Southwest’s Screwup Exposes A Myth Of Margins – How Tesla Is Hurting ETFs

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Hank Greenberg’s email to investors discussing Southwest’s screwup exposes a myth of margins, how Tesla is hurting ETFs, and his 2023 predictions.

Southwest’s Screwup

If there’s one moral to Southwest Airlines’ (NYSE:LUV) screwup last week with thousands of canceled flights, it’s this…

Companies spend woefully little on tech.

What happened at Southwest is really little more than something that has been hiding in plain sight for years.

Q3 2022 hedge fund letters, conferences and more

 

Simply ask yourself: How many times have you heard a retail clerk or customer service agent say, “My computer is slow” or “My computer just went down”?

And it’s not an isolated event.

Mortgage brokers, car rentals, banks, appliance service scheduling, the frustrated cashier at the grocery store… Technical issues always crop up.

The easiest thing to do to keep costs low and margins high – especially for public companies eager to meet or beat quarterly expectations – is for managements to defer tech upgrades in hopes that they’ll get from here to there before things break.

Like they did at Southwest.

It has been happening for years and will continue – especially if earnings come under increased pressure, as many pundits expect.

The last thing to fix is something people can’t see…

And that’s tech, which crumbles quietly in the background until – as the Southwest implosion showed – all the remaining rubber bands holding things together snap at the same time.

As columnist Michael Hiltzik recently wrote in the Los Angeles Times, beyond the airlines, it raises the question about “why American companies generally get caught so often with their pants down when operating conditions materialize on the edge of – or outside – normal expectations.” As Hiltzik went on to say…

The short answer is their underinvestment in preparation and planning. For decades, Big Business has been squandering its resources on handouts to shareholders instead of spending on workers and infrastructure. There’s not enough give in the system, so when crisis comes, it doesn’t bend, but breaks.

The pandemic didn’t help. A 2020 study by Boston Consulting Group showed that under the cover of COVID, 54% of nearly 700 companies surveyed said that they had delayed upgrading existing hardware, and 44% have delayed feature add-ons or upgrades to existing software. As the study went on to say…

Notably, even companies whose businesses are not taking a major hit from the pandemic are pulling back: 45% of those companies have paused deployment of new technology and nearly 20% are deferring maintenance expenses.

The trend was borne out in a series of tweets by my friends at Kailash Concepts – using Southwest as the prime example. They started off by noting…

[Southwest’s] gross profit for the 12 months ending September 30, 2022 was $5.928B, a 53.81% increase year-over-year.

Impressive… But in Southwest’s recent third-quarter earnings report, CEO Bob Jordan said:

As we finalize our plan for next year, we remain laser-focused on our goals to grow full year 2023 profits and margins, excluding special items, year-over-year, and to generate healthy returns on invested capital for our Shareholders.

That sounded good on paper, but as Kailash also observed…

Perhaps it would have served Jordan well to have a laser focus on ensuring that systems were working adequately to ensure the airline could meet the needs of their customers. You know, the people whose spending is actually delivering those profits to shareholders…

Look, we’re not against corporate profits – quite the opposite. But when a company has record profits and fails to invest in the required infrastructure to serve their customers and employees, it HURTS the bottom line. Worse, it hurts people.

Corporate executives need to stop making internal PowerPoints and congratulating themselves and start looking at how they will reinvest so they can sustainably deliver profits to shareholders in the long term.

Margins possess a sort of analytical aphrodisiac during boom times and can foment the irrational euphoria that characterizes market peaks. Contrarily, margins can also add to the “hangover” after such periods, amplifying negative sentiment.

Remember that next time you hear, “Sorry, my computer is slow.”

In 2023, after all… it shouldn’t be.

How Tesla Is Hurting ETFs

Moving on… To some investors, exchange-traded funds (‘ETFs’) are a no-brainer approach to investing…

These are as easy to trade as regular stocks and they’re diversified like mutual funds, but without the mutual fund fees.

What could possibly go wrong?

As many investors are learning, if funds are structured in such a way that they’re top-heavy with companies that have the biggest market caps, they might not be as diversified as they think.

Just look at funds loaded to the gills with electric-vehicle (“EV”) maker Tesla (NASDAQ:TSLA), whose stock has collapsed in recent months.

