Newsletter April 21, 2016
The Implications of Job Losses to Automation And How to Prepare Yourself
Lately, the prospect of jobs being lost to software and automation seems to be a growing fear. McDonald’s has introduced automated ordering. Driverless vehicles could eventually eliminate the role of truck driver. The investment advice business is being automated for some clients with the introduction of “robo-advisors”. There is a fear that even higher level knowledge workers will be replaced by computers with artificial intelligence.
The same kind of fears have been around for at least several hundred years. And indeed many trades and millions of jobs were wiped out by technology. Nevertheless, people adjusted and retrained and the lives of the great majority (but not all) people have been greatly improved though automation.
But now, the fear is that there will be no jobs to retrain for. The fear is that automation will wipe out millions of jobs and there will simply be no jobs for many or most of the displaced workers.
History suggests that in fact new jobs will materialise. But it’s worth thinking about the implications of a world where good-paying jobs are far more scarce due to automation.
In such a world there will a far greater abundance of goods and services produced. That should lead to a higher standard of living, on average. The question will be how can people get their fair share of what is produced if they don’t have good jobs? Perhaps there will a good deal of redistribution of goods and services by government. There might be a guaranteed minimum income for every adult. But it also seems extremely likely that the owners of the automated machines and software will continue to receive an ample share of the output. In that world it will be more important than ever to be an owner of businesses. Therefore it will be more important than ever to invest in equities through the stock market. Those individuals and families that accumulate larger investment portfolios would be setting up themselves and their heirs for success in an increasingly automated world
Thomas Piketty in his book Capital in the 21st Century decried that fact that wealth is becoming ever more concentrated in the hands of the owners of businesses. I’d suggest that a reasonable reaction to that is to set yourself up to be an owner of businesses. For most people that means investing in the equities through individual stocks, exchange traded funds or mutual funds.
The Surprisingly High ROEs of Large Companies
Economic theory suggests that abnormally high returns on equity or ROEs cannot be sustained in the face of competition. For example low interest rates make it easier for companies to invest in new assets which leads to increased competition and lower ROEs. Reality however, begs to disagree.
At the start of 2014, I demonstrated that the Dow Jones Industrial Average as well as a list of companies had high ROEs. In the two years since then, not much has changed.
Recent data from Dow Jones Industrial Average indicates that the average P/E ratio of the 30 companies in the Dow Jones Industrial Average was 17.01 as of March 31, 2016. And the Price to Book Value ratio was 2.99.
The average return on equity (ROE) of the DOW companies can be calculated from the above using the following formula. (This is return on ending equity, rather than the more familiar average equity over the year.)
ROE =earnings/equity = price/book equity divided by price/earnings.
Therefore the DOW ROE was 2.99/17.01 = 0.176 = 17.6%.
In a world where short term interest rates are about 0% and a 30-year US. government bond earns 2.6%, a 17.6% ROE is a staggeringly high return. And this is no anomaly, the ROE on the DOW has been at similar levels for many years.
