Last week, Donald Trump won the latest US Presidential Elections, which would see him be sworn in as the USA’s new President on 20 January 2025. Often, there’s a huge rush of investment themes that accompany the inauguration of a new political leader in a country. It’s no exception this time. 

For my own investment activities, the only theme I’m in favour of with the new Trump presidency – in fact, with any new presidency – is to look at a stock as a piece of a business, and assess the value of that business. Why? Because there’s a long history of investment themes accompanying shifts in political leadership that have soured. In a November 2014 article for The Motley Fool, Morgan Housel shared some examples:

“During the 1992 election, a popular argument was that Bill Clinton’s proposed remake of the U.S. healthcare system would be disastrous for pharmaceutical stocks… by the end of Clinton’s presidency pharmaceutical companies were some of the most valuable companies in the world. Pfizer increased 791% during Clinton’s presidency. Amgen surged 611%. Johnson & Johnson popped 385%. Merck jumped 299%. Those crushed the market, with the S&P 500 rising 251% from January 1993 to January 2001…

…During the 2000 election, Newsweek wrote that if George W. Bush wins, the ensuing tax changes could “help banks, brokers and other investment firms.” By the end of Bush’s second term, the KBW Bank Index had dropped almost 80%. The article also recommended pharmaceutical stocks thanks to Bush’s light touch on regulation. The NYSE Pharmaceutical Index lost nearly half its value during Bush’s presidency…

…During the 2008 election, many predicted that an Obama victory would be a win for green energy like solar and wind and a loss for big oil… The opposite happened: The iShares Clean Energy ETF is down 51% since then, while Chevron (CVX 0.10%) is up 110%.

During the 2012 election, Fox Business wrote that if Obama wins, “home builders such as Pulte and Toll Brothers could see increased demand for new homes due to a continuation of the Obama Administration’s efforts to limit foreclosures, keeping homeowners in their existing properties.” Their shares have underperformed the S&P 500 by 26 percentage points and 40 percentage points since then, respectively.”

It was more of the same in the presidential elections that came after Housel’s article.

When Trump won the 2016 US elections for his first term as President, CNBC proclaimed the banking sector as a strong beneficiary because of his promises to ease banking regulations. But from the day Trump was sworn into office (President-elects are typically sworn in on 20 January in the following year after the elections) till the time he stepped down four years later, the KBW Nasdaq Bank Index was up by less than 20%, whereas the S&P 500 was up by nearly 70%. The KBW Nasdaq Bank Index tracks the stock market performance of 24 of America’s largest banks.

CNBC surveyed more than 100 investment professionals shortly after Joe Biden won the 2020 elections. They thought that “consumer discretionary, industrials and financials will perform the best under a Biden administration.” From Biden’s first day as President till today, the S&P 500 is up by slightly under 60%. Meanwhile, the S&P 500 Consumer Discretionary Index, which comprises consumer discretionary companies within the S&P 500 index, has gained just around 30%. The Dow Jones Industrials Index (a collection of American industrial companies) and the KBW Nasdaq Bank Index are both also trailing the S&P 500 with their respective gains of around 40% and 20%.

I have no idea if the hot themes for Trump’s second term as President would end up performing well. But given the weight of the historical evidence, I have no interest in participating in them. Politics and investing seldom mix well.

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Economist Richard Koo (Gu Chao Ming) is the author of the book The Other Half of Macroeconomics and the Fate of Globalization. Investor Li Lu published a Mandarin review of the book in November 2019, which I translated into English in March 2020. When I translated Li’s review, I found myself nodding in agreement to Koo’s unique concept of a balance sheet recession as well as his analyses of Japan’s economic collapse in the late 1980s and early 1990s, and the Japanese government’s responses to the crash. 

When I realised that Koo was interviewed last week in an episode of the Bloomberg Odd Lots podcast to discuss the Chinese government’s recent flurry of stimulus measures, I knew I had to tune in – and I was not disappointed. In this article, I want to share my favourite takeaways (the paragraphs in italics are transcripts from the podcast)

Takeaway #1: China is currently facing a balance sheet recession, and in a balance sheet recession, the economy can shrink very rapidly and be stuck for a long time

I think China is facing balance sheet recession and balance sheet recession happens when a debt-financed bubble bursts, asset prices collapse, liabilities remain, people realise that their balance sheets’ under water or nearly so, and they all try to repair their balance sheets all at the same time…

…Suppose I have $1000 of income and I spend $900 myself. The $900 is already someone else’s income so that’s not a problem. But the $100 that I saved will go through people like us, our financial institutions, and will be lent to someone who can use it. That person borrows and spends it, then total expenditure in economy will be $900 that I spent, plus $100 that this guy spent, to get $1000 against original income of $1000. That’s how economy moves forward, right? If there are too many borrowers and economy is doing well, central banks will raise rates. Too few, central bank will lower rates to make sure that this cycle is maintained. That’s the usual economy.

But what happens in the balance sheet recession is that when I have $1000 in income and I spend $900 myself, that $900 is not a problem. But the $100 I decide to save ends up stuck in the financial system because no one’s borrowing money. And China, so many people are refusing to borrow money these days because of that issue. Then economy shrinks from $1000 to $900, so 10% decline. The next round, the $900 is someone else’s income, when that person decides to save 10% and spends $810 and decides to save $90, that $90 gets stuck in the financial system again, because repairing financial balance sheets could take a very long time. I mean, Japanese took nearly 20 years to repair their balance sheets.

But in the meantime, economy can go from $1000, $900, $810, $730, very, very quickly. That actually happened in United States during the Great Depression. From 1929 to 1933, the United States lost 46% of its nominal GDP. Something quite similar actually happened in Spain after 2008when unemployment rates skyrocketed to 26% in just three and a half years or so. That’s the kind of danger we face in the balance sheet recession.

Takeaway #2: Monetary policy (changing the level of interest rates) is not useful in dealing with a balance sheet recession – what’s needed is fiscal policy (government spending), but it has yet to arrive for China

I’m no great fan of using monetary policy, meaning policies from the central bank to fight what I call a balance sheet recession…

…Repairing balance sheets of course is the right thing to do. But when everybody does it all at the same time, we enter the problem of fallacy of composition, in that even though everybody’s doing the right things, collectively we get the wrong results. And we get that problem in this case because in the national economy, if someone is repairing balance sheets, meaning paying down debt or increasing savings, someone has to borrow those funds to keep the economy going. But in usual economies, you bring interest rates down, there’ll be people out there willing to borrow the money and spend it. That’s how you keep the economy going.

But in the balance sheet recession, you bring interest rates down to very low levels – and Chinese interest rates are already pretty low. But even if you bring it down to zero, people will be still repairing balance sheets because if you are in negative equity territory, you have to come out of that as quickly as possible. So when you’re in that situation, you cannot expect private sector to respond to lowering of interest rates or quantitative easing, forward guidance, and all of those monetary policy, to get this private sector to borrow money again because they are all doing the right things, paying down debt. So when you’re in that situation, the economy could weaken very, very quickly because all the saved funds that are returned to the banking system cannot come out again. That’s how you end up with economy shrinking very, very rapidly.