As ETF.com recently reported, 310 ETFs of all shapes and sizes ­– from plain vanilla to high risk – hold Tesla. According to the website…

The largest ETF holder of TSLA is the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), with approximately 28.91M shares. Investors may also find of interest that the ETF with the largest allocation to TSLA stock is Consumer Discretionary Select Sector SPDR Fund (NYSEARCA:XLY), with a portfolio weight of 19.15%. On average, U.S. ETFs allocate 2.73% of TSLA to their portfolios.

The story is in the below chart of the top 10 ETFs that recently had the largest Tesla exposure, which my friend Harold Bradley – the former chief investment officer of the Kauffman Foundation – calls the “Will Robinson” chart (as in that famous line from the TV show Lost in Space, “Danger, Will Robinson”)…

As Harold explained in a LinkedIn post…

It shows the massive concentration of TSLA shares in the SP500, a number of enormous consumer discretionary ETFs, some run of the mill ESG [environmental, social, and governance] funds, and other EV or clean energy funds. It’s even a big holding in some of the imploding crypto funds.

I wrote a paper with my colleagues at the Kauffman Foundation warning of the day when cap weighted indexes being drawn up to match about any investment narrative would melt up and possibly melt down as money swarmed into themes, pumping up the biggest holdings in those “passive” [funds] before cascading out of those funds with equal velocity…

The suddenly urgent liquidation of TSLA, which had been a darling of the ESG crowd until it wasn’t, shows how ETF construction may be undermining the rewards of capital markets to good stewards.

The ESG indexes swept up many of the SPAC [special purpose acquisition company] darlings, often promising new EVs, batteries, etc. as assets burgeoned in the Covid speculative bubble. The unwinding now of major companies reporting bad news will take good companies down in ETFs structured with enormous position weights in suddenly vulnerable stocks.

It seemed so farfetched in November 2010, when the paper was published… and the newly public Tesla was trading for a little over $1 a share, adjusted for splits.

Then again, so do all warnings when stocks are rising.

2023 Predictions

Finally, my 2023 prediction (drumroll)…

I don’t have one.

For the record, I realize I’m supposed to, but I hate making annual predictions because I simply don’t know what will happen tomorrow, let alone over the course of the next year. (You tell me what will happen in China and Taiwan and Russia and Ukraine and maybe, just maybe, I’ll venture a guess.)

That point was driven home on a recent On the Tape podcast episode by Michael Mauboussin, head of Consilient Research at Counterpoint Global Morgan Stanley Investment Management, who also doesn’t like making predictions. As he explained (emphasis added)…

Phil Tetlock wrote a fabulous book in 2005… It’s called Expert Political Judgment.

He took 400 experts, masters, [and] PhD level people [and asked] them to make specific predictions in economic, social, and political outcomes. And then he kept track. He realized that those people are just barely better than chance right.

Now, there are two things that were really interesting about this, and it goes right back to your question, Guy [Adami]. The first was he found the more media mentions a pundit had, the worse his or her predictions. So literally, the people you see most frequently on TV are the ones that typically, if you keep track of them, statistically are not.

Why is that? Because if you’re a producer, you don’t want someone saying, “Oh, it might go up, might go down.” [It’s] not very fun TV viewing, right? Not particularly inspirational.

The second thing they found was it did not matter where you were on the political spectrum or what your gender was or whatever was your way of thinking. And they distinguish between hedgehogs and foxes. Hedgehogs are those people that know one big thing. And you guys know we have them on Wall Street, the boosters or the doomsters… And those people always get their 15 minutes of fame, but they’re just not great forecasters.

And then the other one is the foxes. People know a little bit about a lot of different things… They’re not wedded to views very strongly… The hedgehogs tend to be very confident. Foxes tend to be, again, much more equivocal. But foxes are consistently actually better predictors over time.

I think just ingesting that lesson is so important that it’s – epistemic humility is the fancy word for it – just, I don’t know what’s going to happen in the world.

Nobody does. I think my friend Peter Atwater, the contrarian, put it best…

As you take in all the “2023 outlooks,” just a reminder that in the markets, that which the crowd is most certain of is the least likely to occur.

As always, feel free to reach out via e-mail by clicking here. I look forward to hearing from you. Happy New Year!

Regards,

Herb Greenberg