10/2018 Market Commentary

Things are going great for companies that have never made money and not-so great for companies that make (or used to make) money. Titans are falling.


We are in an Uber economy. Uber was able to issue $2 billion debt in a debut bond sale during October. The debt is unrated, suggesting it would otherwise be low quality, not unlike no earnings brethren Tesla (B-) and Netflix (BB-). The debt was “privately placed,” meaning only “sophisticated investors” could buy it. But how sophisticated of an investor do you need to be to wonder how a company so successful in recent years could still be reporting NEGATIVE ADJUSTED EBITDA. There is a lot to unpack from the three words, starting with EBITDA, which is generally a highly manipulated number (within the bounds of GAAP*, of course). Then, it is ADJUSTED (non-GAAP*, or outside the bounds of GAAP*) to management’s liking. Despite all these accounting shenanigans, the EBITDA that comes out the other side of Uber is still NEGATIVE. Note that the brethren, Tesla and Netflix, both have positive EBITDA, adjusted and reported. Keep in mind that EBITDA not only serves as the usual measure of leverage (debt-to-EBITDA), but it is also most common proxy for debt service (EBITDA-to-interest-expense or as proxy for cash flow). With Uber, there is the absence of EBITDA. All that remains is hope. That’s not usually a good starting place for credit analysts.

Another major announcement related to Uber was that it plans to become publicly traded in 2019 (called an Initial Public Offering, or IPO for short). The rumored value the company will seek is $120 billion. Wow! This must be the allure of lending $2 billion to Uber, money is expected to rush in. But at the same time, competitor Lyft announced it also planned an IPO for 2019. The valuation Lyft is seeking is $15 billion, or 1/8 the size of Uber. While rider market share skews to Uber, we wonder which is more prudent for an investor – investing with the hope of keeping market share or investing with the hope of capturing market share in this disruptive (and profitless) industry.

*GAAP is General Accepted Accounting Principles and is a framework within which companies are required to report to the SEC for the benefit of investors.

General Electric

To begin the month, General Electric ousted its 13-month CEO as the company continued to perform poorly (though it was not necessarily his fault, in our opinion). We commented on that as part of the September Market Commentary. To close the month of October, under the new CEO, General Electric announced it would slash its dividend to $0.01 per quarter, down from $0.12 per quarter. For any GE investor holding out for better times, while earning a good dividend yield, the announcement has been a rude awakening. To the new (newest) CEO’s credit, he is not forthcoming with projections or promises. Instead, he has prescribed that his first 100 days will be positioning the company to win “and accelerating deleveraging”. Ballast views these actions as entirely sensible given the situation. However, we do not think stock investors will feel reprieve for some time, considering there is a lot of debt and, therefore, a lot of deleveraging ahead. Also, most of the heavy lifting will come from restoring business fundamentals, something tied more to the economy and less with this CEO’s first 100 days.

A closing thought: Scrutiny of General Electric has reached a number of company segments – including life insurance and power generation – where GE took massive accounting charges in recent quarters. What if General Electric were also to have engine problems in its CFM joint venture? Examples are Jakarta, Southwest, and Southwest 2? Although CFM engines CFM56 and LEAP-1B are different engines, the former is the precursor of the latter, so technologies and processes were likely adopted in the new version. Hopefully that doesn’t mean investors will meet a new CEO next year.


The company has suffered numerous consecutive quarters of revenue decline, despite several initiatives to jump start growth. Watson has yet to take off, and in fact, reviews suggest end-use struggles to be of practical use. Perhaps a major tell is that IBM is marketing through TV commercials to ordinary consumers about the great things that IBM does, but these end consumers don’t buy IBM services – though they might buy the stock. Weird.

Nevertheless, IBM just announced a $34 billion acquisition of Red Hat (ticker RHT), a company that sells services to users of open source software that is used in many servers (think internet, cloud, or virtual). The transaction is part attempt to buy growth and other part attempt to capture more of the cloud services market share. The trick, as always, will be execution – capturing revenue synergies by using IBM’s sales force and keeping major Red Hat customers that also happen to be IBM competitors (Amazon, Oracle, Hewlett Packard Enterprise, et al). Whatever your sentiment on the merits of the deal, the value paid is rich. Prior to the announced acquisition, Red Hat was trading at a market capitalization of $20 billion, though it did reach $30 billion in recent summer months. Still, Red Hat has $3.0 billion revenue and $500 million of net income, making $34 billion enterprise value-paid a high price even factoring in growth. All risk falls to IBM and its shareholders. It is no surprise that IBM price response was lower.

