There is a new paper from GMO, "Value: If Not Now, When?" that is a must-read. The key highlights are below:
- No matter how we define cheap stocks – whether on book, or free cashflow, or forward earnings – they look attractive relative to history. Ten of the eleven definitions of Value presented are cheaper than they’ve been in at least 90% of months since 1971, with the cheap half on price to income the misfit. The relative valuation of this group looks a little bit less compressed at the 13th percentile, but it bears mention that in the cheapest month for U.S. Value of all time – February of 2000 – the cheap half based on this one metric was a similar outlier.
- Though most definitions of Value look cheap in relative terms, we often hear concerns about this attractiveness being an artifact of the universe within which we are choosing cheap stocks. If we are simply selecting the cheapest securities within the U.S., for instance, we will today be comparing beaten-down energy companies and yield-starved banks with profitable technology behemoths. These two groups should clearly have a significant pricing discrepancy. To address this, we can use industry classification standards to select the cheapest half of companies within each sector, group, or industry, looking at the relative valuations of the cheapest companies in the U.S. when we strip out the “class” bets. No matter what we do, U.S. Value still looks exceptionally cheap (see Exhibit 4).
- It’s clear that Value is very cheap in relative space, and that cheap portfolios can be formed even when we avoid industries where traditional accounting does a poor job or where monopolies are wiping out the competition. This is not enough to want to invest in Value, however, if we don’t believe that valuations have a reason to rise. In that case, we need to understand whether absent valuation changes – that is, even if Value were to remain as cheap as it is today – we should expect the factor to outperform. It turns out that we should. We can see this by breaking out Value’s relative returns into four pieces: its fundamental undergrowth to the market, its yield advantage (due to being cheap), the profits from selling holdings that have become expensive and replacing them with cheaper securities (what we call “rebalancing”), and changes in relative valuations. Given that valuations cannot trend in either direction forever, it is the first three – growth, yield, and rebalancing – that determine whether Value’s structural prospects are positive or negative. And both before and after 2006, when we put those three together, we see Value outperforming the market (see Exhibit 7).
- And then 2020 happened. Perhaps it was the lockdown that left people with plenty of time on their hands and no sports to bet on, but this year has seen more crazy activity in the stock market than anything we have seen since 2000. Whether it was Hertz stock rising 10-fold in the spring as a high beta recovery play despite the fact that the company was bankrupt and shareholders wouldn’t have benefitted from a recovery even if it happened, or Kodak stock rising 30-fold after announcing it was going to start making chemicals to enable the production of Covid-19 treatments, very odd and speculative things have been going on. As a more traditionally Growth-y example, Tesla has risen some 800% since the fall of 2019 on the back of 17% growth in vehicles sold. It now has a greater market cap than the sum of all the other U.S. automakers, all the European automakers, and all the Korean automakers, with Honda, Mazda, and Nissan thrown in for good measure. That collection of companies sold approximately 100 times as many cars as Tesla did in 2019. But Tesla isn’t the craziest thing that happened this year, and that is true even if we restrict ourselves to looking only at electric vehicle companies named after Nikola Tesla. This spring a would be Tesla called Nikola went public via a reverse merger with a SPAC at a valuation of $3 billion. In the 2020 EV frenzy, it rose 10-fold to a market cap of about $30 billion. This company is a rare bird in the stock market, a pre-revenue manufacturing company. In fact, Nikola is not only pre-revenue, having never sold any vehicles it has produced, it has also never produced a vehicle. Further, it has not even built the factory in which it aspires to build the trucks that it has yet to sell. This summer, a report came out detailing allegations that almost all of the claims of Nikola’s Elon Musk wannabe founder over the few years of its existence were lies. That founder, Trevor Milton, was forced to resign and the company has yet to meaningfully refute any of the claims made in the report. The stock duly fell, but even after information came out showing that pretty much everything the company has claimed to accomplish in its history was a lie, it still has a market cap more than three times its value at its public debut less than a year ago – a valuation that was presumably predicated on the company’s claims actually being true. With a combination of some the highest valuations ever seen and clear corresponding manic investor behavior, it seems clear to us that Growth stocks are indeed in a bubble.
