Sunday, August 2, 2020

Stay away from popular tech stocks

Today, America's five largest companies by market capitalization are all well-known technology and internet businesses: in descending order, Apple, Amazon, Microsoft, Alphabet (the parent company of Google), and Facebook. Historically, being one of the top companies by market cap has been a contrary indicator, both for the company itself and for the industry to which it belongs. In 1980, right before a decade-long decline in oil prices, six of the top ten were oil companies. In 2000, at the peak of the dotcom bubble, six of the top ten were computer and internet companies.

I think history will repeat and that none of today's Big Five will grow enough to justify its current market cap. So I want to lay out the risks, as I see them, of investing in these companies and popular tech stocks in general.

The Economic Risks

As Facebook and Google have grown, they've become more exposed to the overall economy. During the 2007-09 recession, online advertising was a relatively small part of the total ad market and was steadily gaining market share from other advertising media. These share gains offset the recession's effects and allowed them to keep growing despite broader economic turmoil.

Today Facebook and Google are huge advertising players. In 2017, one survey put their worldwide market share at 20% and another suggested it was as high as 25%. The percentages are presumably even higher today. And as impressive as those figures are, they actually understate the extent to which Facebook and Google have saturated their niche, because online ads are not well-suited to certain kinds of advertising.

As "Ad Contrarian" argues, online ads are particularly ill-suited to brand-building. Much of the appeal of brands is their signaling value. For instance, Nike spends a lot of money on advertising that associates its products with athletic prowess. So people buy Nike apparel because it's a way of showing that they're committed athletes, if only as amateurs. And for this kind of advertising to be effective, "it's not enough for it to be seen by a single person or even by many people. Someone has to know that everyone else has seen it, too." Online advertising generally isn't capable of offering that because it tends to be personalized, for example ads that are generated in response to a search query.

So online advertising's total addressable market may be smaller than investors think, and accordingly Facebook and Google may be closer to saturating it. And the purpose for which online ads are most effective--targeted "direct response" advertising--is particularly attractive to local businesses and niche vendors that want to reach a specific audience. Many of these small businesses have suffered immensely during the COVID-19 epidemic, and some are likely to close permanently.

And they aren't the only online-advertising customers who are at risk of failing. The venture capitalist Chamath Palihapitiya, in his 2018 shareholder letter, claimed that "startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon." Most of these startups are unprofitable, some structurally so. Even if Facebook and Google have great business models, many of their customers don't.

Amazon's retail operation, like Facebook's and Google's advertising platforms, is far more mature now than it was during prior recessions and thus more exposed to economic fluctuations. That is a risk because the retail operation has negative working capital: after a customer purchases something on Amazon, it pays its supplier with a significant lag. The lag means that suppliers are effectively financing Amazon, and that, combined with low spending on property and equipment--since as an online retailer, Amazon doesn't need to invest in physical stores--means that its cash balance increases as its revenue grows. Negative working capital is considered a very attractive trait for businesses, and it is most of the time. The exception is when revenue declines, in which instance cash inflows turn into potentially large cash outflows.

Regarding Amazon as a retailer, investors also need to consider the possibility that online commerce has made retailing structurally more competitive and less profitable by increasing price transparency. In a 2018 academic paper, Alberto Cavallo states that "in the past 10 years online competition has raised both the frequency of price changes and the degree of uniform pricing across locations." As a commenter on Value Investors Club writes, "Many innovations have destroyed industries without capturing a fraction of the value destroyed. The surplus goes to consumers and is one reason for increased standards of living in a free-market economy."

Amazon trades at a high price/earnings multiple because it has trained investors to think that it minimizes current earnings in favor of growth. Maybe the minimal earnings are not a choice but structural feature of online retailing.

The Cloud: Actually a Bubble

"Cloud computing," the provisioning of computing services over the internet, is one of the fastest-growing parts of the technology sector. Traditionally, companies that wanted to host websites, store computer data, or run software applications bought and maintained their own computers for those purposes. Cloud computing lets them outsource all of these functions to "cloud providers" that have more resources and computing expertise. 

The largest cloud provider is Amazon's Amazon Web Services (AWS), which has been growing at 30% per year. Microsoft's Azure, the second-largest provider, has grown at 50% per year. Google's Google Cloud Platform, the third-largest, has grown more than 40%. These growth rates--and the expectation that they will continue for many years as cloud computing becomes more prevalent--have convinced investors to grant high valuations to these and other companies that are involved in the cloud. Amazon devoted significant resources to developing AWS before most investors realized how pervasive cloud computing would become, and this has made it a particular favorite of investors. They see AWS not just as a leader in an attractive sector but as a reflection of Amazon CEO Jeff Bezos's shrewdness and foresight.

I think that cloud computing is over-hyped and that the market's ultimate size and profitability are smaller than investors realize., a news and discussion site for tech workers, has many comment threads devoted to cloud computing. Commenters on the site frequently state that using the cloud is far more expensive than using one's own computers and colocation hosting. Here are some representative comments:

Even the cheapest cloud (seems to be Google at the moment) is 5x or more of the price of an equivalent dedicated server (2x for "compute", >20x for bandwidth, so 5x is somewhat average.

I've done the math many times and it's orders of magnitude cheaper to colocate as long as you can afford an IT guy and the upfront cost of hardware.

[C]loud bandwidth is insanely expensive. For example, Hetzner offers 1.3$/TB (if you happen to exceed their generous 30 TB quota). In comparison, Amazon is 70x more expensive at 90$/TB.

There is no economy of scale with the cloud. As you scale up your service, Amazon/Google happily scale your bill right up with it. When you roll your own datacenter, things get much cheaper per unit (bandwidth, storage, etc) as you get larger.

Dedicated servers, and colocation are going to be far cheaper than the cloud, and worse, the savings directly relate to the size of the infrastructure you need.