Market Correction Redux?

For the Nasdaq, yes. The other indexes, no. Here is the math:

  • Dow Jones: high 26,828 on 3 October, low 24,442 on 29 October, -8.9% decline
  • S&P: high 2,930 on 20 September, low 2,641 on 29 October, -9.8% decline
  • Nasdaq: high 8,109 on 31 August, low 7,050 on 29 October, -13.0% decline

Like we said in March, we do not see this as a buy-the-dip moment. Much of that view remains the same, so you are welcome to read that post as a refresher.

AB Inbev (Anheuser Busch)

The owner of Anheuser Busch, Miller, Corona, Modelo, Stella Artois, et al has seen sales and earnings fall short of targets. As a result, the company slashed its dividend to common stockholders and will focus on deleveraging. Debt increased substantially when Inbev acquired SABMiller in 2016. Competition continues to strengthen from craft beers and consumer shift to wines and spirits. Nevertheless, Ballast views commitment to cut leverage above else as sensible. We appreciate a management that gets ahead of a leverage problem by cutting a dividend.


You remember – that retailer in Everytown USA. It finally filed for bankruptcy after years of decline. Sears, at one point in its history, was one of the biggest companies in the world. Surprising to some are the big brands born under Sears. Some of the more obvious are Diehard, Kenmore, Craftsman, et al. The less obvious are AllState Insurance, Discover Financial, and Homart Development (what became a major part of General Growth Properties, one of the largest mall owners). Then, there were companies bought and later sold by Sears, which includes real estate broker Coldwell Banker and securities broker Dean Witter (now part of Morgan Stanley). It’s been a long decline, and we will see if Sears makes it on the other side of Chapter 11 (reorganization) bankruptcy.


More Tesla in October. We assure you we look forward to one day not having anything to say or report about this saga. Here, again, we will list some of the major occurrences of the month:

  • Musk buys $10 million Tesla stock and pledges to buy another $20 million.
  • Tesla’s China factory is said to produce two car models. But wait – it’s still raw ground, going through approvals. The land was acquired this summer.
  • Critical and short-seller, Citron Research, did a U-turn and said he is long Tesla, believing the company would report a strong third quarter. Mind you, Citron is suing Tesla for the “funding secured” tweet, seeking damages for losses incurred. Citron also said they learned a lot about the auto industry, and it is why he changed his mind. Right…
  • Earlier in the month, Tesla announced the acquisition of land in China for a production plant. At the same time, the company stated it would be two to three years before production would begin.
  • The Vice President of Manufacturing left the company.
  • A company in Michigan specializes in tearing cars apart and evaluating the manufacturing quality. The Tesla report, though not terrible, was not good either, especially from a profitability assessment standpoint.
  • Musk bought $20 million more Tesla stock.
  • A Tesla “skeptic” is surprised by how much he enjoyed riding the new model 3.
  • Tesla plans another tent at California manufacturing facility.
  • Record deliveries take place in the third quarter.

Interest Rates

Some believe that interest rates have finally halted their descent and are now beginning ascent. One can hope. Rates have been depressed because of the Quantitative Easing, or bond purchases by the Federal Reserve and other central banks around the world. The 30-year treasury reached 3.40%, and the 10-year reached 3.23% in October. The lows were reached in July 2016 when the 30-year was 2.09% and the 10-year was 1.35%. The Fed Funds Rate target range stands at 2.00-2.25% with an expected Fed raise again in December.

Since interest rates have been low for nearly a decade, we thought we would remind readers what interest rates once were. In the five years preceding (we use October 2002 to October 2007) the financial crisis, which prompted the current “unusual” interest rate environment, the 30-year treasury averaged 4.86% with a high of 5.59% reached on 14 May 2004. During that same period, the 10-year treasury averaged 4.38% with a high of 5.32% reached on 13 June 2007.

Remember: As an example, earning 5.00% is twice as much as earning 2.50%. Imagine what savers could do with higher interest rates.