- Despite moderately-sized net sector bets and broadly diversified positions across sectors and regions, we were able to build a portfolio with the median long position trading at 1/10th the price/earnings, price/book, and price/sales of the median short, and with almost 6 times the cash flow yield, 5 times the forward earnings yield, and almost 3 times the dividend yield. The median holding on the long side trades at a 58% discount to the average stock on our dividend discount model, and the median short position trades at over a 380% premium. That makes for about a 12:1 ratio, which is very similar to what we saw at the height of the TMT bubble. We are confident the strategy is a reasonable and robust representation of the basic dislocation in equity markets today. It is by no means a low-risk strategy, but we believe its risks are balanced and appropriate in service to profiting handsomely from a recovery in Value, whether that recovery comes in absolute or relative terms.
Take a look through the top 100 Robinhood stocks. In particular, take a look at the following 19 companies trading at exceptionally high multiples of sales despite low profitability:
These 19 companies are trading at a combined value of $1.63 trillion despite having only $74 billion of revenue over the trailing 12 months. That is 22 times trailing sales. (Be sure to read Jesse Felder's piece from a few years ago on the advisability of paying more than 10x sales.)
The combined valuation of $1.55 trillion is equal to about 5% of the S&P 500 companies' value (although most of these 19 are not in the index). It is also equal to 7% of U.S. GDP. Only four of the companies are profitable, earning $1.3 billion, and those trade at a combined market capitalization of $880 billion.
A
funny thing is that some of these compete with each other (TSLA vs the other electric vehicle companies, UBER vs DASH), and the high
valuation of any given one of those presupposes that it will win, and
have a monopoly on, a winner-take-all market. As a correspondent writes,
I think that last part is the killer. The ZM and DOCU valuations assume that they will somehow kill WORK and/or parts of the incumbent tech giants etc. (WORK is not in your list, but it has a $25 billion valuation versus $834 million in revenue and loses money.)
All the electric vehicle companies will literally kill each other if they don't get killed by the incumbent automakers. The same dynamic would happen in sports betting, plant-based meat.
All of these guys are trading like they will form an oligopoly to own the market, but actually they are just burning each other's houses down while huge incumbents wait to pick at the carcass.
So how did things get this crazy? Lyall Taylor has two good essays on this, Market inefficiency, liquidity flywheels and Unravelling value's decade-long underperformance (and imminent resurgence), that are also must reads. Some highlights from his first essay:
- A liquidity flywheel is a situation where inflows into an asset class lead to buying pressure that pushes up prices, leading to favourable apparent return and volatility characteristics in the said asset class. This favourable outcome then attracts yet more inflows, leading to yet more buying, etc. Conversely, poorly performing asset classes with significant downside volatility can lead to investor redemptions, leading to forced selling that contributes to yet further price declines, yielding even worse returns and even greater redemptions, and so on. This process can go on for years, and sometimes even for decades, and is a fundamental contributor - perhaps the most important contributor - to both major asset-class bubbles, as well as asset price busts and secular lows that lead to fire sales prices (which are 'anti-bubbles' driven by the same drivers of bubbles in reverse). The disconnect between the ultimate owner of funds and the at-the-coal-face investors actually engaged in individual security analysis is fundamental to this process, because end investors have little to go on other than realised investment returns and volatility, and it introduces both information asymmetries and agency conflicts that can drive radical market inefficiency.
- A fund manager might have a huge number of very cheap stocks they would love to buy, but if they do not have any available cash, they do not get to 'vote' on the market price by buying in the open market, as they lack the liquidity to do so - in the short term at least (longer term, you can reinvest dividends). Furthermore, if the said manager is suffering investor redemptions due to recent returns being poor, then regardless of the underlying managers' views on the long term attractiveness of individual securities, they will be forced to sell. It is therefore not uncommon for those most informed about the opportunities in undervalued securities to be actually selling them rather than buying, in direct contradiction to the EMH.