The only way to stop this is for the government, which is outside of the fallacy of composition, to borrow money. And that’s the fiscal policy of course, but that hasn’t come out yet. And so yes, they did the quick and easy part with big numbers on the monetary side. But if you are in balance sheet recession, monetary policy, I’m afraid is not going to be very effective. You really need a fiscal policy to get the economy moving and that hasn’t arrived yet.

Takeaway #3: China’s fiscal policy for dealing with the balance sheet recession needs to be targeted, and a good place to start would be to complete all unfinished housing projects in the country, followed by developing public works projects with a social rate of return that’s higher than Chinese government bond yields

If people are all concerned about repairing their balance sheets, you give them money to spend and too often they just use it to pay down debt. So even within fiscal stimulus, you have to be very careful here because tax cuts I’m afraid, are not very effective during balance sheet recessions because people use that money to repair their balance sheets. Repairing balance sheets is of course the right thing to do, but it will not add to GDP when they’re using that tax cuts to pay down debt or rebuild their savings. So that will not add to consumption as much as you would expect under ordinary circumstances. So I would really like to see government just borrow and spend the money because that will be the most effective way to stop the deflationary spiral…

… I would use money first to complete all the apartments that were started but are not yet complete. In that case you might have to take some heavy handed actions, but basically the government should take over these companies and the projects, and start putting money so that they’ll complete the projects. That way, you don’t have to decide what to make, because the things that are already in the process of being built – or the construction drawings are there, workers are there, where to get the materials. And in many cases, potential buyers already know. So in that case, you don’t waste time thinking about what to build, who’s to design, and who the order should go to.

Remember President Obama, when he took over 2009, US was in a balance sheet recession after the collapse of the housing bubble. But he was so careful not to make the Japanese mistake of building bridges to nowhere and roads to nowhere. He took a long time to decide which projects should be funded. But that year-and-a-half or so, I think the US lost quite a bit of time because during that time, economy continued to weaken. There were no shovel-ready projects.

But in the Chinese case, I would argue that these uncompleted apartments are the shovel-ready projects. You already know who wants them, who paid their down payments and all of that. So I will spend the money first on those projects, complete those projects, and use the time while the money is used to complete these apartments.

I would use the magic wand to get the brightest people in China to come into one room and ask them to come up with public works projects with a social rate of return higher than 2.0%. The reason is that Chinese government bond is about 2.00-something. If these people can come up with public works projects with a social rate of return higher than let’s say 2.1%, then those projects will be basically self-financing. It won’t be a burden on future taxpayers. Then once apartments are complete, then the economy still is struggling from balance sheet recession, then I would like to spend the money on those projects that these bright people might come up with.

Takeaway #4: The central government in China actually has a budget deficit that is a big part of the country’s GDP, unlike what official statistics say

But in China, even though same rules should have applied, local governments were able to sell lots of land, make a lot of money in the process, and then they were able to do quite a bit of fiscal stimulus, which also of course added to their GDP. That model will have to be completely revised now because no one wants to buy land anymore. So the big source of revenue of local governments are gone and as a result, many of them are very close to bankrupt. Under the circumstances, I’m afraid central government will have to take over a lot of these problems from the local government. So this myth that Chinese central government, the budget deficit is not a very big part of GDP, that myth will have to be thrown out. Central government will have to take on, not all of it perhaps, but some of the liabilities of the local governments so that local governments can move forward.

Takeaway #5: There’s plenty of available-capital for the Chinese central government to borrow from, and the low yields of Chinese government bonds are a sign of this

So even though budget deficit of China might be very large, the money is there for government to borrow. If the money is not there for the government to borrow, Chinese government bond yields should have gone up higher and higher. But as you know, Chinese government 10-year government bond yields almost down to 2.001% or 2%. It went that low because there are not enough borrowers out there. Financial institutions have to place this money somewhere, all these deleveraged funds coming back into the financial institutions, newly generated savings, all the money that central bank put in, all comes to basically people like us in the financial institutions, the fund managers. But if the private sector is not borrowing money, the only borrower left is the government.

So even if the required budget deficit might be very large to stabilize the economy, the funds are available in the financial market. Only the government just have to borrow that and spend it. So financing should not be a big issue for governments in balance sheet recession. Japan was running huge budget deficits and a lot of conventional minded economists who never understood the dynamics of balance sheet recession was warning about Japan’s budget deficit growing sky high, and then interest rates going sky high. Well, interest rates kept on coming down because of the mechanism that I just described to you, that all those funds coming into the financial sector cannot go to the private sector, end up going to our government bond market. And I see the same pattern developing in China today.

Takeaway #6: Depending on exports is a great way for a country to escape from a balance sheet recession, but this route is not available for China because its economy is already running the largest trade surplus in the world

Export is definitely one of the best ways if you can use it, to come out of balance sheet recession. But China, just like Japan 30 years ago, is the largest trade surplus country in the world. And if the world’s largest trade surplus country in the world tries to export its way out, very many trading partners will complain. You are already such a large destabilizing factor on the world trade, now you’re going to destabilize it even more.

I remember 30 years ago that United States, Europe, and others were very much against Japan trying to export its way out. Because of their displeasure, particularly the US displeasure, Japanese yen, which started at 160 yen when the bubble burst in 1990, ended up 80 yen to the dollar, five years later, 1995. What that indicated to me was that if you’re running trade deficit, you can probably export your way out and no one can really complain because you are a deficit country to begin with. But if you are the surplus country, and if you’re the largest trade surplus country in the world, there will be huge pushback against that kind of move by the Chinese. We already seeing that, in very many countries complaining that China should not export its problems.

Takeaway #7: Regulatory uncertainties for businesses that are caused by the Chinese central government may have played a role in the corporate sector’s unwillingness to borrow

Aside from a balance sheet recession, which is a very, very serious disease to begin with, we have those other factors that started hurting the Chinese economy, I would say, starting as early as 2016.

When you look at the flow of funds data for the Chinese economy, you notice that the Chinese corporate sector started reducing their borrowings, starting around 2016. So until 2016, Chinese companies were borrowing all the household sector savings generated, which is of course the ideal world. The household sector saving money, the corporate sector borrowing money. But starting around 2016, you see corporate sector borrowing less and less. And at around the Covid time, corporate sector was actually a net saver, not a net borrower. So that trend, I think has to do with what you just described, that regulatory uncertainties got bigger and bigger under the current leadership and I think people began to realize that even after you make these big investments in the new projects, they may not be able to expect the same revenue stream that they expected earlier because of this regulatory uncertainty.

Takeaway #8: China’s economy was already running a significant budget deficit prior to the bubble bursting, and this may have made the central government reluctant to step in as borrower of last resort now to fix the balance sheet recession

If the household sector is saving money, but the corporate sector is not borrowing money, you need someone else to fill that gap. And actually that gap was filled by Chinese government, mostly decentralized local governments. But if that temporary fiscal jolt of fiscal stimulus then turn the economy around, then those local government interventions would’ve been justified. But because this was a much more deeply rooted – here, I would use structural problems, this regulatory uncertainties and middle income trap and so forth – local government just had to keep on borrowing and spending money to keep the economy going. That was happening long before the bubble burst. So if you look at total, or what I call general government spending – not just the central government, but the general government – they were financial deficit to the tune of almost 7% of GDP by 2022. This is before the bubble bursting.