SoftBank, a Japan-based telecom, is exploring investing more in WeWork, a commercial real estate company that specializes in leasing shared work spaces. SoftBank directly owns 20% of WeWork through a $4.4 billion equity investment made into WeWork in 2017. Now, SoftBank is exploring taking a majority stake in WeWork for as much as $15 to 20 billion, using its $100 billion private fund called Vision Fund, which has the backing of Saudi Arabia and Abu Dhabi wealth funds. Interestingly, a lot of top valuations in the venture capital/tech investing space have been made by SoftBank and its Vision Fund. Here, with WeWork, SoftBank is outdoing itself with an even higher valuation. Its own balance stands to benefit from the new valuation mark at the expense of the Vision Fund balance sheet. All of this is for a company that occupies some of the priciest commercial properties in the world (New York City as prime example) and does not actually own the real estate. WeWork is in a spread business, leasing raw office space at a lower rate and leasing finished office space at a higher rate. They have yet to make money, as improving raw office space does not come cheaply. Risks abound, but it is apparently worth much more than $20 billion.


Are electric vehicle companies and investors thinking through upstream risks? We were struck by the situation brewing in Chile, reported by Reuters. There are two major miners in the world – SQM and Albemarle. These miners operate mines within three miles of each other in the world’s important lithium production regions. The region is in Chile’s Atacama Desert. One of the major miners is accused of using more water from the underground brine water pool than legally allotted, and they have done this (allegedly) for years. The implications could be shorter mine life, and it could cause the government to limit future permitting until the water naturally replenishes, if ever. That means lithium supply could be at risk of constrained supply, which would likely cause prices to rise and increase the cost of producing batteries. The risks are obviously present, but the outcomes remain unknown.

Loss Loan Rule

Banks, according to WSJ, are fighting the new loan loss accounting rule by taking it, through lobby, to congress. Note, accounting rules are proposed, commented on, written, and implemented by Financial Accounting Standards Board (or FASB). The new rule has taken on the name Current Expected Credit Loss Model and the acronym CECL (pronounced Cecil). The primary result of the rule is that companies issuing credit would be required to model credit risks and record expected losses when the loan is made – and over the course of the loans as expectations shift. Banks are “livid” because this is a bit different than they have been doing things. According to the WSJ article, banks claimed “the rule will make them less able to make loans”. Accounting is accounting. If the bank expects that steep losses up front would preclude the bank from lending, Ballast wonders why the bank would be prepared to make the loan even without CECL.

If, like us, you like the backstory of how things work then here is the expanded explanation of the absurdity of the banking industry response now, after years of lead time. Don’t worry, we have left out the accounting jargon.

Many users of financial statements have held the position that loss recognition standards were too loose prior to the financial crisis, and that is why the bottom fell out from underneath the institutions that found themselves on the brink of bankruptcy in 2008 and 2009. However, the process to craft a revised loan loss standard actually began as a joint project with the International Accounting Standards Board (IASB) in 2005. The IASB issued a proposed standard in 2009, and the FASB proposed their own standard a few months later. The FASB claimed they received a lot of negative feedback from users of US GAAP financial statements on the IASB proposal so they drafted their own proposal.  There were a few iterations of drafts and redrafts for the next few years, but eventually the FASB issued an Exposure Draft (ED) in late 2015. An ED is released to the public, and anyone who wants to comment on how they feel about the proposed rules – in any regard – can submit comments directly to the FASB. Note that the FASB holds open meetings in which they discuss staff recommendations on new potential accounting guidance prior to when an ED is even issued. Then, in April 2016, the final credit loss standard was voted on by the FASB and published in June 2016, with an effective date for public companies for periods beginning after December 15, 2019.

Emerging Markets

In crisis? The IMF says it’s possible. We’ve already commented on Argentina. Now Pakistan has requested emergency loans from the IMF. Other countries are struggling. Ballast continues to monitor.

Security Breach

A computer chip, difficult to detect, made its way into critical servers and was able to back-door hack systems that were previously thought to be highly secure. It’s a good read at BusinessWeek.

03/2018 Market Commentary

So much happened during March, so bear with us as we walk you through it all. We’ve got a new Market Commentary format for you too this month. While we hope it is easier for you to find those topics of interest, don’t be shy. It’s all important as you charge into 2018.

Market Correction

Recovery complete: Nasdaq hits new record. Well, that was easy.

March 2018 Nasdaq

Warren Buffett / Berkshire Hathaway

The much-anticipated Berkshire Hathaway 2017 shareholder letter from Warren Buffett was published this month. The following bullet points are key highlights by Ballast.

  • Key qualities we seek […] a sensible purchase price. That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.
  • Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.
  • The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisition on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious (leaving aside certain exceptions, such as debt dedicated to Clayton’s lending portfolio or to the fixed-asset commitments at our regulated utilities). We also never factor in, nor do we often find, synergies.
  • Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire.

