The Ingham Analytics Weekly Letter on Sunday - 7 March 2021

Sunday, 7 March 2021

Welcome to our Ingham Analytics Weekly Letter on Sunday where we take a step back to see wood for trees, taking stock of things that grabbed our attention during the week that was, and with a bit of light-heartedness.
Last week, we promised you some nuggets from the Berkshire Hathaway annual report but before we get there let's look at luxury goods.

Richemont understandably tends to get the limelight from a JSE standpoint due to its secondary listing of South African Depository Receipts in respect of Richemont A shares. Mr Rupert is chairman of a fine clutch of Maisons that are nurtured with a long-term, family-orientated mindset. This week the share price (SWX:CFR) nudged CHF90 on the Swiss Exchange, having recovered from COVID-19 blues.

Also, in luxury this week a milestone was passed as LVMH Moet Hennessy Louis Vuitton (MC:Euronext) reached a record intraday high of Euro550 per share, valuing the company at around Euro270 billion or $320 billion. 

This gives LVMH the distinction of being the company with the biggest stock market capitalisation in mainland Europe, including Switzerland. The market value is therefore almost three-times that of Hermes and six-times that of Richemont.
Whilst not unscathed, luxury goods have shown relative resilience during COVID-19 and the outlook statement from LVMH in the recent results indicated cautious optimism.

You're paying for that though, based on our forward LVMH estimates a price to earnings ratio of 38x and a princely dividend of 1% before withholding tax.

Posh handbags (that'll be $10,000 for the top notch one, thank you), watches ($10,000 barely gets you started for a Hublot), spirits (Hennessy Richard will knock you back at least $4,000), perfumes (Flower by Kenzo is a snip at under $100) and much else besides is all jolly nice stuff but there is a touch of the ephemeral in it.
But here's the thing, have your cake and eat it too. Indulge in the fashion whilst owning the stock. That way you beat the depreciation on the one by a capital gain on the other.
In three years LVMH stock has shown compound growth of 30% per annum, Hermes has grown by 26% per annum and whilst Richemont hasn't been quite so fleet of foot its has held its value in Swiss francs - considering you must pay a Swiss bank to keep your loot that's ok by us.

Many of our readers are invested either directly or indirectly in Berkshire Hathaway. Mr Warren Buffett, down-to-earth gentlemen that he is, published his annual letter to shareholders last Saturday (a crisp 14 pages) along with the commodious annual report (146 written pages).

And refreshingly homespun and authentic the letter is too, as usual. There are vignettes told about humble people that created big things and became part of the Berkshire Hathaway journey. Interestingly, Mr Buffett reminds his co-shareholders that his bucket is certain to empty because of philanthropic distribution.
If you're a railway buff check out Mr Buffett's link in his letter to a richly illustrated brochure chronicling the history of Burlington Northern Santa Fe, the huge freight railroad company Berkshire has owned since 2010. It is a fascinating history dating back 170 years.

In this age of cloud computing, virtual reality, artificial intelligence and a curse called Zoom, real fixed assets matter, as exemplified by BNSF. During the decade that Berkshire Hathaway has owned BNSF the railroad group has invested $41 billion in fixed assets.     
The "shareholder" of an electricity utility in South Africa, once a byword for excellence, efficiency and long-range planning in power generation and a benchmark for domestic cost of capital, would be well-advised to read Mr Buffett's letter too. This utility has been crippled through years of mismanagement and ignorance.

You'll find no such dereliction at Berkshire Hathaway Energy (BHE) which transmits electricity in the Western United States. In the US, BHE has 40,000 MW of power generation capacity, making it about the same size as the local outfit. Fun fact: BHE's cumulative investment in wind, solar, geothermal and biomass generation alone is $34 billion according to the annual report.   

BHE, says Mr Buffett, has a Spartan policy of paying no dividends, ploughing every spare penny into replacement and expansion capital spending at the electricity utility. Their time horizon?

Decades to come. Moreover, Mr Buffett says "we welcome the challenge and believe the added investment will be appropriately rewarded." The current capital programme was started in 2006 with an end date of 2030- a quarter of a century of forward thinking. 
What is also thought-provoking about BHE is the social necessity of renewable energy and the recognition that billions would need to be invested, with numerous logistical, regulatory and vested interest hurdles to navigate before meaningful revenue would flow. This is a jam tomorrow mindset.

And this can only be achieved because, to quote Mr Buffett, "BHE had the managerial talent, the institutional commitment and the financial wherewithal to fulfil its promises." In case the Union Buildings has privatisation on the agenda because self-inflicted penury leaves it with no option, a call to an office building in Des Moines, Iowa would probably be politely answered.   

This takes us neatly to Apple Inc. The $2 trillion market capitalisation is 9% of the total value of the NASDAQ Composite Index. Six firms (Apple, Microsoft, Amazon, Alphabet, Tesla and Facebook) account for 35% of the total value of the NASDAQ.

They tend to be correlated even though their businesses may differ completely. Apple has no business commonality with Amazon and yet their share prices move in tandem. This means that there is a high degree of concentration risk.

