Finance – Page 17

High flying growth companies will badly damage new shareholders

The problem with having a huge amount of anticipated growth baked into your stock price is that the expectations become incredibly difficult to achieve.

High expectations result in high stock prices.

I’ll post the charts of two of these companies which are household names – Zoom (Nasdaq: ZM) and Docusign (Nasdaq: DOCU):

We will look at Zoom first.

At its peak of $450/share, Zoom was valued at around $134 billion. Keeping the math incredibly simple, in order to flat-line at a terminal P/E of 15 (this appears to be the median P/E ratio of the S&P 500 at the moment), Zoom needs to make $9 billion a year in net income, or about $30/share.

After Covid-mania, Zoom’s income trajectory did very well:

However, the last quarter made it pretty evident that their growth trajectory has flat-lined. Annualized, they are at $3.55/share, quite a distance away from the $30/share required!

Even at a market price of $180/share today, they are sitting at an anticipated expectation of $12/share at sometime in the future.

Despite the fact that Zoom offers a quality software product (any subscribers to “Late Night Finance” will have Zoom to thank for this), there are natural competitive limitations (such as the fact that Microsoft, Google and the others are going to slowly suck away any notion of margins out of their software product) which will prevent them from getting there.

The point here – even though the stock has gone down 60% from peak-to-trough, there’s still plenty to go, at least on my books. They are still expensive and bake in a lot of anticipated growth which they will be lucky to achieve – let alone eclipse.

The second example was Docusign. Their great feature was to enable digital signing of documents for real estate agents, lawyers, etc., and fared very well during Covid-19. It’s an excellent product and intuitive.

They peaked out at $315/share recently, or a US$62 billion valuation. Using the P/E 15 metric, the anticipated terminal earnings is about $21/share.

The issue here is two-fold.

One is that there is a natural ceiling to how much you can charge for this service. Competing software solutions (e.g. “Just sign this Adobe secure PDF and email it back”) and old fashioned solutions (come to my office to scribble some ink on a piece of paper) are natural barriers to significant price increases.

Two is that the existing company doesn’t make that much money:

Now that they are reporting some earnings, investors at this moment suddenly realized “Hey! It’s a long way to get to $21!” and are bailing out.

Now they are trading down to US$27 billion, but this is still very high.

There are all sorts of $10 billion+ market capitalization companies which have featured in this manner (e.g. Peleton, Zillow, Panantir, etc.) which the new investors (virtually anybody buying stock in 2021) are getting taken out and shot.

This is not to say the underlying companies are not any good – indeed, for example, Zoom offers a great product. There are many other instances of this, and I just look at other corporations that I give money to. Costco, for example – they trade at 2023 anticipated earnings of 40 times. Massively expensive, I would never buy their stock, but they have proven to be the most reliable retailer especially during these crazy Covid-19 times.

As the US Fed and the Bank of Canada try to pull back on what is obviously having huge negative economic consequences (QE has finally reached some sort of ceiling before really bad stuff happens), growth anticipation is going to get further scaled back.

As long as the monetary policy winds are turning into headwinds (instead of the huge tailwinds we have been receiving since March 2020), going forward, positive returns are going to be generated by the companies that can actually generate them, as opposed to those that give promises of them. The party times of speculative excess, while they will continue to exist in pockets here and there, are slowly coming to a close.

The super premium companies (e.g. Apple and Microsoft) will continue to give bond-like returns, simply because they are franchise companies that are entrenched and continue to remain dominant and no reason exists why they will not continue to be that way in the immediate future. Apple equity trades at a FY 2023 (09/2023) estimate of 3.8% earnings yield, and Microsoft is slightly richer at 3.2%. Just like how the capital value of long-term bonds trade wildly with changes of yield, if Apple and Microsoft investors suddenly decide that 4.8% and 4.2% are more appropriate risk premiums (an entirely plausible scenario for a whole variety of foreseeable reasons), your investment will be taking a 20% and 25% hit, respectively (rounding to the nearest 5% here).

That’s not a margin of error that I would want to take, but consider for a moment that there are hundreds of billions of dollars of passive capital that are tracking these very expensive equities. You are likely to receive better returns elsewhere.

Take a careful look at your portfolios – if you see anything trading at a very high anticipated price to cash flow expectation, you may wish to consider your overall risk and position accordingly. Companies warranting premium valuations not only need to justify it, but they need to be delivering on the growth trajectory baked into their valuations – just to retain the existing equity value.

SARS-CoV-2 / New mutation / Thoughts

Please read my December 21, 2020 post, Mutant SARS-CoV-2 Viruses, Perceived Risk, Actual Risk, which has aged reasonably well since its publication. The only factor I continue to under-estimate at all instances is the notion of “back to normal”, which from the onset of the Diamond Princess I have been consistently wrong with.

