the size of the credit event occurred in 2008 and the disruption to world economy also the succession of various bubbles: Internet, housing and credit, a retrenchment in PE by 80% is realistic. So far PE compression is 65% from its 2000 peak. In the secular PE compression seems that a move of 80% down is typical. Therefore another 15% compression is highly likely. 
• The current compression cycle should end around 8-9 times 10 years real earnings, as most compression cycles ended in single digits. If we use the current S&P 10 yr earnings of $57.67 per share then that puts the price target of the S&P at 519, some 40% decline from the current level.
  
• There is an expected Bear market in treasuries due to high supply of paper as governments to try to finance deficits, thereby increasing yield, another sign of secular PE compression, as any PE. 

Although history does not repeat itself but it rhymes. History can rewrite the averages here, but events that transpired are not unique to history and has occurred in the past, so we will work them out. And equities will experience another bull market, but I doubt it is going to be now.

Credit and PE Cycles

Credit availability, not leverage, underpins equity valuation. Actually it underpins a lot of economic output but for the purpose of this post I will stick to equity valuation.

Having lower yields on treasury bills affect stock valuation positively, as you discount future dividends, cash flow or earnings streams by lower discount rate, thereby increasing valuation. The opposite have negative affects on valuations; higher rates mean lower value. The concern is for equity valuation going forward is the rapid increase in treasuries yield. 

The massive debt being accumulated in the US and elsewhere is what will cause yields to rise quickly. Here is an excerpt from John Mauldin letter, which can explain why  yields will have to go up very quickly:

The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year.  US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn't do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let's be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

I am not concerned about where the money will come from, it will come, as supply creates its own demand at the right price. What price may that be, you ask? I bet you it is going to be at much higher yields. I suspect somewhere around 6%. Yields have already began to move upwards in a hurry. Look at the the 10 yr Treasury from Yahoo:

So here some observations: 

• The yield rise is not a good sign for a sustainable PE expansion in equity. Given that cyclically adjusted PE, Data from Prof. Robert Shiller, have not dipped under single digit, as historically no sustainable bull market have began from double digit PE. Please look at the second graph.
• Bull markets or PE expansions have been associated with low yields and the prospect of bear market in treasuries do not give me confidence in any PE expansion for the next few years. Observe the 70s era in the second graph.
•  PE compression takes awhile. PE have been compressing since the burst of the Internet bubble in early 2000. That is 9 years only and that is not long enough period. If history holds we can be looking for another 5-10 years of range bound market prices.