So why do companies use cloud providers if they're so much more expensive? ycombinator commenters suggest several reasons:

1. The company's use of computing power is highly variable, so it needs to be able to increase its computing resources on short notice. For instance, an online retailer that receives a flood of orders during the holiday season, or that has a fad product that suddenly becomes popular, may use the cloud to ensure that it can keep its website running smoothly as usage surges.

2. The company is growing quickly, either because it's a successful startup or because it's an established company that's significantly increasing its use of the internet and computing power, and cloud providers let it add capacity almost instantaneously. One commenter states that the cloud "makes it a lot easier for a small startup to build out their services without thinking about scaling challenges."

3. Many corporate information-technology departments are inefficient and unresponsive. They may take weeks to fulfill simple requests for new equipment or software. Using a cloud provider lets corporate managers bypass the IT bureaucracy.

4. Cloud providers let companies replace capital expenditures with operating expenditures. This can appeal to both small businesses that are strapped for cash and publicly-traded companies that want to massage their financial statements.

5. Corporate executives with no technical expertise want to use a cloud provider because it's "the new thing" and they aren't aware of the relative cost. One commenter writes, "[a] lot of companies shouldn't ever have scaling issues and are buying into the cloud to be hip. Just like Hadoop and other big data technologies they didn’t need in 2014."

1 is a valid reason to use the cloud, but it is a niche use, and the potential demand for cloud computing as swing capacity is too small to justify the huge valuations that investors have awarded Amazon etc. 

ycombinator commenters suggest that 2 and 3 are the main reasons why cloud computing is popular. If so, then cloud providers are vulnerable to a slowdown of computing growth. If the cloud is more flexible than internally-maintained computing but much costlier, then companies are likely to prefer the cloud when they are growing their computing power rapidly, but when their growth slows, they should find the lower cost of do-it-yourself more appealing. Likewise, the IT bureaucracy's inefficiency is less of a problem when corporate managers have less need to grow and acquire and install new equipment. One commenter writes, "The cloud isn't a money-saving tactic. It enables you to test demand for a service for a very low absolute cost... As soon as you can confidently predict sufficient demand, the economically rational decision is to hire a good ops team and run real hardware."

Demand from 4 and 5 is hard to quantify but vulnerable to changes in perception. During a recession, or even a growth slowdown, companies typically look for ways to reduce their costs. A company that goes with the cloud because it was the easiest and most visible choice may rethink that decision in a more austere environment.

Many investors assume that cloud computing is a secular trend: corporate use of the internet and computing is quickly increasing, and cloud providers should grow even more quickly as they gain market share from do-it-yourself. Investors need to consider the alternative possibility that, rather than being a play on total demand for computing/internet services, the cloud is a play on the growth of computing demand. And if that growth rate falls, even if overall computing usage continues to rise, then the total addressable market for cloud hosting may be much smaller than commonly assumed.

Capital Allocation and Short-Termism

Amazon, Apple, Facebook, and Google grew rapidly by displacing older firms: newspapers, department stores and mall retailers, Nokia and Research in Motion. As a result, they have corporate cultures that are oriented toward growth. With the older firms vanquished, and Amazon etc. dominating their respective markets, there is a risk that they will try to continue growing by investing in crowded fields where they lack any competitive advantage. That's happening in streaming video, where Amazon and Apple are spending billions to compete with Netflix, Disney, HBO, and others. 

Being a monopoly and having high margins doesn't guarantee good shareholder returns. The monopolist may squander its profits by making bad acquisitions, wasting money on unfocused capex and research, or buying back overvalued shares. In Warren Buffett's Agony and Ecstasy speech, the company he used to illustrate agony was the telephone monopoly AT&T, which, "at the end of 1979, was selling for $10 billion less than the shareholders had either put in or left in the business."

Every one of the Big Five--and especially Amazon, Facebook and Google--gives its employees stock compensation that's significant relative to both the company's operating income and the recipients' base salaries. I believe that this stock comp encourages executives at these companies to prioritize a high stock price in the short term over the long-term health of the business.

Amazon's executives get a particularly high share of their compensation as stock, and Amazon is also the company for which there's the most anecdotal evidence of short-termism. Vox claims that "Amazon is stuffing its search results pages with" sponsored listings, while The Wall Street Journal claims that "Amazon changed [a] search algorithm in ways that boost its own products," and Bloomberg reports that Nike has stopped selling its products directly on Amazon after struggling with counterfeits that third-party merchants were selling on the site.

Amazon's worst decision has been allowing large numbers of Chinese vendors to join the site as third-party merchants. Mainland China has extremely low social trust, and Chinese merchants who sell to US customers are beyond the reach of the US judicial system. So unsurprisingly, many of Amazon's new Chinese merchants are selling counterfeit and defective products.

There are anecdotes across the internet suggesting that Amazon has become less competitive on price. That has been my experience. For years, I bought two niche products on Amazon that I assumed would be hard to find in physical stores. In the past year, both products' categories have been inundated with fakes on Amazon, which prompted me to look for other places to buy them. To my surprise, I found both at a local physical health/beauty retailer: one cost slightly more at the physical retailer and the other was 20% cheaper. 

Many Americans do all their online shopping at Amazon because over time it developed a reputation for reliability and low prices. Knowing that Amazon's products were good and competitively priced reduced the "search costs" of shopping on the Internet. Between bad Chinese merchants, sponsored listings that reduce the accuracy of search results, and higher prices, Amazon is increasing its customers' search costs. Trust is hard to gain and easy to lose, and Amazon is at risk of losing their trust.

The Political Risks

The Big Five face three large and growing political risks: nationalism, populism, and resentful competitors. 

First, nationalism: If I were a politician in Brazil, I would wonder why a couple of companies in California are allowed to earn enormous profits connecting Brazilian businesses to Brazilian consumers. I expect that, over time, countries that are large enough and have enough intellectual capital to develop native internet champions will aggressively regulate American tech giants in order to privilege the local champions. Amazon has invested more than $5 billion in India, and in the past couple years the Indian government has passed laws and regulations targeting Amazon and other foreign companies operating in the country.

