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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: Shane M who wrote (145)	4/5/1998 7:10:00 PM
From: Freedom Fighter	Read Replies (1) \| Respond to of 1722

Shane, >However, in an environment of full employment can we expect companies >to >be _able_ to expand as they would desire? Perhaps there are >increasing >situations where companies know they can turn profits, but cannot >pursue >them all because of limited manpower. This would force companies to >allocate to higher ROE projects, and cut profitable but lower ROE >expansion. You bring up a very good point. It is one that I can only argue about from an intuitive point of view. My guess is that if the margin between the cost of capital and return on capital is still sufficiently large, companies will begin to bid workers away from each other. This would eventually lower ROE (higher wages). Or we could just see competition for market share with lower prices doing the same. In actual practice, I am not so concerned about how margins compress, just IF they eventually do. The margins and the FREE CASH levels that result are among the key determinants of value in the models that are used to value businesses. As such, they are key to determining whether stocks are massively overpriced or just very high. Another thing to think about is that not all companies are in the same competitive situation. It is much more likely that brands and low cost companies can maintain their high ROE than it is for most other companies. This is where all my own investing is focused. I am trying to avoid anything in technology or with a cyclical component with lots of competitors. This is where the margin risks are the highest I believe. (of course I don't know when) I am in all brands or companies with competitive advantages. This has been a reason I have been a little skeptical about most technology and financial companies. (the darlings of this bull market) Very few have any advantage over their competitors yet the margins are at all time highs. One could guess that some of this is unsustainable or at least not worth paying for because of the potential lowering of margins. If the ROE remains high for the reasons you describe, we must then figure out what the companies are going to do with the extra free cash they are generating. If they retire debt, I would consider this a good thing in some ways, but it would also tend to reduce ROE because it would deleverage the balance sheet. In the models that are used (which a sort of agree with here) there is a tradeoff between the risks of higher debt and the higher ROE. Higher debt is considered value enhancing up to a point and then value reducing after a point because of the risks. In any event buying in bonds is a lower rate of return than an equity investment. ROE and free cash levels relative to equity would drop. They could also buy in shares. Here too the rate of return on this money becomes progressively lower as prices rise. At current prices it is certainly lower than an equity investment. I wrote about this in my March MARKET VIEW. Time will tell. It may be some time before we know. The thing that is certain is that if higher profit margins than has historically been the case are sustainable, you are not getting them for free. You are paying through your teeth for them right now. If they are not, you are dramatically overpaying for businesses relative to history and guarateeing low rates of return going forward. I believe that this is what Warren Buffet meant in this year's letter to shareholders. "Margin of safety has been materially eroded" He alluded to the margin issue last year and this year. It really is critical to knowing where we stand value wise. He has hinted strongly that he does not think current margins are sustainable, but he has hedged that position a little. Summed up I do not think current margins in aggregate are sustainable. But even if I am proved wrong over time I would have lost nothing by not buying most of the companies. The prices already reflect the margins as a certainty. Therefore I am missing no bargains on this issue and potentially avoiding a disaster. Wayne