Here are the recent ROEs, as well as P/B and P/E data, of some (mostly) large companies:
|Canadian National Railway Company (CNR, Toronto CNI, New York)||25.3%||4.32||18.2|
|Canadian Western Bank (CWB, Toronto)||12.9%||1.07||8.7|
|Stantec Inc. (STN, Toronto and New York)||14.4%||2.32||17.8|
|Canadian Tire (CTC.a, TO)||12.8%||2.03||16.4|
|MELCOR DEVELOPMENTS LTD. (MRD, Toronto)||5.4%||0.48||9.3|
|Alimentation Couche-Tard Inc., ATD.B||24.9%||5.39||23.0|
|Wal-Mart (WMT, New York)||19.0%||2.79||14.8|
|Berkshire Hathaway Inc. (BRKB, New York)||7.0%||1.39||20.4|
|Boston Pizza Royalties Income Fund (BPF.un, Toronto)||12.4%||1.49||13.7|
|Costco (COST, N)||21.8%||6.35||30.3|
|Wells Fargo (WFC, United States)||12.7%||1.47||11.8|
|Bombardier (BBD.B, Toronto)||negative equity|
|Toll Brothers Inc. (TOL, New York)||9.2%||1.30||14.6|
|RioCan Real Estate Investment Trust (REI.UN, Toronto)||6.4%||1.08||17.4|
|Bank of America Corporation (BAC, New York)||6.3%||0.65||10.6|
|Dollarama Inc. (DOL, Toronto)||63.8%||24.68||30.7|
|Constellation Software Inc. (CSU, Toronto)||124.7%||30.13||26.1|
|Liquor Stores N.A. Ltd. (LIQ, Toronto)||4.4%||0.61||14.6|
|Element Financial Corporation (EFN, Toronto)||5.4%||0.90||20.5|
|American Express Company (AXP, New York)||26.8%||2.98||11.4|
|Onex Corporation (OCX, Toronto)||-79.2%||39.21||negative earnings|
|Agrium Inc. (AGU, Toronto and U.S.)||17.0%||2.03||11.6|
|TransForce Inc. (TFI, Toronto)||18.2%||2.21||12.8|
|Royal Bank of Canada (RY, Toronto and U.S.)||17.0%||1.78||11.3|
This table shows a few companies with low or even negative ROEs, however many of them are very high. Unfortunately the companies with high ROEs also tend to have prices that are high multiples of book value.
A high ROE does not guarantee that the company will be a good investment. It’s earnings could fall or the high ROE might be fully reflected in a very high price to book value ratio. Still, a high ROE company will often turn out to be a very a good investment. In fact, if the ROE remains high for many years, then the investment is sure to turn out well unless it was purchased at too large of a multiple to book value.
Why Interest Rates Are So Low
It’s popular to believe that interest rates are low simply because central banks pushed them down so low. And there is certainly some truth to that. But the central banks of most countries would raise interest rates if inflation exceeded about 2%. But slow growth in the economy and technological innoivations have kept inflation very low. This suggests that we could blame low interest rates on low growth.
And that brings up another theory for why interest rates are so low. This theory suggests that interest rates are set by the supply of savings versus the demand for loans. This theory can be used to explain the very high interest rates of the 1970’s. In those years the bulk of the baby boomers were forming households and borrowing to buy houses and cars. The pool of money to be loaned out came largely from older people. But the young people greatly outnumbered the older people due to the baby boom and to the earlier baby bust during the depression and perhaps even due to those lost in the war. In addition, retirees in the 1970’s often had little in the way of savings. Overall there was a huge demand for borrowing and small supply of savings available to be loaned out. Simple supply and demand and economics 101 would suggest this would lead to high interest rates which lowered the demand for borrowing and perhaps increased the supply of savings.
The supply and demand theory of interest rates also offers a possible explanation for today’s ultra low interest rates. Today, many (but certainly not all) baby boomers have accumulated large amounts of savings. Pension funds contain massive pools of savings. Meanwhile there is a smaller number of people forming households and borrowing to buy houses. Simple supply and demand suggests that interest rates had to drop in order to increase the demand for borrowing in order to sop up all of those savings.
The reality may be more complex, but it seems to me that the simple supply of savings and demand for borrowing does partially explain today’s ultra low interest rates.
How Corporate Directors Are Deferring Income Taxes
Corporate directors and executives often receive at least a portion of their compensation in the form of deferred stock units, stock options or restricted stock options. This part of their compensation does not require the payment of income taxes until some years later. However, there is usually a large cash component of compensation that does attract current income tax. This is much more the case for executives than for directors.
However, I recently saw that a number of companies are allowing their directors to be paid exclusively in the form of deffered stock units or restricted stock units or stock options. In one case that I looked at directors were receiving about $200,000 per year in deferred stock units as compensation and not paying a dime of income taxes on it until they would retire from the Board years later.
As an investor, this practice is not of much or any concern. However, as a tax paying citizen, I find this practice to be reprehensible. Why should these directors be allowed to defer all of their income tax on their director compensation for years? And why should corporations facilitate and even encourage this? I have contacted some newspaper columnists to see if some light can be shed on this tax deferral behavior.