So if you are already running a budget deficit, 7% of GDP before the onset of balance sheet recession, then whatever you have to do to stop balance sheet recession, we have to be on top of the 7%. Suppose you need 5% GDP equivalent to keep the economy going, then you’re talking about 12% of GDP budget deficit. I think that’s one of the reasons why Chinese policy makers, even though many of them are fully aware that in the balance sheet recession, you need the government to come in, they haven’t been able to come to a full consensus yet because even before the bubble burst, Chinese government was writing a large budget deficit.

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

After years of investing in stocks, I’ve noticed that stock market participants place a lot of emphasis on how recessions and changes in interest rates affect stocks. This topic is even more important right now for investors in US stocks, given fears that a recession could happen soon in the country, and the interest rate cut last month by the Federal Reserve, the country’s central bank. I have no crystal ball, so I have no idea how the US stock market would react if a recession were to arrive in the near future and/or the Federal Reserve continues to lower interest rates.   

What I have is historical context. History is of course not a perfect indicator of the future, but it can give us context for possible future outcomes. I’ve written a few articles over the years in this blog discussing the historical relationships between stocks, recessions, and movements in interest rates, some of which are given below (from oldest to the most recent):

• Points 16, 22, and 23 in 24 Facts About The Wild World Of Finance and Investing
• The Thing About The Coronavirus, Market Meltdowns, And Recessions…
• The Truths About Investing In Stocks During Recessions
• Recession and Stocks
• Risk-Free Rates and Stocks
• Stocks and Interest Rate Cuts

I thought it would be useful to collect the information from these separate pieces into a single place, so here goes!

The history of recessions and stocks

These are the important historical relationships between recessions and stocks:

• It’s not a given that stocks will definitely fall during a recession. According to a June 2022 article by Ben Carlson, Director of Institutional Asset Management at Ritholtz Wealth Management, there have been 12 recessions in the USA since World War II (WWII). The average return for the S&P 500 (a broad US stock market benchmark) when all these recessions took place was 1.4%. There were some horrible returns within the average. For example, the recession that stretched from December 2007 to June 2009 saw the S&P 500 fall by 35.5%. But there were also decent returns. For the recession between July 1981 and November 1982, the S&P 500 gained 14.7%.
• Holding onto stocks in the lead up to, through, and in the years after a recession, has mostly produced good returns. Carlson also showed in his aforementioned article that if you had invested in the S&P 500 six months prior to all of the 12 recessions since WWII and held on for 10 years after each of them, you would have earned a positive return on every occasion. Furthermore, the returns were largely rewarding. The worst return was a total gain of 9.4% for the recession that lasted from March 2001 to November 2001. The best was the first post-WWII recession that happened from November 1948 to October 1949, a staggering return of 555.7%. After taking away the best and worst returns, the average was 257.2%. 
• Avoiding recessions flawlessly would have caused your return to drop significantly. Data from Michael Batnick, Carlson’s colleague at Ritholtz Wealth Management, showed that a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint.
• Stocks tend to bottom before the economy does. The three most recent recessions in the USA prior to COVID-19 would be the recessions that lasted from July 1990 to March 1991, from March 2001 to November 2001, and from December 2007 to June 2009. During the first recession in this sample, data on the S&P 500 from Yale economist Robert Shiller, who won a Nobel Prize in 2013, showed that the S&P 500 bottomed in October 1990. In the second episode, the S&P 500 found its low 15 months after the end of the recession, in February 2003. This phenomenon was caused by the aftermath of the dotcom bubble’s bursting. For the third recession, the S&P 500 reached a trough in March 2009, three months before the recession ended. Moreover, after the December 2007 – June 2009 recession ended, the US economy continued to worsen in at least one important way over the next few months. In March 2009, the unemployment rate was 8.7%. By June, it rose to 9.5% and crested at 10% in October. But by the time the unemployment rate peaked at 10%, the S&P 500 was 52% higher than its low in March 2009. Even if we are right today that the economy would be in worse shape in the months ahead, stocks may already have bottomed or be near one – only time can tell.
• The occurrence of multiple recessions has not stopped the upward march of stocks. The logarithmic chart below shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over these 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy having encountered numerous recessions. If you’re investing for the long run, recessions are nothing to fear.

The history of interest rates and stocks

These are the important historical relationships between interest rates and stocks:

• Rising interest rates have been met with rising valuations. According to Robert Shiller’s data, the US 10-year Treasury yield was 2.3% at the start of 1950. By September 1981, it had risen to 15.3%, the highest rate recorded in Shiller’s dataset. In that same period, the S&P 500’s price-to-earnings (P/E) ratio moved from 7 to 8. In other words, the P/E ratio for the S&P 500 increased slightly despite the huge jump in interest rates. It’s worth noting too that the S&P 500’s P/E ratio of 7 at the start of 1950 was not a result of earnings that were temporarily inflated. Yes, there’s cherry picking with the dates. For example, if I had chosen January 1946 as the starting point, when the US 10-year Treasury yield was 2.2% and the P/E ratio for the S&P 500 was 19, then it would be a case of valuations falling alongside rising interest rates. But this goes to show that while interest rates have a role to play in the movement of stocks, it is far from the only thing that matters.
• Stocks have climbed in rising interest rate environments. In a September 2022 piece, Carlson showed that the S&P 500 climbed by 21% annually from 1954 to 1964 even when the yield on 3-month Treasury bills (a good proxy for the Fed Funds rate, which is the key interest rate set by the Federal Reserve) surged from around 1.2% to 4.4% in the same period. In the 1960s, the yield on the 3-month Treasury bill doubled from just over 4% to 8%, but US stocks still rose by 7.7% per year. And then in the 1970s, rates climbed from 8% to 12% and the S&P 500 still produced an annual return of nearly 6%.
• Stocks have done poorly in both high and low interest rate environments, and have also done well in both high and low interest rate environments. Carlson published an article in February 2023 that looked at how the US stock market performed in different interest rate regimes. It turns out there’s no clear link between the two. In the 1950s, the 3-month Treasury bill (which is effectively a risk-free investment, since it’s a US government bond with one of the shortest maturities around) had a low average yield of 2.0%; US stocks returned 19.5% annually back then, a phenomenal gain. In the 2000s, US stocks fell by 1.0% per year when the average yield on the 3-month Treasury bill was 2.7%. Meanwhile, a blockbuster 17.3% annualised return in US stocks in the 1980s was accompanied by a high average yield of 8.8% for the 3-month Treasury bill. In the 1970s, the 3-month Treasury bill yielded a high average of 6.3% while US stocks returned just 5.9% per year. 
• A cut in interest rates by the Federal Reserve is not guaranteed to be a good or bad event for stocks. Josh Brown, CEO of Ritholtz Wealth Management, shared fantastic data in an August 2024 article on how US stocks have performed in the past when the Federal Reserve lowered interest rates. His data, in the form of a chart, goes back to 1957 and I reproduced them in tabular format in Table 1; it shows how US stocks did in the next 12 months following a rate cut, as well as whether a recession occurred in the same window. I also split the data in Table 1 according to whether a recession had occurred shortly after a rate cut, since eight of the 21 past rate-cut cycles from the Federal Reserve since 1957 took place without an impending recession. Table 2 shows the same data as Table 1 but for rate cuts with a recession; Table 3 is for rate cuts without a recession. What the data show is that US stocks have historically done well, on average, in the 12 months following a rate-cut. The overall record, seen in Table 1, is an average 12-month forward return of 9%. When a recession happened shortly after a rate-cut, the average 12-month forward return is 8%; when a recession did not happen shortly after a rate-cut, the average 12-month forward return is 12%. A recession is not necessarily bad for stocks. As Table 2 shows, US stocks have historically delivered an average return of 8% over the next 12 months after rate cuts that came with impending recessions. It’s not a guarantee that stocks will produce good returns in the 12 months after a rate cut even if a recession does not occur, as can be seen from the August 1976 episode in Table 3.