There are 2,500 stocks in the Nasdaq Composite so 0.24% of all the listed stocks are over one third of the total market cap. It exhibits similar concentration to the JSE where two stocks in the All Share are over 20% of the index. We've said before that the US markets are more like an emerging market than a developed market. Apple is at the apex.
What has struck us this past couple of years is how large this consumer electronics firm has become in relation to Berkshire Hathaway, at least insofar as market valuation goes.

Whilst names like BNSF, BHE, Borsheims, See's, NetJets, Fruit of the Loom, Nebraska Furniture Mart or Acme Brick are redolent of Berkshire Hathaway, the passive stake in Apple is now the largest single entity by market value. 

Berkshire has 5% of Apple stock accounting for 43% of the equity securities held as at 31 December 2020 and 14% of total assets. The size of the stake on Friday this week, $110 billion, is equivalent to 20% of the total market capitalisation of Berkshire, being $565 billion. So, all else equal, a 5% move in Apple would have a 1% effect on Berkshire.

Portfolio construction in investments, excluding the 26.6% of Kraft Heinz and wholly owned or majority owned operational assets, is excessively weighted to Apple (43%) with other larger holdings being Bank of America at 11%, Coca-Cola 8% and Amex 6% before falling away quite sharply. Under others, valued at $40 billion, is included Occidental Petroleum at $10 billion.

Berkshire is required by accounting regulations to mark to market and report investment gains and losses so that does create noise in the reported earnings and affects the balance sheet at reporting date. It has become a big item. In the past two years Berkshire has had $125 billion in unrealised investment gains, $112 billion net of losses on securities sold, compared to $23 billion in losses in 2018.

Apple would be the lion's share of the gains. Cost is $31 billion in late 2016 and the market value at balance sheet date was $120 billion. And we know too that Berkshire trimmed its holding in Apple by $11 billion last year. The $3 billion in dividends over four years seems small comparatively. Given the size of Apple, a reversal in the share price would affect the Berkshire share price.   

Mr Charlie Munger, Mr Buffett's long-time partner, gave a noteworthy interview to a Professor at Caltech in December. He commented: "Think about what Apple is worth compared to John D. Rockefeller's empire."  He has a point.

In that interview, Mr Munger spoke of the "frenzy" in the stock market and with respect to Apple he deems it "the most dramatic thing that's almost ever happened in the entire world history of finance."

Looking forward to the next decade, Mr Munger doesn't expect the kind of returns investors have enjoyed over the past 10 years. "Frenzy is so great, and the systems of management, the reward systems, are so foolish."

To our point last week about bonds, Mr Munger also questioned how long the Federal Reserve can keep supporting stocks. "We're in very uncharted waters," he said. "Nobody has gotten by with the kind of money printing now for a very extended period without some kind of trouble. We've very near the edge of playing with fire." 

Related to this theme, this week we published "Now what do they want?" which focused on central banking. The US yield curve has steepened sharply. The major central banks have dug themselves into a policy hole. Short-term policy rates are at or close to the zero-bound giving little or no room to move on the downside and trapped by their public statements to maintain policy rates as they are for a considerable period.

If inflation does return central bankers will struggle with the reality of markets normalising term rates all on their own, raising risk management issues in other asset markets that are priced to perfection.

The Bank of Japan has been interfering in the Japanese government bond market to keep 10-year bonds trading in a narrow yield range straddling 0% and in the equity market by buying ETFs listed on TOPIX. Also, the Reserve Bank of Australia made a surprise "one-off" purchase program in 3-year bonds for which they have specifically stated a yield target for the foreseeable future.

The above suggests central banks are straying from being a liquidity provider of last resort to taking up a questionable role of asset purchaser of first resort.

We also issued our latest Banks Monitor entitled "Budget blues." Not such fun fact: in three years total South African bank impairments have risen by 126% and have grown at a compound rate of 12% per annum in ten years, reaching a record - that means impairments have increased well above growth in nominal GDP (moribund) or credit extension (flatlining).
And finally, we analysed Airbnb last week. This week, the bed and breakfast online marketplace made a $2 billion announcement that should give short sellers pause for thought.

On Thursday, Airbnb announced the pricing of its 0% convertible senior notes due in 2026 to raise $2 billion. That's right, zero percent. The notes will not bear interest and the principal amount will not accrete.

The senior notes are priced at $1,000 and will convert into the equivalent of 3.4645 Airbnb shares, translating to a share price of $288.64. The price on Friday was $180 so a 60% premium. Over five years it suggests 10% per annum compound growth.

Airbnb will use the $2 billion to pay down debt and of that use $100 million to fund the cost of capped call transactions. The capped call transactions should reduce potential dilution to Airbnb's Class A common stock upon conversion of the notes. The conversion would increase the total number of shares outstanding by 14% from 50m to 57m. The cap price is $360.80.

This is the clearest indicator yet of institutional investor appetite for Airbnb.

It also gives a forward look at what the price could be. This is effectively a locked in call as institutions only participate in upside if the stock exceeds $288.64. For investors accepting zero now on the Airbnb convertible note they must be confident that an opportunity cost in the medium term is more than compensated by future potential capital appreciation because anything less than $288.64 means they lose money.

The big deal for us this week is LVMH Moet Hennessy Louis Vuitton which reached a record share price and now has the biggest market capitalisation in mainland Europe, including Switzerland.

Thank you all for visiting us.

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