Weekend Reading 10/1/2021

• Impact of the China’s “3 red lines” for property developers. Implementing these standards forced developers to curtail operations and liquidate assets which, in some cases, exacerbated the problem.
• “The property sector is notorious for its addiction to debt.”
  • Not just borrowing from banks and bond markets but preselling apartments, paying contractors and suppliers with commercial paper and receivables.
• “the property bubbles has resulted in a lot of empty homes and apartments- between one-fifth and one quarter of the total housing stock, especially in more desirable cities, owned by speculative buyers who have no interest in either moving in or renting out.”
• “the most worrying aspect of financial distress behavior is that once it is set off, it often seems to spiral quickly out of control. Before that can happen, a credible outside agent must step in to guarantee the continued operations of the company and its ability to service its debts.”
  • The Global Financial Crisis was the precedent for these sort of interventions by central governments and these interventions proved to be successful.
• Interesting point made about high-quality growth versus residual growth
  • High-quality growth = rising consumption, exports, investments
  • Residual growth = debt-fueled expansion, malinvestment into property sector & bridges-to-nowhere.
  • “As long as Beijing sets GDP growth targets that exceed the country’s high-quality growth rate, China has no choice but to rely on residual growth to meet its target; and as long as it relies on residual growth, debt must rise faster than the overall economy’s debt-servicing capacity.”
• Beijing has several problems to solve
  • Limit contagion. The end is simple but the means are complicated.
  • In limiting contagion, Beijing also has to provide some certainty for contractors, suppliers, owners, etc.
  • BUT Beijing must provide certainty and ringfence certain groups WITHOUT coddling the irresponsible behavior that fueled this crisis.

Evergrande hasn’t been in the headlines in a few days but the problems with China’s overleveraged property sector are far from resolved.

The profitability of US corporations is structurally higher than it used to be (and will continue to grow). Through this lens, the market’s valuation doesn’t appear so excessive.

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If you listen to the financial media, it would make you believe the market is about to crater. The reason why? As-reported profit margin forecasts aren’t rising anymore.
According to this school of thought, as Bloomberg recently highlighted, when analyst estimates for as-reported profit margins stop rising, investors should brace themselves for severe market drops. According to Bloomberg, this could have predicted the 2011, 2015, 2018, and 2020 market drops.
However, turning to Uniform Accounting metrics, we can see there is a more important driver of market risk.

As we highlighted in the Aug. 9 Investors Essentials Daily, a deeper, longer-term look at real U.S. corporate profits shows that the current market isn’t some aberration… Nor is it unsustainable.
It’s true that companies are performing at the top of their historical range, but this is part of a long-term, secular trend in corporate profitability.
We’ve seen a steady secular move upward in Uniform returns on assets. Corporate profitability has consistently reached higher highs, and higher lows, through cycles.
As U.S. corporations have moved away from lower-return manufacturing business and into higher-return intellectual property based businesses, they’ve also become more focused on operating efficiencies. Quality and efficiency regimes like “Lean” and “Six Sigma” have permeated through the entire corporate world – boosting aggregate ROAs.

Companies have also gotten smarter about limiting investments when they can’t find growth opportunities. That has come with significant new modeling and forecasting capabilities made available by easily accessible Big Data.
With the right data, the movement of the benchmark S&P 500 Index over the past 20 years makes more sense.
After dropping in 2001 and 2002, Uniform ROA levels reached 10% in 2006 and 2007. These levels exceeded the levels of 1999 and 2000, just as the market was making new all-time highs.
Then after dropping in 2008 and 2009, Uniform ROA again reached new peaks in 2011 and 2012. By early 2013, the market was making new all-time highs.
After falling due to energy-market headwinds from 2013 to 2015, markets were on the way to new highs before the coronavirus pandemic threw a wrench in the supply chain. This is part of the reason why the stock market recovery was so robust.
Said otherwise, companies aren’t teetering at the top of a business cycle. Take a look…

Although negative cycles cropped up in 2000, 2009, 2015, and 2020, they weren’t driven by cyclical profitability trends… but rather by credit crunches interrupting the profit cycle. This is the other part of why in 2020, when the trough was driven by forced economic closures to fight the pandemic and credit was open, the stock market rebounded so quickly.

This understanding of the credit cycle gives context to our position in the profit cycle. So long as capital remains free-flowing, companies maintain plentiful cash buffers to service their obligations, and interest rates remain stable, a hot economy alone is no reason to panic. It can actually be a sign that the economy is strong and will remain so for the foreseeable future.

Although analysts predict a minor contraction in 2022 Uniform ROA, there’s no need to worry so long as credit markets stay healthy. Corporate productivity will still be higher than it has ever been pre-pandemic.
Even when looking at market expectations, we see a reasonable picture. Based on current valuations, the market expects Uniform ROAs to expand to 13% in 2025. While this may prevent investors from reliving the surprise big gains of 2020 and the first half of 2021, there’s no reason to believe that cash stashed on the sidelines will perform better than stocks.

Not really an investable trend but one that interests me. I firmly believe that 10 years from now, we will not recognize the NCAA.

• The National Labor Relations Board (NLRB) is now jumping into the fray with some force… in 2017, when Northwestern athletes went to unionize, the NLRB issued a weak endorsement but stayed on the sidelines.
• In footnote #1, the NLRB lawyer states that the term student athlete was “created to deprive those individuals of workplace protections.”
• An employer-employee relationship clearly exists… it’s going to be interesting to watch this develop.
• Interestingly enough, this is all happening at a time when on-campus education as a whole is facing a bit of a reckoning thanks to COVID.