Conclusion

Knowing how stocks have performed in the past in the context of recessions and changes in interest rates provides us with possible paths that stocks could take in the future. But it’s also worth bearing in mind that anything can happen in the financial markets. Things that have never happened before do happen, so there are limits to learning from history. Nonetheless, there’s a really important lesson from all the data seen above that I think is broadly applicable even far into the future, and it is that one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any company mentioned. Holdings are subject to change at any time. 

Editor’s note: We’re testing out a new series for the blog, the “Company Notes Series”, where we periodically share our notes on companies we’ve studied in the recent past but currently have no vested interest in (we may invest in or sell shares in the companies mentioned at any time). The notes are raw and not updated, and the “as of” date for the data is given at the start of the notes. The first edition in the series can be found here. Please give us your thoughts on the series through the “Contact Us” page; your feedback will determine if we continue with it. Thanks in advance!

---

Start of notes for BayCurrent Consulting

Data as of 31 May 2023

Background

• Founded in March 1998 as PC Works Co. Ltd for the purpose of consulting, system integration and outsourcing related to management, operations and IT. In December 2006, PC Works Co. Ltd changed its name to BayCurrent Consulting Co. Ltd. In April 2014, Byron Holdings Co. Ltd was set up. In June 2014, Byron Holdings Co. Ltd acquired BayCurrent Consulting Co. Ltd and then the combined entity changed its name to BayCurrent Consulting Co. Ltd.
• HQ: Tokyo, Japan
• Listed on September 2016 on the Tokyo Stock Exchange Mother’s section; moved to First Section of Tokyo Stock Exchange on December 2018; moved to Prime Market of the Tokyo Stock Exchange on April 2022
• Ticker: TSE: 6532
• Total number of consultants as of FY2023 (financial year ended February 2023) is 2,961; total number of employees as of FY2023 is 3,310

Business

• BayCurrent is a consulting firm that supports a wide range of themes such as strategy, digital, and operations for Japan’s leading companies in various industries. BayCurrent provides planning and execution support to clients, such as company-wide strategy planning and business strategy planning to support decision-making by management, and support for examining business operations using digital technology.
• Examples of the projects that BayCurrent is currently working on under Digital Consulting:
  • Finance, Cashless payment, and Design: Building a UX improvement process to continue achieving high customer satisfaction over the long term
  • Pharmaceutical manufacturing, Digital technologies, and Market research: Formulating plans to enter the Japanese market of advanced digital medical equipment business for foreign companies 
  • Telecommunication, Metaverse, and Business planning: Developing plans to use metaverse and examine the use of AI toward the smart city concept
  • Automobiles, AI, and Business creation: Building a model for business using AI and supporting its implementation, aiming to reduce the risk of traffic accidents
• Examples of the projects that BayCurrent is currently working on under Sustainability Consulting:
  •  Energy, ESG, and Support for practice: Forming a scheme and supporting negotiations for realizing offshore wind power business
  • Finance and Carbon neutrality: Considering policies in response to TCFD (Task Force on Climate-Related Financial Disclosures) in anticipation of sales of solutions in the future
  • High-tech, EV, and Business planning: Considering business domains and creating a road map for popularizing EVs (electric vehicles) to reduce CO2 emissions
  • Manufacturing, ESG, and Supply chain management: Considering the possibility of commercializing supplier ESG assessments and risk management
• See also Figures 1, 2, 3, and 4 for examples of BayCurrent’s projects

• BayCurrent groups its customers into three industry categories: Finance (banking, securities, insurance etc); Telecommunications/Media/High-Tech; and Others (energy, entertainment, government offices, food etc). In FY2023, 25% of revenue was from Finance, 35% was from Telecommunications/Media/High-Tech, and 40% from Others. In FY2019, the split was 40% from Finance, 30% from Telecommunications/Media/High-Tech, and 30% from Others. BayCurrent’s largest customer in FY2023 was Pfizer Japan, accounting for 12.0% of revenue; it seems like there’s no other company that accounted for more than 10% of revenue during the year.
• In FY2023, revenue from customers based in Japan was at least 90% of BayCurrent’s total revenue.

Market opportunity

• According to IDC Japan’s “Forecast for domestic business consulting market: 2021-2025” (announced on 1 July 2021), the Japanese consulting market is expected to have a CAGR of 7.8% from around ¥900 billion in 2020 to more than ¥1.2 trillion in 2025; within the consulting market is the digital consulting sub-segment which is expected to have a CAGR of 30.1% from more than ¥100 billion in 2020 to around ¥500 billion in 2025. BayCurrent ended FY2023 with revenue of just ¥76.1 billion.
• According to BayCurrent: “In today’s business environment, the challenges faced by corporate managers are becoming more diverse and complex due to intensifying market competition and changes in market structure. There is a growing need for consultants with a high level of expertise. Furthermore, with the further development of digital technology in the future, the need for the utilization of new technologies in business is expected to increase year by year, and the consulting market is expected to continue to grow at a high rate.”
• In Japan, there’s an initiative called DX (Digital Transformation) that began to be promoted heavily by the Japanese government starting in 2018 with the publication of the “DX [Digital Transformation]” report by the Ministry of Economy, Trade, and Industry (METI) during the year. METI warned that Japan would face an economic loss of ¥12 trillion per year by 2025 if traditional mainframes and backbone core systems were not updated and the shortage of ICT engineers were not addressed. Moreover, in 2016, the percentage of companies that have been operating their core systems for 21 years or more is 20%, and 40% for companies that have been in operation for 11 to 20 year; if this situation continues in 10 years, in 2025, the percentage of companies that have been operating core systems for 21 years or more will be 60%. Japanese companies appear to have heeded the government’s DX call. Surveys conducted by the METI and FUJITSU in 2020 indicated that almost half of the SMEs were actively promoting DX companywide, while large companies with more than 5.000 employees indicate an adoption rate close to 80%. These are a tailwind for BayCurrent Consulting.