This last point should settle in. Leverage can help you get somewhere, but reducing leverage will allow you to stay there.

If you heed Mr. Buffett and have been an excited equity investor in the recent year, we would encourage you re-read the first bullet point above. The other points provide excellent expert perspective of general activities we are seeing in the market place.


We have commented on Netflix in previous newsletters. An analyst at UBS upgraded Netflix recommendation, and the stock price and company market capitalization set new records. Speculators may play, but the gravitational pull of cash flows and earnings will eventually have its way.


Speaking of speculators… Tesla has its work cut out for it.

General Electric

We discussed GE in our January newsletter. In it, we explained an adverse scenario that we had heard from a hedge fund manager. We had disagreed on it and sought comment from GE, as well as the hedge fund, for clarification. The hedge fund never responded, but GE Investor Relations talked to us about recent insurance charges in the Capital unit, as well as the long-term service agreements, the importance of credit ratings to sales, and company commitment to deleverage.

A GE related headline hit the press in March. General Electric – industrial conglomerate and manufacturer of electricity generation turbines, jet engines, healthcare equipment, oil & gas equipment, and a lot more – market capitalization fell below that of each of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) for the first time. What GE produces is the backbone of the economy.

We continue to monitor GE with interest.

Dollar Tree

The economy is strong, and inflation is about to rise – or so popular market narrative goes. However, Dollar Tree (the owner of chains, Dollar Tree and Family Dollar) shares fell as much as 15% on March 7 due to a weak outlook that was provided during the company’s latest reporting to investors. The company is not exactly the bellwether for the stock market, but how can things be looking down for Dollar Tree while inflation, wage, and earnings expectations continue to rise and drive the narrative? We wonder. To us, this would suggest one of two scenarios: 1) that low-wage earners are doing well and upgrading consumption or 2) that they are not doing well and tightening belts. Gas prices and rent (key expenses for most households) have increased in the past year (CPI was +2.2% in February), while average hourly wages increased 2.5% y/y.

Dollar tree

Oil Market

Many seem to have an opinion on which direction oil is going. In fact, last summer, Ballast said, “our opinion is for status quo or lower near-term” but that was back when oil (WTI) was $50. Now it is $65. While we feel somewhat the same today, we’ve seen a few industry leaders make some points that are difficult to ignore.

Mark Papa, an industry titan and former CEO of EOG Resources, was recently recruited out of retirement to run a new company formed by private equity to acquire shale assets out of the energy distress in 2016. We think he is worth listening to. Mr. Papa has made waves with public comments about the promise of the shale revolution. His point is that it’s not as promising as many think – the low hanging fruit has been picked, and it gets worse from here. The article linked above highlights, among Papa’s points, the best drilling locations in both North Dakota and South Texas have been tapped, rivals are being too optimistic, operational challenges abound, and high returns now demanded by investors are leading to squeeze. Papa expects the US will not fulfill oil production projections. The bottom line, according to this thinking, is that oil prices are set to go higher – and soon. If correct, it seems like significantly higher oil prices would choke US economic growth prospects.

Cigna & Express Scripts

More mind-bending activities in the health care markets… In December, CVS announced it would acquire Aetna, a major health insurer. This March, Cigna, another major health insurer, agreed to acquire Express Scripts, a pharmacy benefit manager. We won’t layout the background of each here, only that our immediate reaction to the news was, “huh!?” and our reaction was matched by the equity markets. Cigna’s stock promptly fell in price. The price began the month at $195, and it has settled to around $167 now. In fact, Cigna’s stock price reached its apex of $225 in late January 2018. The Express Scripts acquisition will represent a major leveraging event, and we see no clear value in the combination. To the contrary, we suspect there will be value destruction. We shall steer our clients clear of this heap.


Buying things that “might be” is not generally a good policy. It’s especially not a good policy at high prices. A few years ago, there was an “arms race” of sorts for companies to buy potential block buster drugs in the pharmaceuticals industry before peers did. At the beginning of 2018, that arms race seemed to have kicked off again with big acquisitions by Celgene (Juno and Impact) and others as risks have mounted in existing drug portfolios. These risks have become pronounced with big headlines of drugs failing in trials or being pulled. Biogen and Abbvie took their multiple sclerosis drug off the market after patients were suffering severe complications from the treatment. Not long after, Abbvie announced that a key drug in its pipeline had disappointed in drug trials. Both Biogen and Abbvie stock prices have suffered greatly in March. Several other pharmaceutical companies have too. We only highlight this here as risks lurk, and in our opinion, many investors have not been paying attention.