I have very consciously been trying to avoid any political discussions of COVID-19 on this site, except when things interfere with the financial markets.

For the most part, the “known unknowns” have been well priced into equities.

However, we might have a game-changer that will require some re-thinking.

Insert today’s scare headline, the B.1.1.529 variant:

The issue here is regarding the psychology of the effectiveness of COVID-19 vaccinations.

Most people believe they work. Indeed, because of this popular support, governments have been able to coerce those that do not into taking them.

The issue is that just like influenza and HIV, you might be able to take something to address the clinical symptoms (which the existing vaccinations have done) versus dealing with the transmission of SARS-CoV-2.

Without preventing the transmission of SARS-CoV-2, vaccinations to mask clinical symptoms of COVID-19 are a delaying tactic at best.

The best analogy I can make here is the advent of computer viruses and anti-virus software. Initially there were programs (McAfee and Norton Anti-virus) that you ran in MS-DOS to search executables for specific code snippets (containing viruses). They worked initially (sometimes producing false positives), and you had to get updates to tell the program the new code snippets of new viruses that were coded and spread around. However, technology advanced (such as auto-modifying code) and conventional anti-virus software is practically useless as a form of computer security (it is beyond the scope of this post to discuss this fascinating matter). Anti-virus software continues to be sold today and all it serves is to slow down the computer system and provide a false sense of protection.

Likewise in the biological world, mutations are rapidly rendering COVID-19 “anti-virus software” (vaccinations) obsolete. You might be able to protect against the “old school” strains, but for the new software versions (variants), you have much less protection.

This is the result of having a population monolithically vaccinated with the same anti-virus software. It doesn’t take much of a code modification to work around it.

What isn’t discussed about the B.1.1.529 variant is whether the severity profile is more or less severe than Delta. This remains to be seen.

Unlike computer viruses, which are engineered to have a specific impact, biological viruses are positively selected for transmissibility, and not for clinical severity. Indeed, too severe clinical symptoms would work against transmissibility, just as it did for SARS-CoV-1.

The changing psychology will be increasing public awareness that the existing COVID-19 vaccinations do a minimal job of protecting against transmission. They were fighting yesterday’s battle. It will be sold to the public as a necessary “first step” to fighting COVID-19, with much more to go, even though it is pretty evident the “vaccinate everybody” strategy that was taken has proven to be incorrect. The correct strategy was to vaccinate those that are at high risk, but now that mostly everybody is vaccinated, there is going to be a new strain that will dominate and this might be B.1.1.529. The question at this point is whether this new variant exhibits increased severity of clinical symptoms.

In the past my ability to predict public reaction to SARS-CoV-2 has been terrible. If B.1.1.529 picks up, from historical reaction over the previous 18 months, the cultural of zero risk will force more sanctions, “to prevent the spread”.

Governments always want to be seen doing something, even if their actions have no effect on the outcome (e.g. outdoor mask mandates).

They will also never admit that their past strategies have been terrible to preserve whatever credibility they have remaining to implement new measures.

My guess at present is that the Covid-sensitive sectors which got hit from March to June of 2020 will probably face another dial-back. Until I see how B.1.1.529 evolves, I’ll reserve judgement on timing.

Headlines are too panicky

There is a cliche and that is that markets do not crash when everybody is fearful.

Glossing over a few headlines today, we have:

‘Global equities are likely to be under pressure in coming months’: Citi

Households that made money in the pandemic should prepare for some financial pain

Eyeing higher inflation and volatility, investors turn more selective: fund managers

Almost nobody out there is saying “buy stocks”.

I’m not saying GME is going to a thousand dollars, but I wouldn’t bet my life on it NOT happening.

When is it time to cash in the chips?

It’s been a good run up in the market in the past month. Just last month I thought I was headed for the first negative quarter since Covid hit. Now it’s a race for the finish in the last two weeks of September.

There’s been a component in my portfolio (you can guess which one it is, I’ve written about it before) that almost has GME-like properties at the moment, albeit the business model is slightly more viable and I think the hype cycle is around the 3rd inning of this particular baseball game.

One always needs to ask themselves when enough is enough.

The trading mechanics of stocks nearing a mania high is punctuated by intense volatility both on the upside and downside.

Gamestop is a perfect illustration of this.

You had a few trading days (look at late January) where it ranged from $200 to $450 in what could be classified as insanity.

Even a week before that, when it spiked from $40 to $100, that was considered insanity.

Nobody wants to be the person selling GME at $40 on its way up to $400, but you had to wait four trading days (not to mention a weekend) to make this happen. Retrospect makes for 20/20 vision, but doing this in the heat of the moment is a hugely difficult endeavour.

What’s funnier is if you set your limit order at $300, psychologically you would have still felt ripped off since you had the potential for another 50% gain ($450)… “If only I set the limit sell price at $400 instead of $300 that day”.