- The opposite is also true for fund managers receiving large inflows - they must buy regardless of their personal views on the valuation appeal of stocks within their purview. It is perfectly possible they believe the stocks to be overvalued and yet still buy them in size, because they have to. Many fund managers are explicitly constrained in how much cash they can hold by their fund charter, but even for those managers that are not so explicitly constrained, if the said manager elects to hold a large amount of cash hoping for a better opportunity to buy, and markets continue to rise, they risk potentially catastrophic levels of underperformance, and so is a luxury they can ill-afford.
- It is important to understand that market inefficiency is structural and behavioural, not informational. Many investors attempt to invest on the basis that market inefficiency is informational in nature, and dedicate tremendous amount of time and resource to trying to come up with better information than the next guy. However, in today's markets, the primary source of inefficiency is structural/agency driven, and the way to exploit that is not to acquire better information, but to have a structure that allows one to engage in long term value arbitrage that other investors cannot (often taking the form of buying underlying assets that are actually low risk, but are priced as if they were very high risk because they are part of an asset class that is generally perceived to be high risk). This requires a wide and unconstrained mandate (by geography, asset class, etc), long term capital, a rigorously long term approach, and an extreme tolerance for volatility and benchmark variation, which requires patience and emotional fortitude that is sorely lacking in today's instant gratification world.
- Outperforming in the long term is actually not very difficult, but it requires highly lumpy results, often marked by long periods of lackluster returns, punctuated by short periods of spectacular results, which happen alongside liquidity flywheel/momentum reversals, which are inflection points that do not happen very often. Furthermore, usually, the worse value is performing, the closer one is to the end of a liquidity flywheel bubble cycle (value had a woeful time in 1999, for instance), because value is the 'anti-bubble' expression - a Newtonian equal and opposite reaction - of liquidity flywheels driving bubbles elsewhere in markets. It is redemption flywheels that drive value opportunities, and redemption flywheels are often the result of investors pulling money out of unpopular areas of the market in a rush to get exposure to hot areas of markets.
- Outperforming in the short term with consistency, by contrast, is extremely hard. The best way to do it is usually a momentum strategy, which works most of the time, but occasionally yields disastrous results on sudden momentum reversals. Momentum is the polar opposite of value - it generates good returns most of the time, and disastrous returns a minority of the time. The latter strategy is a more remunerative strategy for fund managers, however, even if it often leaves long term investors worse off, which is why it is more popular/common. While the good times roll, large performance fees are banked, and it is investors that are left with the losses when it all turns to custard. This is why value investing remains relatively uncommon, despite its long track record of success, and in my view a combination of agency conflicts, information asymmetry, volatility-phobia, and the desire for quick results, will all but ensure market inefficiencies continue, and considerable opportunities for long term value investors will remain for many generations to come.
And from the second:
- Contrary to popular belief, there has been no degradation in returns on capital or earnings for value quintiles, which would substantiate the existence of excess 'disruption' in value as compared to historical averages. In fact, value portions of the market have actually done slightly better on these metrics vs. long term averages over the past decade. Asness' analysis concludes that the primary driver of value's underperformance has simply been value getting cheaper and growth getting more expensive, as has been the case in every past cycle where value has underperformed (of which there have been many).