Insurance & Reinsurance

Continuing previous comment pieces on the insurance and reinsurance market, here we point out the AXA acquisition of XL Group for $15.3 billion. Now, Aspen Insurance Holdings may be placing a “for sale” sign up. The reinsurance market is clearly consolidating, but there is no evidence yet that capital is leaving. This means high competition and status quo of undesirable profitability.

Market Correction? Yes. Buy the Dip? No.

The Dow Jones Industrial Average (“DJI”) fell from a high of around 26,600 on 1/26 to an intraday low of approximately 23,800 on 2/6, a downswing of 2,800 or 11.7% from top to bottom. By definition – typically considered 10% price movement – it was a “market correction”. We think “market correction” tends to carry an underlying investible opportunity connotation – a buy-the-dip moment. The January-February market correction was astonishing to most people, but not to Ballast because we looked at it quite differently. Here are some of the ways we put it into perspective:

Prior Performance

Year-over-year price performance of the DJI from December 31 of 1900 to 2017 yields another perspective. Index price returns for December 31 over the prior year-end from 1900 to 2017 generates 117 observations. For the year 2017, the index price return was 25%. This is right at the 20th percentile of observed returns. This means 80% of all the return observations were lower than 25%. For context, the range of returns were -52.7% in 1931 and 81.7% in 1915, all with a mean of 7.4%.


We consider the correction a modest giveback considering the generous returns provided up to January 26, and we would not expect an equally benevolent remainder of the year.


From the beginning of the year at 24,800 to the peak of 26,600, the index gained 7.2%. That annualizes to more than 86% (a level even the most bullish can agree is unsustainable). From the beginning of the year, the DJI was down a paltry 4% to the intraday low, and it was essentially flat by close of February 6. Remember, this was just one month into the year. There are no alarm bells going off here.

Days Not Years

To us, it hardly seemed like a market correction, or at least the buy-the-dip, investible variety. Each leg down in value, we looked back in time and measured the decline in terms of days, weeks, and months since the last time the DJI was at that price. In other words, the price gain that was eroded during the retreat. At its lowest intraday price of 23,800 during the correction, the DJI only retreated to November 28, 2017 price levels. To us, that is hardly a noteworthy movement. If anything, the reverse was true – the run-up from November 28, 2017 to January 26, 2018 was awesome. If the market had retreated more than a year we might be wowed and seek greater opportunity. What this highlights to us, and hopefully to you, is how uncharacteristically one directional (up) the market has been for the past few months and year. It was simply unsustainable, and so, the trend reset.


Think of the market as an intense workout. The athlete needed a break to cool down, but the athlete didn’t have a medical emergency. However, the media would have you believe the market was on life support.

Relative Strength Index

In fact, a popular technical indicator, the Relative Strength Index (“RSI”), which measures average price advances as a ratio of average price declines for a specified period, was at its highest level for DJI since 1904. We saw an internet commentator digitally overlay an image of a protractor on an index price chart with a caption that said, “just checking”. He was making sure the index price chart had not gone to 90° – straight up. It wasn’t far off. We found it funny because we held similar thoughts (a 2-year price chart shows increasing upward acceleration from November 2017 through January 2018). Some call this a “melt-up”, which is something common in late stage bubbles – yep, bubble. It happens as FOMO takes hold and indiscriminate buyers enter en masse.


No science here. Just look at it visually.

Buy the dip or revert to trend?

Earnings Breakeven

Another way we look at it is to ask how long it would take for an investor to recoup the lost market value in terms of earnings. (We prefer to think in terms of cash flow, but we’ll settle on earnings here.) The DJI constituents reported 1,240 in 2017 earnings per DJI “share”, according to Bloomberg. The 2,800 peak-to-trough price swing would take 2 ¼ years to regain through earnings. This is nothing to balk at, but the peak price-to-earnings ratio (“PE”) was 21.5x, a lofty valuation by historical standards. As reference, the DJI PE last saw those levels in the Dot-Com bubble. We would say, owning an asset at 21.5x earnings starts with expecting stable long-term intrinsic value, investing without earnings in mind, or expecting strong growth. In any of those cases, the 2 ¼ year breakeven should not now be concerning.