Growth strategy

• BayCurrent is focused on further increasing the added value of its consulting services; the recruitment and training of human resources; and providing an attractive work environment. 
• BayCurrent’s support services for corporate managers in all industries are knowledge-intensive, and so management believes that improvements in the company’s consultants’ ability to make proposals and solve problems will affect its growth. For this reason, management strives to recruit excellent human resources with various backgrounds and focusing on creating an environment and treatment that makes it easy for each consultant to work with peace of mind. Management has established a wide variety of training programs and study sessions to improve its consultants’ skills for strategic planning and solving management issues. Management believes that BayCurrent is able to formulate viable strategies that meet the needs of clients precisely because the company’s consultants are professionals who have worked on numerous projects across industries and service areas; for this reason, management strives to not limit its consultants to specific fields. Figure 5 shows the establishment of the BayCurrent Institute, a business management research institute.
• Management also distributes knowledge obtained through dialogue with university professors working on research subjects and members of the management teams of leading companies, in order to gain visibility from the public. Most recent examples of such work:
  • Participated in FIN/SUM, one of Japan’s largest fintech conferences, co-hosted by the Financial Services Agency and Nikkei Inc. BayCurrent did the following: Joji Noritake, Managing Executive Officer and CDO, conducted a standalone lecture on “Sustainable customer experience connects emotional memories”; took part in panel discussion on “Possibility of future individual investment through digital technology”
  • Participation in Green CPS Consortium, an organization aimed at building eco-friendly industry and society by controlling material loss, energy loss, and other aspects in all economic activities while driving economic growth
  • Made a donation to the VR/metaverse in the corporate sponsored practical research program of the University of Tokyo Virtual Reality Educational Research Center. The research program conducts basic research on the creation and operation of metaverse space and conducts demonstration experiments to develop practical applications of the metaverse in society. 
• Growth of number of consultants vs growth of revenue (note the higher revenue growth vs consultant growth):

Financials

• Financials from FY2016 to FY2023 (financials in ¥; earliest data we could find was for FY2016): 

• Solid CAGRs in revenue:
  • FY2016-FY2023: 25.1%
  • FY2018-FY2023: 30.1%
  • FY2023: 32.4%
• Profitable since at least FY2016. Net income CAGRs and average net income margins:
  • FY2016-FY2023: 52.3% CAGR, 15.3% average margin
  • FY2018-FY2023: 60.3% CAGR, 18.1% average margin
  • FY2023: 43.3% growth, 27.6% margin
• Positive operating cash flow since at least FY2016. Operating cash flow CAGRs and average operating cash flow margins:
  • FY2016-FY2023: 34.0% CAGR, 19.4% average margin
  • FY2018-FY2023: 45.0% CAGR, 21.6% average margin
  • FY2023: 35.5% growth, 27.2% margin
• Free cash flow positive since at least FY2016. Free cash flow CAGRs and average free cash flow margins:
  • FY2016-FY2023: 34.0% CAGR, 19.1% average margin
  • FY2018-FY2023: 45.8% CAGR, 21.3% average margin
  • FY2023: 33.6% growth, 26.7% margin
• Balance sheet was initial in net-debt position and became net-cash in FY2020 onwards; high net-cash position of ¥33 billion in FY2023
• Minimal dilution as weighted average diluted share count increased by only 0.8% per year for FY2016-FY2023, and -0.3% in FY2023
• Management aims for a total shareholder return ratio (dividends and share buybacks) of around 40% of earnings; dividend payout ratio is typically 20%-30% under IFRS. In FY2023, interim dividend of ¥14 per share (adjusting for 1-for-10 stock split in November 2022) and final dividend of ¥23 per share, for a total dividend of ¥37 per share for FY2023, representing a payout ratio of 27%.

Management

• Yoshiyuki Abe, 57, is President and CEO. Became President in December 2016. Joined the original BayCurrent Consulting Co. Ltd in September 2008 and became an executive director in November of same year. Yoshiyuki Abe became President in December 2016 after some major turmoil at BayCurrent that happened in H2 2016:
  • Failed to gain deals matching waiting consultants and then suffered a largely lowered operation rate
  • Additionally faced the defection of employees as a result of a talk about withdrawal that resulted in the loss of credibility of the clients receiving the support for many years
  • Revised earnings forecasts downwardly on 9 December 2016; on the same day, the former President left office
• Kentaro Ikehira, 46, is Executive Vice President. Became Vice President in May 2021. Joined the original BayCurrent Consulting Co. Ltd in September 2007.
• Kosuke Nakamura, 41, is CFO. Became CFO in May 2021. Joined the original BayCurrent Consulting Co. Ltd in January 2007.
• Management has a long history of significantly beating their own mid-term growth projections. Examples:
  • In FY2018 earnings presentation, a projection for FY2019-FY2021 was given where revenue was expected to have a CAGR of 15%-20%, ending at ¥32-35 billion. Actual FY2021 revenue was ¥42.8 billion. 
  • In FY2022 earnings presentation, a projection for FY2022-FY2026 was given where revenue was expected to have a CAGR of 20% to end at ¥100 billion and EBITDA was expected to end at ¥30 billion. Projection given for FY2024 was for revenue of ¥94.6 billion and EBITDA of ¥36 billion – so FY2026 medium-term projection could be achieved/beat by as early as FY2024
• Management has set a target of FY2029 revenue of ¥250 billion, which represents a 20% CAGR from FY2024’s projected revenue of ¥94.6 billion.

Compensation of Management

• Yoshiyuki Abe’s total FY2023 compensation was ¥333 million, consisting of ¥40 million of fixed pay, ¥192 million of performance-linked remuneration, and ¥101 million of restricted stock compensation. Total compensation in FY2023 was just 1.6% of FY2023 net income as well as free cash flow. 
• Yoshiyuki Abe’s tota FY2022 compensation was ¥297 million, FY2021 compensation was ¥206 million, and FY2020 compensation was ¥137 million.
• Comparison of Yoshiyuki Abe’s compensation growth vs BayCurrent’s revenue/net income/FCF growth over past few years:

Valuation (as of 31 May 2023)

• 31 May 2023 share price of ¥5,110
• Trailing revenue per share is ¥496.47, hence PS is 10.3
• Trailing diluted EPS is ¥137.19, hence PE is 37.2
• Trailing FCF per share is ¥132.71, hence PFCF is 38.5
• Reminder that revenue growth projection for FY2029 is for CAGR of 20% from FY2024 – the valuation does not look too rich if BayCurrent is able to grow as projected 

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have no vested interest in any company mentioned. Holdings are subject to change at any time.

Last week, the Federal Reserve, the USA’s central bank, opted to lower the federal funds rate (the key interest rate controlled by it) by 50 basis points, or 0.5%. The move, both before and after it was announced, was heavily scrutinised by market participants. There’s a wide-held belief that the Federal Reserve wields tremendous influence over nearly all aspects of financial market activity in the USA.

But Aswath Damodaran, the famed finance professor from New York University, made an interesting observation in a recent blog post: The Federal Reserve actually does not have anywhere close to the level of influence over America’s financial markets as many market participants think.