- Furthermore, it is a major mistake to assume the impact of disruption is confined merely to low multiple stocks (or even felt disproportionately by value). Kodak was a very highly rated, high quality company up until the late 1990s, as was Blockbuster video rentals. That didn't stop them from being disrupted. Indeed, it is actually often the highest quality and highest rated companies that have the most to lose from disruption, as they have both high valuations with very long duration payoffs and very high profitability. This means not only do they have a long way to fall if anything goes wrong (and even the fear of disruption can crush these stocks, whether or not it actually transpires), but their fat margins also act to invite disruption by creating an outsized opportunity for would-be disruptors. One of the reasons Uber exists is that taxis were previously morbidly overpriced, and one of the reasons we have not seen (and are unlikely to see in my view) fintech disruption of the banking industry is that lending spreads are already very thin, and the industry highly capital intensive (onerous regulatory capital requirements) and not especially profitable, so there is little opportunity/reward for doing so.
- A century of quantitative evidence from market history suggests investors tend to underprice stocks with the most apparently assuredly poor future prospects, and over price those believed to have the most assuredly promising prospects, and underestimate tail risk (both upside and downside), and there is nothing in the past decade's market experience to suggest that has fundamentally changed. Further evidence of this stems from the multiple studies that have been done on net-nets - the worst of the worst in terms of business quality and future outlooks (the outlook is so assuredly bad investors are not even willing to pay a price above net working capital net of all liabilities). As a group, such stocks have substantially outperformed over time. However, very interestingly, when studied have been done where investors were given the opportunity to choose the 'best of a bad bunch', choosing only those that were profitable or paid a dividend for instance, the results were much worse. Taking out the 'worst' of the worst lead to inferior returns. Why? Because if it's obviously bad to you, then it's obviously bad to everyone else as well, and the stock will be priced accordingly, with the probability of unexpectedly favourable change underestimated, leading to greater scope for a major re-appraisal of its prospects if conditions do unexpectedly improve. And occasionally, that happens. Most of the time it doesn't, but sometimes it does, and occasionally you end up with an Apple (which was a net net circa 2000).
- What all of these cycles have in common is that the initial bout of outperformance was fundamentally justified by emerging secular trends and reasonable starting-point valuations, but subsequently, as a liquidity flywheel was set in motion that drove rapid multiple expansion over many years, the trend ended up being carried to morbid excess. What happens is that fund managers that due to good luck or good foresight owned those secular winners early report great numbers, and great numbers attract inflows. Those inflows are then invested in the same names, pushing share prices higher still. Investors' greed and get-rich-quick instincts are piqued by strong and consistent performance, and particularly when buttressed by an exciting thematic narrative that seems to justify the strong gains and promise more to come, and with results appearing to validate that assessment. More sector-based funds are birthed and promoted to cash in on this growing investor enthusiasm, and as more and more money flows in, prices get pushed ever higher, further validating the narrative, emboldening investors, and dulling risk aversion.
- As a liquidity driven boom roles on year after year, investors become increasingly skeptical about the role of valuation, for the simple reason that valuation has proven to be a poor predictor of share prices in recent history. Stocks that looked expensive just kept going up (due to liquidity, which is why they were expensive in the first place), so investors - many of which lack decades of experience - come to believe that focusing too much on valuation is a bad idea. Investors will also point to a handful of big secular winners like CSCO and MSFT (in the 1990s) and AMZN this cycle and note they were 'always expensive' and that it was a mistake to pass them up simply because they didn't trade on low multiples. They will then use this logic to justify paying almost any price for companies of vastly inferior quality, ignoring how unique and uncommon companies like AMZN are, so long as stock prices keep going up and validate the narrative. They are right that valuation is not a good predictor of share prices, but are wrong about why. They think it is because it is growth and business quality driving returns, when in fact it is simply liquidity. Nifty-50 investors learned this the hard way when the same high quality businesses with the same high quality and defensive operating results they had always had fell 80% in the 1970s.
- Zoom Communication's peak market capitalisation was recently about US$200bn. Even to trade on a relatively high 20x earnings, it would need to earn US$10bn after tax. Are investors aware of how few companies there are in the world that actually make US$10bn? It's about as much money as Coca-Cola and Visa make, for instance - two of the world's finest enterprises. Very few companies make more than US$10bn, because that is a lot of money, and the world is not infinitely big.