Second, populism: The Big Five have created a lot of wealth, but most of that wealth has gone to a relatively small group of founders, highly-skilled employees, venture capitalists, and shareholders. Many large tech companies outsource their menial work, meaning that low-level workers don't share in the companies' profits and lack opportunities for advancement. Relevant to this, The New York Times published an interesting article contrasting the employment practices of Kodak during its glory days with employment at Apple today. 

Third, resentful competitors: The Big Five's scale and ubiquity give them power over smaller tech companies and startups. Promising startups may face pressure to sell out to a tech giant, with the threat that otherwise it will drive the startup out of business. After Snapchat created a social-media platform with novel features, Facebook expressed an interest in acquiring it. When Snapchat rebuffed Facebook, it proceeded to copy many of Snapchat's features on Instagram.

So far most investors have ignored these political risks. They are being too blase. Facebook benefited significantly from acquiring Instagram, which has continued to grow robustly as Facebook's user base in the U.S. and Canada has essentially stopped growing. A similar acquisition today would not be politically feasible. And the European Union has levied €8.2bn of fines against Google over the past few years.

The tech giants' size guarantees that, if the political environment becomes more hostile, there are numerous things that politicians and regulators can use to justify punishing them with onerous new regulations. For example, Google tweaks its search results in various ways, and according to The Wall Street Journal, "In one change hotly contested within Google, engineers opted to tilt results to favor prominent businesses over smaller ones, based on the argument that customers were more likely to get what they wanted at larger outlets." In another article, the Journal claims that at Amazon, contrary to claims it has made before Congress, "employees have used data about independent sellers on the company's platform to develop competing products."

Speculation as a Service

So far I've written exclusively about the five largest technology and internet companies, but software as a service (SaaS) also deserves a mention. Similar to cloud hosts, SaaS companies offer their services remotely: unlike traditional software that customers install on their own computers, SaaS runs on the vendor's own servers, and customers access it over the internet.

While SaaS companies are all smaller than the Big Five, they are far more numerous, and as a group they are big part of the tech/internet sector's aggregate market capitalization. They have also been among the stock market's best performers. But in contrast to their stock performance, I believe that SaaS vendors offer poor economic returns to public-market investors.

SaaS vendors typically have very high gross margins, but most of that margin gets captured by employees, notably in the form of stock compensation. Salesforce (CRM), which is one of the leading SaaS companies, had a gross margin of 74% in the financial quarter ended April 30, 2020, but its operating margin was slightly negative. That isn't a fluke; other large SaaS companies like Workday and Servicenow have similar financial profiles. I believe that two things give SaaS employees significant bargaining power:

1. Few people have software development and engineering skills, and even fewer are elite programmers, so their skills have scarcity value.
2. Most tech/software companies are concentrated in Silicon Valley and a few other places like Seattle. The geographic concentration makes switching employers easy.

A few technology companies like Facebook and Google are able to pay significant compensation and still earn high profits because they've established lucrative monopolies. So the question a SaaS investor has to ask is: how many SaaS companies will achieve that kind of monopoly? Judging by their valuations--the companies typically trade above 10x sales--the answer is "most of them."

In part, investors have awarded SaaS vendors high valuations because the first generation of software behemoths like Microsoft, Oracle, and SAP did achieve lucrative monopolies. All three companies have products with high switching costs, and Microsoft's Windows and Office also have significant network effects. So the assumption is that many of today's SaaS offerings will replicate that success. But the comparison is inapt.

When Microsoft, Oracle, and SAP became tech superstars in the 1980s and early 1990s, the kinds of products they sold were unprecedented. The power of computer hardware had risen, and its cost had fallen, enough that for the first time companies could cost-effectively run advanced business software. And since most of the companies that bought such software had never used anything like it before, they didn't consider the possibility that they would be "locked in" to using Oracle or SAP. They were just happy to acquire software that could significantly reduce their costs and increase their efficiency and capabilities. 

Today every large company has experience buying software and understands the risk of being locked in, and they will do what they can to avoid it. In an interview with Patrick O'Shaughnessy, Hamilton Helmer articulates this argument:

It's very rare, once you have a business up and running, to introduce switching costs, because what happens is that customers at that point are smart and they realize what you're up to... It's hard to establish it after the fact. And so that's why usually for switching-costs businesses, you need to get customers during the take-off phase, when things are growing so rapidly that customers are just worried about "Can I get the product?" and they're not worried about all the things associated with it, like switching costs.

And unlike Microsoft, Oracle, and SAP during their glory days, most SaaS is not revolutionary. It's an incremental improvement over existing software, not the kind of boon that would cause software customers to throw caution to the wind.

Also, in the first generation of software, there were numerous losers for every winner. For every Oracle, there was an Ingres, an Informix, a Sybase. I don't expect many SaaS vendors to achieve monopolies with high switching costs, but even if some do, there will be corresponding losers. Yet every SaaS stock is priced for ultimate success.

Which brings me to one final point: In 1994, when Microsoft was the leader in operating systems but had yet to vanquish IBM's OS/2 and completely dominate the market, it traded at 5-6x sales net of excess cash and was nicely profitable. In the same year, Oracle traded at 5x sales and also had a high profit margin. Contrast that with SaaS vendors trading at 10-20x sales with minimal earnings.

Monday, November 5, 2018

Book review: “The Myth of Capitalism” by Jonathan Tepper

The Myth of Capitalism is an upcoming book--it's set to be released later this month--that I highly recommend. The myth in the book's title is idea that Americans live in a free-market economy, while in many cases industry consolidation has eroded the competition and openness that are integral to free markets. The book's treatment of this issue is essentially microeconomic, but its analysis and arguments are also relevant to macroeconomics and investing.

