Pricey Utilities, Shrinking Stock Markets, & Why Stocks Beat Gold and Bonds

We start this week with a follow-up chart to a previous Beach Reading. We recently discussed how utility stocks as a sector are trading at a premium to the market rather than at their historical discount to the market. Blackrock’s Russ Koesterich recently published this chart displaying the historical premium/discount of utilities to the broader market which provides context for today's relative valuations. You can see utility multiples in relation to the broader market are close to their all-time highs. This doesn't mean that utilities are at all-time highs (though they're close), but rather that the P/E multiple of the utility sector almost never trades at such a premium to the P/E of the broader stock market. In other words, defensive stocks are expensive.

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From there we move to an old article from the Oracle of Omaha and Berkshire Hathaway Chairman and CEO Warren Buffett. The article is entitled “Why Stocks Beat Gold and Bonds” and was penned in early 2012.

It is the single best, most compact explanation of investing I’ve ever read and is my go-to article when someone asks for a brief investing primer.

With interest rates close to all-time lows, stocks once again look relatively attractive compared with cash and most types of bonds. In the article Buffett states “Right now bonds should come with a warning label.” With rates lower now than they were then, he almost certainly still feels that way.

The article also touches on why gold is a long-term inferior asset when compared to stocks. Buffett does a good job explaining why investors shouldn't be terribly interested in the yellow metal and instead focus their attention and portfolio on productive, cash flowing businesses. If one lived in a developing country with an unstable currency and constant risk of wealth confiscation, gold would be a much more desirable asset. But in the U.S., there are still many better alternatives for long term investment.

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Why Stocks Beat Gold & Bonds

In an adaptation from his upcoming shareholder letter, the Oracle of Omaha explains why equities almost always beat the alternatives over time.

From there we move to a short article from Business Insider highlighting the shrinking stock market. The article discusses how the growth of private equity (as profiled in last week’s article on KKR), later-stage IPO’s, and buybacks have reduced the overall number of publicly listed shares in America every year since 2011.

What the article doesn’t highlight is how the overall number of public companies has shrunk dramatically since the turn of the century. Increased regulation of public companies has raised the minimum size needed to cost-efficiently run an enterprise which has led to fewer small businesses going public. While the regulations put in place after the financial crisis meant to protect small investors from financial frauds were well-intentioned, they’ve had the unintended consequence of stifling capital formation for small companies in public markets. Add to that regulatory burden the ease of raising private money and you see why more small companies are bypassing Wall Street (and therefore Main Street) to Middle America's detriment. Fewer small public companies means the average person won't be able to buy the next Google or Facebook before they are already quite large and therefore the upside is somewhat diminished.

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Stock Markets are Shrinking

The stock market is shrinking. More specifically, the US stock market has shrunk by 2.3% since 2018, according to Citigroup strategists led by Robert Buckland, adding to shrinkage in every year since 2011.

We finish the week with an interesting way to look at brokerage companies and who their target customers are by analyzing their commercials. In years past, most of the "discount brokers" (Charles Schwab, Fidelity, TD Ameritrade, E*Trade, etc.) generally marketed to the same demographics and competed for the same customers. Looking at each company's new ad campaigns, that's obviously not the case anymore. I’ve been struck by how obviously they are targeting their prospective customers and what it says about their fortunes going forward.

For example, check out this E*TRADE commercial showing pampered dogs and finishing with the phrase “There are dogs with better lives than you.” This envy-based ad campaign seems to very clearly target working class people who may be entirely new to investing and feeling FOMO (fear of missing out).

Juxtapose that with TD Ameritrade’s “Green Room” ad campaign. They’re obviously targeting slightly higher net worth, do-it-yourself individuals who would like the ability to discuss a potential transaction with a TDA representative. Personally, I think calling a 1-800 number to ask a non-fiduciary brokerage rep if you should make a trade is an obvious sign one doesn’t know enough to be making the transaction in the first place. “To ask the question is to answer it” as the saying goes. This doesn't even consider the conflict of interest inherent in an employee "sanity checking" a trade when their company directly profits from increased transactions. Never ask the barber if you need a haircut!

With trading revenues shrinking as a percentage of overall sales at most brokerage firms and profits increasingly coming from bank interest, trying to attract day-traders seems like a losing strategy. If you ever see Schwab or Fidelity ads, you’ll notice the difference in target markets almost immediately. They're focusing on higher net worth, more sophisticated investors. We think this strategy bodes well for their futures.

Thanks for reading and enjoy the weekend!