- Peter Lynch observed that it's always incredibly dangerous in markets when investors say company Y will be 'the next X'. In his experience, Y almost always blew up, and in my view that is because outsized success requires a unique and unlikely alignment of stars that occurs infrequently, and is also often the result of a lack of competition leading to an early advantage. The dot.com bust for instance may have helped Amazon a lot by cutting off access to capital to new emergent competition for many years, giving it time to solidify its lead. That doesn't happen in an environment where a million startups are getting funded and VCs are throwing billions of dollars at anything with a large TAM. When you have half a dozon companies all throwing billions of dollars at becoming the 'Amazon of South East Asia', a far more likely outcome is that they all fail and simply end up incinerating cash battling it out amongst each other for market share, just like the ill-disciplined airline industry of old.
- At the late/extreme stages of a cycle, it can often reach the point where investors liquidate other assets wholesale in order to increase participation in the boom. This is usually the point in the cycle where multiple dispersion really starts to accelerate, and value funds not only lag from a relative perspective, but also begin to report poor absolute returns as well, as redemptions force sales and drive down prices.
- The other thing that happened was that the stock market worked in fulfilling its capital intermediation role. If there is insatiable appetite for anything tech which drives valuations higher and higher, the financial industry will manufacture more product to sate that demand, which included a flood of tech IPOs. Eventually there was so much new IPO product it was able to absorb and overwhelm the wave of buying liquidity. We are seeing the same thing today. In the past on this blog, I talked about how there was a VC bubble unmatched by the stock market, and this was why we were seeing so few tech IPOs - the valuations would not stand up to the scrutiny of public markets. That has now changed - the IPO/listed space has become as/more frenzied than the VC space, and this has led to a flood of tech IPOs. As more and more IPOs come to market, not only is more capital raised to fund yet more product development and hence more competition, but there is simply are greater supply of stock to sate speculative demand. Secondary issuances, and continuing copious SBC (stock based compensation) and insider selling serve to further continuously increase supply. At some point, the force of supply will start to overwhelm demand, and that happened in 2000. And it led reflexively to an escalating cyclical downturn as tighter access to funding slowed IT spend, which had cascading impacts through the supply chain.
So what should we do? Well, I have been waiting for this for a long time. I have been mostly in cash with small allocations to Tesla puts and cheap micro caps. (And it has been painful on both ends, even holding mostly cash).
But we are getting the onslaught of supply that Lyall talks about in his last point. In the past two days, there have been 20 more SPACs announced. The people running these companies are sharks, not dreamers, and so are their VC backers. You can bet they are going to feed the ducks while they are quacking. So NIO sold stock last week, Tesla sells stock hand over fist, and then we have insiders selling. The promoter who took SPCE (Virgin Galactic) public through a SPAC last year just dumped a big chunk of his holdings.
I think the opportunity is to buy anti-bubble, value stocks (energy, tobacco, banks, coal, and timber are some cheap sectors) while simultaneously betting against the Robinhood bubble. I think that most of the 19 stocks that I posted above are worthless and a handful are maybe worth 0.1x the valuations they currently trade. That makes it a $1.5 trillion short opportunity, as big as the housing bubble shorts (including the mortgages) were when I started this blog.
We know that we can't short them, because criminals and the innumerate can squeeze them to arbitrarily high levels before they collapse. The logical conclusion would be the same one that we came to in 2007-2008: long term put options.
I have started to play with the risk/reward numbers on the Robinhood Bubble 19. It is actually hard to beat Tesla as a put option candidate - with NKLA for example, you have a more certain downside but more expensive options.
Take this example: if Tesla traded at the same $35 billion market capitalization as Ford (which would be more than 1x sales), it would have a $40 share price. You can buy a January 2023 $50/$40 put spread on TSLA for a debit of less than 75 cents. In other words, pricing in a 7.5% chance that it would trade at the same valuation as an automaker with 4x as much revenue.
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