In the interest of full disclosure, I need to state that Jonathan Tepper is a friend of mine and sent me uncorrected proof of the book. So when I say that it's a must-read, I'm biased. But you don't have to take my word for it: the book has received endorsements from many prominent people in and out of finance, including Paul Marshall, Kyle Bass, Josh Wolfe, Martin Wolf, Niall Ferguson, Sir Angus Deaton, Ken Rogoff, Tim O'Reilly, and Richard Lugar.

My favorite finance/investing books mix theory with explanatory anecdotes. Myth of Capitalism follows that format. It surveys the academic literature on economic concentration, citing dozens of academic papers and books that are broadly relevant. But it also has industry-specific case studies and anecdotes, some of them quite illuminating.

The basic message

When most people think of harmful industry concentration, they think of monopolies: Standard Oil and the like. Myth of Capitalism argues that this emphasis is misplaced, with duopolies and oligopolies being almost as anti-competitive as monopolies and far more common.

The book also argues against the prevailing anti-trust philosophy pioneered by Robert Bork and various Chicago School economists. At the risk of oversimplifying, the Chicagoans asserted that mergers are generally good because they lower consumer prices and increase corporate efficiency.

The book cites research suggesting that both claims are wrong: mergers are more likely than not to raise prices, especially once an industry consolidates to a handful of players, and price hikes are more important than synergies in increasing profit margins after a merger.

And even if one accepts the Bork/Chicago arguments, they ignore several things:
Business concentration doesn't just affect consumer prices; it also gives companies more bargaining power versus their workers.
The internet has given rise to several new businesses that dominate their respective niches while offering free products, e.g. Facebook in social networks and Google in internet search. A narrow focus on consumer prices ignores these companies' ability to take abusive and anti-competitive actions against business rivals.
Corporate efficiency isn't the end-all and be-all of competition. While large, mature businesses enjoy economies of scale, they also innovate far less than smaller companies, adjusting for size. I found the book's discussion of this to be one of its highlights.

Regulation and economic concentration

Tepper isn't Elizabeth Warren or Thomas Piketty, and Myth of Capitalism doesn't argue for higher taxes or against capitalism. While the book calls for greater anti-trust regulation, it points out that other kinds of regulation frequently reduce competition. In particular, large companies can bear the cost of onerous or complex regulations more easily than their smaller competitors.

In 1892, Richard Olney, then a railroad lawyer and later US Attorney General, presciently described how regulation can serve the interests of big corporations:
The [Interstate Commerce] Commission, as its functions have now been limited by the courts, is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a Commission gets to be, the more inclined it will be found to take the business and railroad view of things. It thus becomes a sort of barrier between the railroad corporations and the people and a sort of protection against hasty and crude legislation hostile to railroad interest...

The book mentions intellectual property law as another way the government suppresses competition. Since 1982, the number of patents issued each year in the United States has surged, even after adjusting for population growth. And copyright terms have been lengthened, thanks in large part to lobbying by Walt Disney Company. Ironically, many of Disney's movies are based on traditional stories that have long been in the public domain.

Yet another problem is the revolving door between regulators and the companies they regulate. For instance, patent examiners who later move to jobs in the private sector are more likely to approve patents, especially for the companies that ultimately hire them.

Highlights for investors

Of the many academic papers the book cites, two are particularly relevant for investors:

In a 2017 paper, Gustavo Grullon, Yelena Larkin and Roni Michaely find that 75% of industries in the U.S. have become more concentrated over the past twenty years and that as an industry consolidates, its constituents experience abnormally high stock-market performance.

Writing in 2006, Margaret Levenstein and Valerie Suslow find that real interest rates determine the prevalence of corporate cartels. As the book states, “the most important factor in the creation and breakups of cartels was the interest rate. Cartels are more likely to breakup during periods of high real interest rates, presumably because higher interest rates require higher immediate rates of return for collusion. [Levenstein and Suslow] found the relationship was almost perfect.”


Despite its wealth of information, Myth of Capitalism isn't a dispassionate analysis of economic concentration. At heart, it's a work of advocacy, one that argues for stricter anti-trust measures. In light of that, and although I agree with its main argument, I'd push back on a couple things:

1. As mentioned, cartels are more likely to form and last longer when real interest rates are low. So economic concentration is cyclical, and we may see a decline in concentration even if anti-trust regulation remains permissive.

2. By focusing on economic concentration and cartels, the book downplays alternative explanations for some of the problems it describes.

For instance, it mentions that corporate profits' share of GDP has risen, and employee compensation's share has commensurately fallen, since the 1980s and especially since 2001. This coincides with the cartelization of American business, but it also coincides with globalization. I think it's no coincidence that China joined the World Trade Organization in 2001.

On the other hand, there are many oligopolistic industries for which globalization is irrelevant. Health care in the U.S. is mostly insulated from foreign competition, and some of the book's most striking case studies involve drug companies and other health-care players.


I've tried to capture Myth of Capitalism's highlights, but it has many other details readers may appreciate, for instance:

Which government was the first to issue patents
How Standard Oil's business model influenced German industrialization before World War II
How the merger wave of the 1890s-1900s differed from a second merger wave in the 1920s
How companies with abnormally high lobbying expenditures tend to outperform their peers in the stock market
Why economic concentration disproportionately affects rural areas
Why new business formation has declined in the U.S. since 2009

If this sounds interesting, you can pre-order the book on Amazon. Although given the subject, I would recommend bypassing the monopolist and ordering from Barnes & Noble instead.

Sunday, July 29, 2018

After years of underperformance, are value stocks worth buying?

Last month, Sean Markowicz of Schroders wrote an article titled "Where's the value in value investing?" Mr. Markowicz mentions that before the 2007-08 financial crisis, value stocks almost always outperformed growth stocks as measured by rolling ten-year returns, but since then growth has outperformed value on the same measure:

This is partly because "the 12 month forward price-to-earnings ratio of growth stocks has risen by 55% compared to only 11% for value stocks" and because "growth stocks, unlike value, have a greater proportion of their cash flows occurring in the distant future... This makes them akin to long-duration assets, which are more sensitive to changes in long-term rates. As a result, growth stocks have benefited far more than value stocks from rates falling to record lows."