That said, share dispositions do not have to be a binary decision – you can choose to trim tiny amounts as prices rise. This is my personal approach to things, although logically it doesn’t make sense.

Overall, however, we are seeing a commodity-driven boom. There is a lot of forward expectation and you can see this with the single digit P/Es projected in most of these companies.

ARCH, for instance, is trading at 6 times projected 2021 earnings. Coking coal is going crazy and Arch is down 4% today. What gives?

My Divestor Oil and Gas index has Q2 guidance below current spot prices and even with that guidance, companies are trading at EV/(free cash flow) levels of the high single digits (and if you ignore debt leverage, the price to cash flow ratio is even lower). Natural gas is spiking – you’re seeing Henry Hub gas prices this winter heading north of US$5/mmBtu, and AECO is north of CAD$4 and it’s still September.

It’s a really difficult decision to be selling equities that are trading at single digit multiples of cash flows when prevailing investing options for near-safe money is so terrible. You can’t even go to the debenture or preferred share markets, which are more or less a wasteland in my humblest of opinions.

Still, I sold a small holding of Western Forest (TSX: WEF) earlier this year, when they were on track to earn about a quarter of their market capitalization in 2021.

Embedded in each of these companies is an implied bet on the future of specific commodities (met coal, gas, oil or otherwise). There is also an embedded skepticism that current prices will remain in each of the share prices. It could entirely be the case that the market is assigning a gigantic discount to future cash flows for whatever reason. If this is the case then buying and waiting for the returns to flow in is logical. Inevitably, it will happen – the most conservative approach companies make is paying down their debt, and then after that, they will have the choice of raising dividends or buying back stock.

This is unless if the real economy crashes and takes the commodity market with it. Then, those single-digit P/Es will rise very quickly.

As for the title of this post, I do not know. As much as it makes mathematical sense, margin investing always makes me nervous. The proper time to do it is when you are feeling absolutely sick in the stomach to buy and right now it just makes too much damn sense to borrow at 1.5% and buy these single digit P/E stocks. This is why I’m not doing it and am slowly raising cash instead, because the decision to increase zero-yield cash in my portfolio hurts the most. It won’t be an extreme move – just enough to make me a little more comfortable.

Hunting for ideas in this market

I’ve been noticing that certain sectors get hyped at certain periods of time. There are various influences out there (intelligent ones that, in general, are typically directionally correct and hence they gain a credible following over time) which form narratives and the digital financial wave decides to latch on until such a point they get washed away.

Today it appears that a bunch of hype is building up with uranium producers, the claimed narrative is that with Sprott opening up a physical Uranium ETF (TSX: U.UN) that this will suck up world supplies to a point where prices will rise and make all uranium miners spike. If storing vaults of gold and silver wasn’t enough to spike their respective commodity prices, surely storing yellowcake will be different!

The uranium market has been a cesspool for over a decade, which was not helped by Fukushima. In general, worldwide supplies of Uranium ore has been healthy to the point where Canada’s Cameco (TSX: CCO) decided it was easier to just buy than mine.

The claimed investment thesis is that an entity is essentially trying to corner the market on Uranium, so therefore you should buy the crap out of it before Sprott does. We also get a bunch of narrative about how China and India are building nuclear power plants, etc., etc. It’s a great narrative. The story is very easy to understand.

Uranium production itself is also a relatively small space in the publicly traded sphere (especially in North America) and there isn’t a lot to pick and choose from, hence it is a great target to hype up – a relatively small amount of capital will result in outsized price changes.

When I read these narratives from external sources (especially confirmed in multiple locations, which makes me suspect that there is a degree of inter-connectedness in these pronouncements) I get skeptical that I am behind the curve rather than leading it. I literally do not buy into these things.

I am sure there will be a decent price ramp (it is already occurring) but once the capital inflow dries up, it’ll be really interesting to see the conviction of these people that are looking for triple-digit gains in months when the geopolitical situation for this particular commodity will play out over years (specifically when fossil fuels get really expensive… come back later this decade for the resolution of this story).

My investment ideas have to be generated from non-narrative sources, and especially from sources that are not trying to sell subscription newsletters.

Unfortunately, this means that I tend to not pay much attention to various stories of hype – including the boom in marijuana companies in the second half of the last decade, the cryptocurrency boom, etc. I’m content with letting others gamble in that casino.

So when you are trying to be sold a story, ask yourself which stories are not being pitched to you, and look in that direction. It is much more difficult, cognitively, to look at a piece of information and then figure out what is not there, instead of fixating on the piece of information itself.

Stock screeners are great for generating a reasonable amount of random and obscure selections that can be subsequently mined for suitability. If one has views on specific sectors, selections can also be concentrated on that.

At present, however, my usual cautious approach to the markets has been getting even more cautious as of late. A chart of the S&P 500 or the TSX is not properly reflective of the level of fragility that likely exists out there.