In his post, Damodaran looked at the 249 calendar quarters from 1962 to 2024, classified them according to how the federal funds rate changed, and compared the changes to how various metrics in the US financial markets moved. There were 96 quarters in the period where the federal funds rate was raised, 132 quarters where it was cut, and 21 quarters where it was unchanged. Some examples of what he found:

• A median change of -0.01% in the 10-year Treasury rate was seen in the following quarter after the 96 quarters where the federal funds rate increased, whereas a median change of 0.07% was seen in the following quarter after the 132 quarters where the federal funds rate was lowered. Put another way, the 10-year Treasury rate has historically tended to (1) decrease when the federal funds rate increased, and (2) increase when the federal funds rate decreased. This means that the Federal Reserve has very little control over longer-term interest rates. 
• A median change of -0.13% in the 15-year mortgage rate was seen in the following quarter after the quarters where the federal funds rate increased, whereas a median change of -0.06% was seen in the following quarter after the quarters where the federal funds rate was lowered. It turns out that the Federal Reserve also exerts little control over the types of interest rates that consumers directly interact with on a frequent basis.
• A median change of 2.85% in US stocks was seen in the following quarter after the quarters where the federal funds rate increased, a median change of 3.07% was seen in the following quarter after the quarters where the federal funds rate was lowered, and a median change of 5.52% was seen in the following quarter after the quarters where the federal funds rate was unchanged. When discussing the stock-market related data, Damodaran provided a provocative question and answer: 

“At the risk of disagreeing with much of conventional wisdom, is it possible that the less activity there is on the part of the Fed, the better stocks do? I think so, and stock markets will be better served with fewer interviews and speeches from members of the FOMC and less political grandstanding (from senators, congresspeople and presidential candidates) on what the Federal Reserve should or should not do.”

I have always paid scant attention to what the Federal Reserve is doing when making my investing decisions. My view, born from observations of financial market history* and a desire to build a lasting investment strategy, is that business fundamentals trump macro-economics. Damodaran’s data lends further support for my stance to mostly ignore the Federal Reserve’s actions when I assess opportunities in the stock market. 

*A great example can be found in Berkshire Hathaway, Warren Buffett’s investment conglomerate. Berkshire produced an 18.7% annual growth rate in its book value per share from 1965 to 2018, which drove a 20.5% annual increase in its stock price. Throughout those 53 years, Berkshire endured numerous macro worries, such as the Vietnam War, the Black Monday stock market crash, the “breaking” of the Bank of England, the Asian Financial Crisis, the bursting of the Dotcom Bubble, the Great Financial Crisis, Brexit, and the US-China trade war. Damodaran’s aforementioned blog post also showed that the federal funds rate moved from around 5% in the mid-1960s to more than 20% in the early-1980s and then to around 2.5% in 2018. And yet, an 18.7% input (Berkshire’s book value per share growth) still resulted in a 20.5% output (Berkshire’s stock price growth).

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have no vested interest in any company mentioned. Holdings are subject to change at any time.

Over the past few years, I have observed the different ways that companies conduct their share buybacks. This made me realise that the way a company conducts its share buybacks can have a profound impact on the long term returns of its stock.

Here are some share buyback strategies and what they mean for shareholders.

Opportunistic

The best way to conduct share buybacks is what I term as opportunistic buybacks. This means buying back shares aggressively when shares are undervalued and vice versa.

An example of a company that does this very well is the US-listed company Medpace, which helps drugmakers run drug trials. 

In 2022, when markets and its own stock price were down, Medpace took the opportunity to buy back its shares aggressively. The company tapped the debt markets to procure more capital to buyback shares, to the extent that its net-cash position of US$314 million at the end of 2021 flipped to a net-debt position of US$361 million as of 30 June 2022.

But as its stock price went up, Medpace became less enthusiastic about buying back shares and instead started to pay off the debt it incurred; the company ended 2022 with a lower net-debt position of US$180 million

This type of opportunistic buyback strategy is the most efficient buyback strategy in my opinion.

The plot below shows the amount spent by Medpace on buy backs over the last 3 years.

With its stock price now at a much higher level, Medpace has not conducted buybacks for the last four quarters. Medpace’s management team is likely waiting for its shares to fall to a lower valuation before they conduct buybacks again.

Regular buybacks

Another way to conduct buybacks is to do it on a regular basis. The parent of Google, Alphabet, is one such company that has conducted very regular buybacks. In the past 10 quarters, Alphabet has consistently spent close to US$15 billion a quarter on buybacks. This includes quarters when the company’s free cash flow was less than US$15 billion.

Although I prefer opportunistic buybacks, regular buybacks may be best suited for a company such as Alphabet which has to deploy large amounts of capital. Alphabet’s shares have also consistently traded at a reasonable valuation over the last few years, making regular buybacks a decent strategy.

The chart below shows the amount that Alphabet spent on buybacks in each quarter for the last 10 quarters. 

Poor timing

At the other end of the spectrum, some companies try to time their buybacks but end up being aggressive with buybacks at the wrong time.

Take Adobe, the owner of Photoshop, for example.

Adobe seems to change the level of aggressiveness in its share buybacks from quarter to quarter.

In the first quarter of 2022 , Adobe’s stock price was close to all-time highs, but the company was very aggressive with buybacks and spent more than US$2 billion – or 143% of its free cash flow in the quarter – to repurchase its shares. 

When its stock price started falling later that year, instead of taking advantage of the lower price, Adobe surprisingly cut down on its buybacks to slightly over US$1 billion a quarter, less than what it generated in free cash flow during those periods. So far in 2024, Adobe has again increased its buybacks after its stock price increased.

The optimum strategy would have been to do more buybacks when its stock price was low and less buybacks when its stock price was high.

Bottom line

Buybacks can be a great way to add value to shareholders. However, it is vital that companies conduct buybacks at low valuations to maximise the use of their capital to generate long term returns for shareholders. 

Medpace is an excellent example of great capital allocation, even going so far as to tap the debt markets to be even more aggressive with buybacks when its stock price is low. In the middle, we have companies such as Alphabet that consistently buyback shares. But on the other end of the spectrum is Adobe that seems to become more aggressive with buybacks at the wrong times.

Hopefully, more companies can follow in the footsteps of Medpace and make sure they put their capital to use only when the time is right.

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Adobe, Alphabet, and Medpace. Holdings are subject to change at any time.

In Pain Before Gain, I shared Walmart’s past business growth and corresponding stock price movement (emphases are new):

“From 1971 to 1980, Walmart produced breath-taking business growth. The table below shows the near 30x increase in Walmart’s revenue and the 1,600% jump in earnings per share in that period. Unfortunately, this exceptional growth did not help with Walmart’s short-term return… Walmart’s stock price fell by three-quarters from less than US$0.04 in late-August 1972 to around US$0.01 by December 1974 – in comparison, the S&P 500 was down by ‘only’ 40%. But by the end of 1979 (when inflation in the USA peaked during the 1970s), Walmart’s stock price was above US$0.08, more than double what it was in late-August 1972 (when inflation was at a low in the 1970s)…

…At the end of 1989, Walmart’s stock price was around US$3.70, representing an annualised growth rate in the region of 32% from August 1972; from 1971 to 1989, Walmart’s revenue and earnings per share grew by 41% and 38% per year…

…It turns out that in late-August 1972, when its stock price was less than US$0.04, Walmart’s price-to-earnings (P/E) ratio was between 42 and 68… This is a high valuation… at Walmart’s stock price in December 1974, after it had sunk by 75% to a low of around US$0.01 to carry a P/E ratio of between 6 and 7 the easy conclusion is that it was a mistake to invest in Walmart in August 1972 because of its high valuation. But as can be seen above, Walmart’s business continued to grow and its stock price eventually soared to around US$3.70 near the end of 1989. Even by the end of 1982, Walmart’s stock price was already US$0.48, up more than 10 times where it was in late-August 1972.”