Markowicz summarizes his message by stating that "the valuation picture seems fairly supportive of value’s relative return prospects."

While the article makes a lot of thought-provoking points and is worth reading, I disagree with its conclusion. I don't want to say that value is doomed to continue underperforming growth, but I don't think buying value stocks is a good trade ex ante, for several reasons.

Value and how it's defined

My main disagreement with the article relates to how it defines value. It calculates value's performance relative to growth by comparing a basket of stocks with the lowest price-to-book ratios (the value stocks) to a basket of stocks with the highest P/B ratios (the growth stocks). This means that the actual valuation of value stocks will vary significantly with the market's overall valuation and the dispersion of P/B multiples. So today's value stocks may be radically different from the value stocks of yesteryear, making value's historical outperformance potentially less meaningful than it appears.

I think it is less meaningful: despite their long underperformance, value stocks are noticeably more expansive than they were the last time value was out of favor. In 2000, when the technology bubble peaked, many "old economy" stocks had fallen 25-50% over the prior 18 months and were trading at low P/E ratios. For instance, Autozone and Sherwin-Williams traded at 10-11x earnings despite growing their earnings per share steadily for years. Some companies with more mundane financial results traded at even lower prices, e.g. Universal (UVV) and Ball Corp (BLL) traded at 5x earnings in March 2000.

Maybe I'm not looking hard enough, but I don't see anything like that today. Most companies with steady EPS growth are trading at or above the market's P/E multiple, and the ones trading at single-digit P/Es tend to be cheap for good reason: the business is cyclical, they're failing retailers, they were part of a leveraged buyout and carry a huge debt load, etc.

By buying stocks cheaply, value investors try to create a "margin of safety"--they hope that even if the underlying business disappoints, they'll avoid losing money because the price they're paying for the stock discounts a lot of potential bad news. In my opinion, absolute valuation is what creates a margin of safety, not relative valuation or relative performance. If investors buy a stock at a discount to its net working capital, they won't suffer crippling losses even if the company has to liquidate. If they buy a stock at 5x earnings, they'll earn back their investment in five years, freeing them from the need to make assumptions about the distant future.

Obviously, that's an oversimplification: companies that trade below their net-net value occasionally incur large operating losses, and companies that trade at low P/Es can squander the E on ill-advised acquisitions. But in general, buying absolutely cheap stocks is both safe and rewarding in a way that relative-value investing isn't.

Energy stocks provide a good test of absolute versus relative valuation. After the price of oil collapsed in 2014-15, many energy bulls made relative-value arguments: energy stocks had become an unprecedentedly small part of the Standard & Poor's 500 index, their underperformance vs. the index had reached extreme levels, etc. At the same time, most energy stocks weren't particularly cheap when valued individually: the ones that had earnings traded at high P/Es and would trade at high P/Es even assuming oil rebounded. Many were also poorly managed and prioritized production growth over shareholder return. Ultimately the relative-value arguments didn't matter: energy stocks kept falling until the oil price bottomed, and since then they've barely kept pace with oil futures despite their significant financial and operational leverage to higher oil prices.

Implicit macro and sector bets

Buying value stocks involves making implicit macro and sector bets. Interest rates are a major influence on value's relative performance:

(Source: Claus Vistesen)

This influence works in a couple of ways. One is the dynamic that Markowicz mentions, in which growth stocks tend to be longer-duration while value stocks tend to be shorter-duration. Another is that value stocks, as measured by price to book, disproportionately belong to the financial sector. Since banks borrow short and lend long, i.e. they typically borrow money through overnight deposits or short-term certificates of deposit and make multi-year loans, the shape of the yield curve affects their profitability. All else being equal, banks should earn higher profits when the yield curve is steeper.

So long as the European and Japanese central banks practice ZIRP and financial repression, I doubt the US yield curve will steepen dramatically. When foreign institutional investors buy US bonds, they often finance the bonds by borrowing dollars on a rolling three-month basis. This hedges their currency risk. If the US curve steepens while the European and Japanese curves stay relatively flat, longer-term US debt financed with short-term USD borrowing becomes more attractive to foreign investors, and any movement they make into US debt should re-flatten the curve.

This doesn't mean interest rates--and by extension bank profitability and value stocks--can't rise, but it makes a sustained rally less likely.

I believe that the preponderance of banks among value stocks has also affected value's relative performance in another, more obscure way.

Banks have two unique risks that don't affect other industries. One, they depend on the trust of their depositors and lenders and can quickly fail if they lose that trust. Two, regulators can force them to issue new equity during a crisis or at the bottom of an economic cycle, diluting shareholders at the worst possible time. These risks hit many banks in 2007-09. E.g. Washington Mutual failed, and Citigroup had to massively dilute its shareholders to survive. Despite rising 600% from its 2009 low, Citigroup shares are still 87% off their 2007 high.

I believe that value's underperformance since the financial crisis is partly a byproduct of these risks hitting banks. Bank stocks declined during the crisis, failure and dilution made the decline permanent, and this has depressed the rolling ten-year returns for value stocks. This dynamic isn't supportive of mean reversion. If a bank underperforms the broad market because it had to take a "hard reset" by issuing new equity at the bottom, that doesn't imply it will subsequently outperform.

To be fair, the article touches upon this, but it's something that I would have emphasized more. The article also mentions that the value's underperformance vs. growth shrinks when the value and growth indices are adjusted to reduce the financial and technology sectors' respective weightings.

