Stocks rose once again yesterday although gains were modest and not broad-based. Bond yields edged lower. 10-year Treasury yields are now below 4.3%. At the end of October, they touched 5.0%. That tells almost all of the story as to why November will prove to be the best month for stocks in 2023.
Lower rates, together with a yield curve that is still inverted from 0-5 years, suggests two possible conclusions. First, signs that inflation is going to fall to the Fed’s 2% target are increasing. We have shown charts of the progress to date. The job isn’t done, but keeping rates higher for longer should lead to the desired conclusion. Second, a drop in rates almost always occurs in a recession. Yields at the short end of the curve fall because the Fed needs to loosen monetary policy when economic growth declines. Since in a recession demand falls faster than supply, prices fall as well (or at least they rise more slowly). That pushes long rates lower as well. If, as is true today, the yield curve going into a slowing economy is inverted largely due to the impact of tight monetary policy, the Fed will ultimately loosen policy as growth and inflation move closer to its long-term targets.
That still doesn’t answer the question whether a soft landing or a recession lies ahead. There are signs pointing to both. For equity investors focused on the prospects for individual companies owned or to be purchased, whether GDP declines 0.5% or increases by 0.5% shouldn’t make a huge difference. Good managements don’t let the economic backdrop dictate their fortunes. Weakened competitors die during recessions leaving the strong to gain market share. Well financed companies can invest for future growth while small competitors with restricted access to capital have to sit on the sidelines.
Perhaps most important is the role of innovation. We can look to technology as a solution, but technology is simply a tool. Really successful companies succeed by solving problems and filling holes that exist in our everyday lives. When I was an MBA candidate, statistical regression analysis required multiple arduous manual calculations. Then along came the calculator. A decade later, the laptop computer. Two decades later the smartphone, computer searches, and social media. At first, the smartphone was a phone and a way to get email. Only later did we find that it also could buy tickets, make reservations, and get us from point-to-point most efficiently. In each case, technology made life easier. Of course, sometimes technology solves problems that don’t really exist. Not much demand today for an electric can opener. They finally disappeared when can manufacturers introduced pop-top lids. Innovation doesn’t always mean a chip or a computer has to be involved. Indeed, the greatest innovations in history would have to include such items as a lever or pulley.
In today’s world most innovations are first steps. Hybrid cars boosted energy efficiency. Today’s EVs take it a step further. Will the lithium-ion powered vehicle be the core technology of the next 20+ years, or will it be upstaged a decade from now? I don’t know, but what I do know is that great companies not only innovate, they persistently innovate. It’s like building an onion from the inside out, adding layers upon a core. Microsoft# started with a computer operating system, DOS. Then it expanded it with multi-user capabilities. Windows. It built apps that ran on Windows. Word, Excel, and Outlook. Microsoft started from the ground up. Its first users were at the bottom of the computerization pyramid. The big IBM mainframes were at the top. But as it moved up the stack, its focus had to change from the individual user to the enterprise. Small computers were never going to be as powerful as large ones. But strung together properly, they could compete in performance and offer substantially greater flexibility. The cloud added yet another layer. Now AI is emerging. All this for just one company.
Microsoft isn’t unique, nor does all innovation happen in the IT world. Phil Knight started Nike to make running shoes. Then it made sneakers for other sports. Performance apparel may start at the feet, but before long, Nike was making apparel from head-to-toe, not only for athletes, but everyone. Oh, by the way, sneakers may improve performance, but they are also more comfortable that stiff leather shoes. Walk down the street today and look down at everyone’s feet. It’s more than likely that you will see more sneakers than shoes. That includes people wearing business attire.
I can go simpler: McDonald’s. 60 years ago, a meal at McDonald’s was a hamburger, French fries and a Coke. All for $0.50. Along the time spectrum eventually came the Big Mac, the Egg McMuffin (a burger isn’t a big breakfast item), Happy Meals, and, most importantly, drive-thru windows. Today over two-thirds of its sales come through those windows. Kiosks now take your order. As AI improves, a computer will take your order at the drive thru and you will simply tap a card or phone at the payment window before picking up your order. If you bought McDonald’s stock when you could buy a meal for under a buck, your cost basis today would be well under $1 per share.
All this brings me to a memorial tribute, something I rarely do. Charlie Munger died yesterday at age 99. The Vice-Chairman of Berkshire Hathaway, he played a glorious second fiddle to his younger friend, Warren Buffett (only 93). Buffett was a real Graham & Dodd investor. He was willing to buy anything at the right price with the one proviso that he didn’t have the talent to run the business he was buying, requiring the acquiree to have management to keep the business going. Buffett had many early successes, notably in the insurance industry. Geico is his trophy. Munger was a growth stock guy. Buffett is from Nebraska. Munger was from LA. I often paraphrase Buffett saying he would rather buy great companies at a fair price than mediocre companies at a cheap price. It took Charlie Munger a few decades to teach Warren that idea. Thus, early investment successes like Wells Fargo and Coca-Cola were later dwarfed by his successful investment in Apple. What happens to Berkshire now? Buffett has a deep investment staff today. Recent big purchases like Occidental Petroleum suggest maybe he is going back to his roots. He always keeps a lot of liquidity to be able to snatch bargains in difficult times. Should there be a recession in 2024, look for him to swoop in.
But Buffett is in his 90s and everyone knows it. He is a lot less visible on CNBC and in the public arena than he used to be. As a business, Berkshire is a throwback to the conglomerate era. Burlington Northern has little in common with See’s Candies. Buffett rarely invokes the word synergies when discussing a new purchase. There is a clump of insurance assets, a clump of utility and pipeline assets, a clump of core industrial businesses, and a scattering of other enterprises. And, of course, there is the large investment portfolio with Apple being by far the largest holding. Should Buffett cede leadership in some fashion in the future, I wouldn’t expect sudden change. But over time, perhaps over a decade, it probably would make sense to simplify the structure. Our government today wants to break up several of the big tech companies. In the case of Berkshire, post-Buffett, I suspect that will happen naturally. Just as the company swallowed up public companies like Burlington Northern, or Precision Castparts, it could spin pieces out to the public again. Are the parts worth more than the whole? Berkshire’s stock sells near an all-time high today reflecting the value of investments Buffett and Munger made over more than 60 years. No one is logically betting that he is going to pull another rabbit out of his hat over the next couple of years.
While Berkshire is hard to define with so many different businesses and investments, at its root it operates with a very simplified structure. All the financial and industrial complexities are at the operating business levels. It took six decades to put it together. Neither Buffett nor Munger were interested in adding layers of oversight or overlap that only added costs and slowed things down. At their roots, both Munger and Buffett were investors. They knew what made a business successful. Good products and good leadership. Over time, their thoughts merged, but not entirely. Buffett was the more willing buyer. Munger had no fear of saying no. That may have cost Buffett some good opportunities, but it also probably saved Warren from a lot of mistakes. Charlie Munger will be missed. Over the next few days, leading media outlets will write missives about Munger. Read them and learn. It will be worth your time.
Today, Denver Bronco quarterback Russell Wilson is 35. Trumpeter Chuck Mangione turns 83. Actress Diane Ladd, the mother of Laura Dern, is 88.
James M. Meyer, CFA 610-260-2220