In When Genius Failed (temporarily)*, I explored a little-discussed aspect of Teledyne’s history (emphasis is from the original passage) :

“Warren Buffett once said that Singleton “has the best operating and capital deployment record in American business… if one took the 100 top business school graduates and made a composite of their triumphs, their record would not be as good.”

Singleton co-founded Teledyne in 1960 and stepped down as chairman in 1990… According to The Outsiders, a book on eight idiosyncratic CEOs who generated tremendous long-term returns for their shareholders, Teledyne produced a 20.4% annual return from 1963 to 1990, far ahead of the S&P 500’s 8.0% return. Distant Force, a hard-to-obtain memoir on Singleton, mentioned that a Teledyne shareholder who invested in 1966 “was rewarded with an annual return of 17.9 percent over 25 years, or a return of 53 times his invested capital.” In contrast, the S&P 500’s return was just 6.7 times in the same time frame… 

…based on what I could gather from Distant Force, Teledyne’s stock price sunk by more than 80% from 1967 to 1974. That’s a huge and demoralising decline for shareholders after holding on for seven years, and was significantly worse than the 11% fall in the S&P 500 in that period. But even an investor who bought Teledyne shares in 1967 would still have earned an annualised return of 12% by 1990, outstripping the S&P 500’s comparable annualised gain of 10%. And of course, an investor who bought Teledyne in 1963 or 1966 would have earned an even better return… 

…But for the 1963-1989 time frame, based on data from Distant Force, it appears that the compound annual growth rates (CAGRs) for the conglomerate’s revenue, net income, and earnings per share were 19.8%, 25.3%, and 20.5%, respectively; the self-same CAGRs for the 1966-1989 time frame were 12.1%, 14.3%, and 16.0%. These numbers roughly match Teledyne’s returns cited by The Outsiders and Distant Force”

My article The Need For Patience contained one of my favourite investing stories and it involves Warren Buffett and his investment in The Washington Post Company (emphasis is from the original passage):

“Through Berkshire Hathaway, he invested US$11 million in WPC [The Washington Post Company] in 1973. By the end of 2007, Berkshire’s stake in WPC had swelled to nearly US$1.4 billion, which is a gain of over 10,000%. But the percentage gain is not the most interesting part of the story. What’s interesting is that, first, WPC’s share price fell by more than 20% shortly after Buffett invested, and then stayed in the red for three years”

Buffett first invested in WPC in mid-1973, after which he never bought more after promising Katherine Graham (the then-leader of the company and whose family was a major shareholder) that he would not do so without her permission. The paragraph above showed that Berkshire’s investment in WPC had gains of over 10,000% by 2007. But by 1983, Berkshire’s WPC stake had already increased in value by nearly 1,200%, or 28% annually. From 1973 to 1983, WPC delivered CAGRs in revenue, net income, and EPS of 10%, 15%, and 20%, respectively (EPS grew faster than net income because of buybacks). 

Walmart, Teledyne, and WPC’s experience are all cases of an important phenomenon in the stock market: Their stock price movements were initially detached from their underlying business fundamentals in the short run, before eventually aligning with the passage of time, even when some of them began with very high valuations. They are also not idiosyncratic instances.

Renowned Wharton finance professor Jeremy Siegel – of Stocks for the Long Run fame – penned an article in late-1998 titled Valuing Growth Stocks: Revisiting The Nifty-Fifty. In his piece, Siegel explored the business and stock price performances from December 1972 to August 1998 for a group of US-listed stocks called the Nifty-Fifty. The group was perceived to have bright business-growth prospects in the early 1970s and thus carried high valuations. As Siegel explained, these stocks “had proven growth records” and “many investors did not seem to find 50, 80 or even 100 times earnings at all an unreasonable price to pay for the world’s preeminent growth companies [in the early 1970s].” But in the brutal 1973-1974 bear market for US stocks, when the S&P 500 fell by 45%, the Nifty-Fifty did even worse. For perspective, here’s Howard Marks’ description of the episode in his book The Most Important Thing (emphasis is mine):

“In the early 1970s, the stock market cooled off, exogenous factors like the oil embargo and rising inflation clouded the picture and the Nifty Fifty stocks collapsed. Within a few years, those price/earnings ratios of 80 or 90 had fallen to 8 or 9, meaning investors in America’s best companies had lost 90 percent of their money.”

Not every member of the Nifty-Fifty saw their businesses prosper in the decades that followed after the 1970s. But of those that did, Siegel showed in Valuing Growth Stocks that their stock prices eventually tracked their business growth, and had also beaten the performance of the S&P 500. These are displayed in the table below. There are a few important things to note about the table’s information:

• It shows the stock price returns from December 1972 to August 1998 for the S&P 500 and five of the Nifty-Fifty identified by Siegel as having the highest annualised stock price returns; December 1972 was the peak for US stocks before the 1973-1974 bear market
• It shows the annualised earnings per share (EPS) growth for the S&P 500 and the five aforementioned members of the Nifty-Fifty
• Despite suffering a major decline in their stock prices in the 1973-1974 bear market, members of the Nifty-Fifty whose businesses continued to thrive saw their stock prices beat the S&P 500 and effectively match their underlying business growth in the long run even when using the market-peak in December 1972 as the starting point.

You may have noticed that all of the examples of stock prices first collapsing then eventually reflecting their underlying business growth that were shared above – Walmart, Teledyne, WPC, and members of the Nifty-Fifty – were from the 1970s. What if this relationship between stock prices and business fundamentals no longer holds now? It’s a legitimate concern. Economies change over time. Financial markets do too.

But I believe the underlying driver for the initial divergence and eventual convergence in the paths that the companies’ businesses and stock prices had taken in the past are alive and well today. This is because the driver was, in my opinion, the simple but important nature of the stock market: It is a place to buy and sell pieces of a business. This understanding leads to a logical conclusion that a stock’s price movement over the long run depends on the performance of its underlying business. The stock market, today, is still a place to buy and sell pieces of a business, which means the market is still a weighing machine in the long run. This also means that if you had invested a few years ago in a stock with an expensive valuation and have seen its stock price fall, it will likely still be appropriately appraised by the weighing machine in the fullness of time, if its fundamentals do remain strong in the years ahead. 

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the first quarter of 2024 – was held two weeks ago and contained useful insights on the state of American consumers and businesses. The bottom-line is this: Economic indicators in the US continue to be favourable and American consumers are in good shape, but there are a number of risks on the horizon, so JPMorgan’s management is preparing for a wide range of outcomes.  

What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call.