A couple of final comments

• I think the stock market is more competitive than ever before and that this will suppress returns for many styles of investing including value. Academic research into "investing factors" has increased interest in statistical-value strategies, and the proliferation of hedge funds means that cheap small- and micro-cap stocks that institutional investors traditionally ignored are no longer ignored and are less likely to stay cheap. Don't assume that value will outperform growth in the future just because it typically has.

• Good relative performance doesn't guarantee good absolute performance. Value stocks could outperform growth stocks while actually falling, for instance if glamour stocks like Facebook, Amazon, Netflix, and Google fell 25-30% during a correction while value stocks fell 10-15%.

Thursday, July 26, 2018

The new Nifty Fifty: today's one-decision stocks

On Twitter, Ryan P. Dolan asks, "If we are in a Nifty Fifty 2.0 environment, beyond the obvious members (AAPL, AMZN, GOOG, MSFT, FB, NFLX, TSLA, MA/V, etc), what other companies would you include?"

It's a good question. I agree with Mr. Dolan that today's stock market echoes the Nifty Fifty era of the early 1970s. Many large-capitalization stocks are trading at high price-to-earnings and price-to-revenue multiples, but unlike during the technology bubble of 1999-2000 and the housing bubble of 2003-06, the speculative excesses we see now aren't limited to one industry or sector of the economy.

Instead, like in the early '70s, investors are bidding up glamorous companies--ones that are growing quickly or have high returns on invested capital--irrespective of their industry. The Nifty Fifty was a mix of established-but-still-growing blue chips and newer, sexier companies; likewise for today's market leaders.

I'm going to take a stab at his question and offer a Nifty Fifty 2.0 below. The original Nifty Fifty was an informal, unscientific list, and so is mine. For instance, Apple doesn't trade at exorbitant valuation multiples, but it's undeniably a market leader and glamour stock, so I'm including it. Notwithstanding that, each company on my list has a market cap is $10 billion or more, along with some or all of the following characteristics:

• It's popular among hedge funds
• It's been described as a quality business, compounder, or disruptor
• Its leader has been described as an outsider CEO or a great capital allocator
• It has a price-earnings ratio above 25
• It has an up-and-to-the-right stock chart
• Much of the stock's performance since 2009 has come from multiple expansion

The new Nifty Fifty

Activision Blizzard (ATVI)
Adobe (ADBE)
Align Technology (ALGN)
Amazon (AMZN)
Apple (AAPL)

Autodesk (ADSK)
Automatic Data Processing (ADP)
Berkshire Hathaway (BRKA, BRKB)
Blackrock (BLK)
Boeing (BA)

Booking Holdings (BKNG)
Broadcom (AVGO)
Charter Communications (CHTR)
Copart (CPRT)
Costco (COST)

Danaher (DHR)
Electronic Arts (EA)
Facebook (FB)
Fiserv (FISV)
Google (GOOG, GOOGL)

Home Depot (HD)
Idexx Laboratories (IDXX)
Intuit (INTU)
Intuitive Surgical (ISRG)

JP Morgan (JPM)
Lowe's (LOW)
Marriott (MAR)
MasterCard (MA)
Microsoft (MSFT)

Netflix (NFLX)
Nike (NKE)
Nvidia (NVDA)
Palo Alto Networks (PANW)
Paypal (PYPL)

Rollins (ROL)
Roper Technologies (ROP)
Ross Stores (ROST)
Salesforce (CRM)
Sherwin-Williams (SHW)

Take-Two Interactive (TTWO)
Tesla (TSLA)
Texas Instruments (TXN)
TJX Cos. (TJX)
Transdigm (TDG)

United Health (UNH)
Verisk Analytics (VRSK)
Visa (V)
Wayfair (W)
Workday (WDAY)

Honorable mentions

Interactive Brokers (IBKR) is a cult favorite that's grown steadily, has a revered CEO, and trades at a high multiple, but I excluded it because its free float and trading volume are relatively small.

I wanted to limit the list to American companies, but Alibaba (BABA), ASML (ASML), Brookfield Asset Management (BAM), Constellation Software (CSU), JD.Com (JD), Shopify (SHOP), Spotify (SPOT), and Tencent (TCEHY) are foreign companies that are beloved by American investors, have well-known growth stories, and trade at rich valuations.

Thursday, June 28, 2018

Will tight monetary policy and loose fiscal policy push the dollar higher?

I recently read Jack Schwager's trader-interview book The New Market Wizards, which includes an interview with Stanley Druckenmiller. Many people consider Druckenmiller one of the best investors alive, and he lives up to his reputation in the interview, sharing a number of fascinating anecdotes and ideas.

One idea in particular caught my attention. Druckenmiller tells Schwager that:

I never had more conviction about any trade than I did about the long side of the Deutsche mark when the Berlin Wall came down. One of the reasons I was so bullish on the Deutsche mark was a radical currency theory proposed by George Soros in his book, The Alchemy of Finance. His theory was that if a huge deficit were accompanied by an expansionary fiscal policy and tight monetary policy, the country's currency would actually rise. The dollar provided a perfect test case in the 1981-84 period. At the time, the general consensus was that the dollar would decline because of the huge budget deficit. However, because money was attracted into the country by a tight monetary policy, the dollar actually went sharply higher. When the Berlin Wall came down, it was one of those situations that I could see as clear as day. West Germany was about to run up a huge budget deficit to finance the rebuilding of East Germany. At the same time, the Bundesbank was not going to tolerate any inflation. I went headlong into the Deutsche mark. It turned out to be a terrific trade.

Today the United States has a similar combination of tight monetary policy and loose fiscal policy. The Federal Reserve has begun raising interest rates and shrinking its balance sheet ahead of its European and Japanese counterparts, while the US fiscal deficit is set to surge following a large corporate tax cut.

So after reading the interview, my initial reaction was to assume that the current regime is positive for the dollar. But after further research, I think the U.S. today has enough differences with Druckenmiller's two examples that any comparison is meaningless. I want to emphasize that I'm not a macro expert, so some of these arguments may be flawed, but here are what I see as the differences:

• The dollar is already relatively high.