---

1. Management sees economic indicators in the USA as favourable, but there are many risks on the horizon (including geopolitical conflicts, inflationary pressures, and the Fed’s quantitative tightening) so they want to be prepared for a range of outcomes; the economy always looks healthy at the inflection point; management thinks the US economy will be affected even if problems happen elsewhere

Many economic indicators continue to be favorable. However, looking ahead, we remain alert to a number of significant uncertain forces. First, the global landscape is unsettling – terrible wars and violence continue to cause suffering, and geopolitical tensions are growing. Second, there seems to be a large number of persistent inflationary pressures, which may likely continue. And finally, we have never truly experienced the full effect of quantitative tightening on this scale. We do not know how these factors will play out, but we must prepare the Firm for a wide range of potential environments to ensure that we can consistently be there for clients…

…But what I caution people, these are all the same results [referring to the comments in Point 2 and Point 6 below about consumers and businesses being in good shape] of a lot of fiscal spending, a lot of QE, et cetera. And so we don’t really know what’s going to happen. And I also want to look at the year, look at 2 years or 3 years, all the geopolitical effects and oil and gas and how much fiscal spending will actually take place, our elections, et cetera. So we’re in good — we’re okay right now. It does not mean we’re okay down the road. And if you look at any inflection point, being okay in the current time is always true. That was true in ’72, it was true in any time you’ve had it. So I’m just on the more cautious side that how people feel, the confidence levels and all that, that doesn’t necessarily stop you from having an inflection point. And so everything is okay today, but you’ve got to be prepared for a range of outcomes, which we are…

…I think that when we talk about the impact of the geopolitical uncertainty on the outlook, part of the point there is to note that the U.S. is not isolated from that, right? If we have global macroeconomic problems as a result of geopolitical situations, that’s not only a problem outside the U.S. That affects the global economy and therefore the U.S. and therefore our corporate customers, et cetera, et cetera.

2. Management is seeing consumers remain healthy with overall spend in line with a year ago, and although their cash buffers have normalised, they are still higher than pre-COVID levels; management thinks consumers will be in pretty good shape even if there’s a recession; the labour market remains healthy with wages keeping pace with inflation

Consumers remain financially healthy, supported by a resilient labor market. While cash buffers have largely normalized, balances were still above pre-pandemic levels, and wages are keeping pace with inflation. When looking at a stable cohort of customers, overall spend is in line with the prior year…

… I would say consumer customers are fine. The unemployment is very low. Home price dropped, stock price dropped. The amount of income they need to service their debt is still kind of low. But the extra money of the lower-income folks is running out — not running out, but normalizing. And you see credit normalizing a little bit. And of course, higher-income folks still have more money. They’re still spending it. So whatever happens, the customer’s in pretty good shape. And they’re — if you go into a recession, they’d be in pretty good shape.

3. Auto originations are down

And in auto, originations were $8.9 billion, down 3%, while we maintained healthy margins and market share.

4. Net charge-offs (effectively bad loans that JPMorgan can’t recover) rose from US$1.1 billion a year ago, mostly because of card-related credit losses that are normalising to historical norms; management expects consumer-spending on credit/debit cards to have strong growth in 2024

In terms of credit performance this quarter, credit costs were $1.9 billion, driven by net charge-offs, which were up $825 million year-on-year predominantly due to continued normalization in Card…

…And in Card, of course, while charge-offs are now close to normalized, essentially, we did go through an extended period of charge-offs being very low by historical standards, although that was coupled with NII also being low by historical standards…

….Yes, we still expect 12% card loan growth for the full year. 

5. The level of appetite that companies have for capital markets activity is uncertain to management

While we are encouraged by the level of capital markets activity we saw this quarter, we need to be mindful that some meaningful portion of that is likely pulling forward from later in the year. Similarly, while it was encouraging to see some positive momentum in announced M&A in the quarter, it remains to be seen whether that will continue, and the Advisory business still faces structural headwinds from the regulatory environment…

…Let me take the IPO first. So we had been a little bit cautious there. Some cohorts and vintages of IPOs had performed somewhat disappointingly. And I think that narrative has changed to a meaningful degree this quarter. So I think we’re seeing better IPO performance. Obviously, equity markets have been under a little bit of pressure the last few days. But in general, we have a lot of support there, and that always helps. Dialogue is quite good. A lot of interesting different types of conversations happening with global firms, multinationals, carve-out type things. So dialogue is good. Valuation environment is better, like sort of decent reasons for optimism there. But of course, with ECM [Equity Capital Markets], there’s always a pipeline dynamic, and conditions were particularly good this quarter. And so we caution a little bit there about pull-forward, which is even more acute, I think, on the DCM [Debt Capital Markets] side, given that quite a high percentage of the total amount of debt that needed to be refinanced this year has gotten done in the first quarter. So that’s a factor.

And then the question of M&A, I think, is probably the single most important question, not only because of its impact on M&A but also because of its knock-on impact on DCM through acquisition financing and so on. And there’s the well-known kind of regulatory headwinds there, and that’s definitely having a bit of a chilling effect. I don’t know. I’ve heard some narratives that maybe there’s like some pent-up deal demand. Who knows how important politics are in all this. So I don’t know.  

6. Management is seeing that businesses are in good shape

Businesses are in good shape. If you look at it today, their confidence is up, their order books drop, their profits are up.

7. Management thinks that the generally accepted economic scenario is nearly always wrong and that no one can accurately predict an inflection point in the economy

And the other thing I want to point out because all of these questions about interest rates and yield curves and NII and credit losses, one thing you projected today based on what — not what we think in economic scenarios, but the generally accepted economic scenario, which is the generally accepted rate cuts of the Fed. But these numbers have always been wrong. You have to ask the question, what if other things happen? Like higher rates with this modest recession, et cetera, then all these numbers change. I just don’t think any of us should be surprised if and when that happens. And I just think the chance of that happen is higher than other people. I don’t know the outcome. We don’t want to guess the outcome. I’ve never seen anyone actually positively predict a big inflection point in the economy literally in my life or in history.

8. Management thinks the US commercial real estate market is fine, at least when it comes to JPMorgan’s portfolio; management thinks that if interest rates rise, it could be roughly neutral or really bad for the real estate market, depending on the reason for the increase in interest rates

First of all, we’re fine. We’ve got good reserves against office. We think the multifamily is fine. Jeremy can give you more detail on that if you want.

But if you think of real estate, there’s 2 pieces. If rates go up, think of the yield curve, the whole yield curve, not Fed funds, but the 10-year bond rate, it goes up 2%. All assets, all assets, every asset on the planet, including real estate, is worth 20% less. Well obviously, that creates a little bit of stress and strain, and people have to roll those over and finance it more. But it’s not just true for real estate, it’s true for everybody. And that happens, leveraged loans, real estate will have some effect.

The second thing is the why does that happen? If that happens because we have a strong economy, well, that’s not so bad for real estate because people will be hiring and filling things out. And other financial assets. If that happens because we have stagflation, well, that’s the worst case. All of a sudden, you are going to have more vacancies. You are going to have more companies cutting back. You are going to have less leases. It will affect — including multifamily, that will filter through the whole economy in a way that people haven’t really experienced since 2010. So I’d just put in the back of your mind, the why is important, the interest rates are important, the recession is important. If things stay where they are today, we have kind of the soft landing that seems to be embedded in the marketplace, everyone — the real estate will muddle through.

9. Consumers whose real incomes are down are slowing their spending, but they account for only a small proportion of the overall population, and they are not levering up irresponsibly

And there are some such people whose real incomes are not up, they’re down, and who are therefore struggling a little bit, unfortunately. And what you observe in the spending patterns of those people is some meaningful slowing rather than what you might have feared, which is sort of aggressive levering up. So I think that’s maybe an economic indicator of sorts, although this portion of the population is small enough that I’m not sure the read-across is that big. But it is encouraging from a credit perspective because it just means that people are behaving kind of rationally and in a sort of normal post-pandemic type of way as they manage their own balance sheets. 

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.