In 1980, the dollar had fallen by half against yen and mark during the previous decade. In November 1989, the mark was off its highs versus the dollar and had been flat for the previous three years despite a large and rising trade surplus. Whereas today, the dollar's real effective exchange rate is near a decade high:

A chart of the trade-weighted US dollar index also puts the dollar's strength in stark relief:

• Anecdotally, sentiment is also high.

The consensus of Wall Street currency strategists seems to be that, since the US growth has accelerated at the same time that economic data have surprised to the downside in many other countries, the dollar can only continue to rise for the foreseeable future.

By contrast, as Druck mentions, in the early 1980s “the general consensus was that the dollar would decline because of the huge budget deficit.”

Likewise, he tells Schwager that in 1989, “[Buying Deutsche Marks] was made easier by the generally bearish sentiment at the time. The Deutsche mark actually fell during the first two days after the wall came down because people thought that the outlook for a growing deficit would be negative for the currency.”

• The U.S. current account and NIIP are weak.

In the late 1970s and early 1980s, the U.S. ran trade deficits that were relatively small by today's standards, and it had a strong net international investment position. Germany's trade surplus steadily grew throughout the 1980s.

Today the U.S. has both a weak NIIP and a weak current account. A chart from Horseman Capital illustrates how much the US NIIP has deteriorated since the early '80s:

Simply, the U.S. has less wherewithal to run government deficits without incurring major risks.

Also, my hunch—and I'll reiterate here that I'm not a macro expert, so this may be completely wrong—is that the NIIP plays a major role in determining whether deficits are good or bad for a currency. 

Most investors have a home-country bias, i.e. they prefer to invest domestically so long as domestic investments have a competitive risk/reward. So if a country increases its supply of government securities (expansionary fiscal policy) and also guarantees that those securities earn high returns (tight monetary policy), and its citizens own significant foreign assets (a positive NIIP), some of them will sell those foreign assets to buy the newly-created domestic securities, which will push the country's currency higher. Whereas if its citizens have significant international debts (a negative NIIP), this dynamic isn't possible.

• The “return on deficit” will be lower.

In the early 1980s, the U.S. experienced two recessions that kept its economy below potential. In 1989, Germany had a significant identifiable need for investment in the form of integrating East Germany. By contrast, today the U.S. is nine years into an economic recovery, the unemployment rate is low, and there are many anecdotal signs of labor shortages.

An economy with minimal spare capacity and full employment will be less responsive to fiscal stimulus than one that with significant spare capacity and unemployment, so I would expect the current US deficit to be far less stimulative than the two deficits Druckenmiller mentions.

And even before the tax cut, the U.S. government was running large deficits in the midst of a long economic expansion. This suggests that a large part of the deficit is structural, so rather than being economically beneficial it's a sign of weakness.

Saturday, December 9, 2017

Book review: "Long-Term Front-Running" by Michael Fritzell

Many stock traders try to make money by predicting the immediate future: Will tax reform spark a stock-market rally? Will Apple beat earnings estimates next quarter? Et cetera.

Long-Term Front-Running suggests a different tack: instead of guessing at the near future, investors should try to predict which companies will take off in the next few years and buy their stocks before other people catch on. By getting in before the crowd, they'll benefit both as the company's earnings rise and as investors catch on to the story and award the company a higher price/earnings multiple. In my experience, the best-performing stocks are usually a product of those two things paired together, so investors who look for “compounders” should find the book interesting.

Short-term traders should also find it interesting. Trading off immediate events can induce tunnel vision and make one's trading strategy essentially reactive. Looking past the near term should give traders both more perspective and less competition.

A big strength of Long-Term Front-Running is its versatility: it discusses both corporate fundamentals and investor sentiment, both macroeconomic and company-specific events and processes, etc. It also touches on the importance of “reflexivity,” i.e. how perception can affect reality in the financial world and create positive feedback loops.

Unfortunately, in a way the book's versatility is also a drawback. Since it covers a lot of ground in just 100 pages, its specific ideas are mostly rules of thumb, i.e. guidelines on what to do in typical situations. And as I get more investing experience, I've come to believe that many of the best investment opportunities involve atypical situations.

For instance, Fritzell writes that “The best time to bet on a commodity is when inventory is tight; future supply is likely to be low while demand is racing ahead.” This is generally true, but the shale-drilling revolution provides a counterexample. There have been times in the recent past when natural gas inventories were low, yet prices didn't rise. The shale revolution seems to have overwhelmed the traditional relationship between inventories and future prices.

Lest I seem too critical, I'll say that I enjoyed many of the book's rules of thumb. For instance, it includes a checklist for identifying corporate fraud that I found very useful. I also liked its case studies, particularly the one about Delclima, an Italian HVAC manufacturer that began life as a neglected spin-off but soon became a stock market darling.

Notable and quotable

To give you a flavor of the book, here are some of my favorite passages:

The potential to tap future customer demand can be summarized in the term “consumer surplus.” It can be defined as the difference between the price customers are willing to pay and the what the product costs. If there is a huge gap, then the company is potentially sitting on a goldmine.

Return on invested capital itself is not a useful metric: it often reflects a cyclical peak in the industry or the mature phase of the ramp-up of a particular technology.

Products that aren't particularly functional – Tamagochi, baseball cards, Beanie Babies, etc. - are fun for a while but we usually get tired of them. If the product is fashionable and also serves a real functional purpose – for example UGG shoes or Canada Goose jackets – they may survive for a longer period of time.

(In my opinion, this mix of fashion and function explains much of Apple's popularity. Apple's smartphones cost much more than competing phones—they clearly have a fashion premium. Yet they're also cheaper and more functional than what preceded smartphones—the iPhone is like a mobile phone, laptop, digital camera, watch, and GPS rolled into one. The combination of so many things in a convenient device lets people justify paying the fashion premium.)

Not every company is able to take advantage of industry growth... in a commodity industry, ruthless competition may take away most of the opportunity for gain, despite a solid underlying growth trend.

Sometimes people criticize new technology due to certain weaknesses but fail to realize that those weaknesses will disappear over time. Online streaming in the early 2000s was unbearably slow, but with the spread of fixed broadband, online streaming was almost certain to take off.

High credit growth not only pushes money into the stock market, it also improves the value of assets used as collateral in loans, improving creditworthiness and fueling further credit growth.

Whenever a particular method of investing becomes popular, flows into that strategy start to accumulate. Those flows can by themselves help that strategy perform and attract further inflows.

Thoughts on convertible bonds

A convertible bond becomes “busted” when the issuer's stock price falls so far below the strike price as to render the conversion feature nugatory. When this happens, the convertible begins to trade like a regular bond. For instance, if bonds of similar size and credit quality trade at a 9-10% yield to maturity, the convert will typically trade at a price—almost certainly a big discount to par—that gives it a similar YTM.

Busted converts were great investments during the 2001-02 market downturn and again during the Global Financial Crisis. Their strong performance during those periods of stress piqued my interest, and I read as much as I could about the convert market, assuming that it would offer similar opportunities during the next crisis.

After a couple days of reading, I no longer think that will be the case. Actually, my reading suggests that converts will be relatively unattractive going forward, for several reasons:

The market has shrunk. Since 2007, the face value of outstanding convertible bonds has fallen from approximately $700bn to $500bn worldwide and from $300bn to $200bn in the United States. (By comparison, Apple's market cap is $870bn.) There are two reasons why the market is smaller: One, many companies issue converts to save money on interest, and historically low interest rates obviate that. Two, convertible arbitrage funds are major buyers of converts, and since the GFC they've been forced to use less leverage than they'd previously used, reducing their buying power.

With arbs using less leverage, there's less potential for forced selling to create bargains. Investor psychology has also changed. The convertible selloff after Lehman Brothers' bankruptcy was so ferocious in part because it took people by surprise. Nothing like that had happened before, at least not on the same scale. Now investors know it's within the realm of possibility, which I think makes it less likely to happen again. As the old cliché goes, a watched pot never boils.

Transaction costs during the post-Lehman selloff were exorbitant, with bid/ask spreads equal to 7% or more of the midpoint price for many converts:

(Source: The Handbook of Convertible Bonds by de Spiegeleer and Schoutens)

The market was chaotic and illiquid, with December 31, 2008 13f-hr filings showing that various hedge funds had one bond—Ciena's $300mm May 2013 issue—valued at anywhere from 48 to 53 cents on the dollar. Buying converts in 2008 was a great trade on paper, but trading costs made the true returns lower.

Convert issuers tend to be smaller, more speculative, lower-quality companies. Many of these companies also have debt that's senior to their converts—typically, converts are subordinated to all other existing and future debt issues. The GFC was painful but brief; in a protracted recession, converts would likely experience much higher defaults.

Tech industry over-represented

Technology companies are over-represented among convert issuers. I think this is because a convert is most attractive when the issuer's stock is volatile but it has low credit risk. Usually the two conditions don't go together: a company that's less likely to default will typically have a less volatile stock price. But tech companies often trade at high valuations because investors expect them to grow quickly. Hence the stocks are very sensitive to investors' beliefs about the future, and they can be quite volatile without implying anything about the companies' creditworthiness.

Issuers with net cash

In looking at dozens of convert issuers, I found a surprising number that had more cash than debt. Even more surprisingly, the net cash didn't necessarily make them safe credits.

Many tech companies issued convertibles during the dot-com bubble. In 2001, after the bubble had burst and the tech industry was suffering, some of these companies still had net cash. How their converts performed from that point on depended on how they had financed themselves. Some issuers that had raised money primarily through converts defaulted, while the ones that had raised money through a mix of equity and convert issuance almost all survived. In the latter group, many converts paid off at par even after the issuer's stock had fallen 95-99%.

A couple of tech issuers managed to stay afloat only by repurchasing most of their outstanding bonds at a big discount to par. These buybacks meant that they technically satisfied their obligations, but most of their bondholders didn't benefit.

While the dotcom-era tech issuers generally treated their creditors well, that wasn't the case during the GFC. Many issuers with net cash took creditor-unfriendly actions:

ADC Telecom bought back stock in late 2008 while its converts traded at 45 cents on the dollar.
Ciena made a big all-cash acquisition in 2009 as the GFC appeared to be ending, taking it from a net cash position to a significant net debt position. Integrating the acquisition was more difficult than expected and Ciena lost money for several years.
Energy Conversion Devices invested most of its cash in growth initiatives, only to find that its niche solar technology wasn't cost-competitive with polycrystalline solar cells.
TTM Industries made a big acquisition in 2009 that took it from having working capital in excess of all liabilities to having significant net debt, primarily bank loans that were senior to its converts.

Energy Conversion Devices went bankrupt within a few years. The other companies survived and repaid their converts, but the expectation that their net cash provided a margin of safety turned out to be wrong.

By looking at issuers' recent actions, investors may be able to find net-cash issuers that are more favorably disposed to creditors:

In 2002, Juniper Networks had $1.7bn of cash and $1.15bn of outstanding convertible bonds. That May, it acquired Siemens' networking business. Juniper had enough money to buy the business entirely for cash, but instead it paid in a mix of cash and stock, leaving it with a net cash position. A few months after the acquisition, it bought back ~18% of its converts at a discount to par. In 2003, it tendered for the remaining bonds at par.

In 2007, Arris Group acquired C-Cor. Like Juniper, Arris made the acquisition with a mix of cash and stock that left it with a net cash position. It later bought back some of its converts during the GFC and stated in its 2008 10-K that “Maintain[ing] a strong capital structure, mindful of our 2013 debt maturity” was a key part of its corporate strategy.