This post is co-written by Elliot Turner and David Doran
There’s been a great conversation in the blogosphere specifically about the validity and predictive power of Cyclically Adusted P/E Ratios (aka CAPE) and more generally about the valuation of US equities. The incredible run of the last year has only made the valuation debate more important. John Hussman has been one of the more vocal advocates on the Bearish side, while the pseudonymous @JesseLivermore from the Twittersphere has done an outstanding job deconstructing CAPE. In doing so, @JesseLivermore has highlighted why CAPE might not be relevant along with presenting an alternative way to look at valuation.
Here is what the CAPE looks like right now:
We think indicators like the CAPE offer valuable information, though they can never be looked upon conclusively. Further, we think that no one indicator has any worth outside of context. In an effort to simplify, context is often underappreciated in the investment community.
One key area where CAPE fails to ascertain the context is how it thinks about the valuation of businesses. Since the CAPE deals with P/E, it is purely a reflection of the price of a security, relative to its earnings power. This ignores capitalization, and as such, presents a considerable problem for comparison across time. Consider: a company that trades at $100 per share with $10 cash/share and $0 debt/share that earns $10 in net income/share vs a company that trades at $100 per share with $0 cash/share and $10 debt/share that also earns $10 in net income. On a P/E basis, both companies trade at a 10 P/E, though both companies are not “worth” the same. Assuming all else is equal, the company with a net cash position of $10/share is clearly worth more to the equity holder than the company with $10/share of debt.
For this reason, some turn to the market’s Price to Book ratio, or the Tobin Q in order to gain insight from the relationship between the market price and companies’ asset value. In fact, Eugene Fama in his studies on market efficiency long ago documented that a low P/B has high predictive power for outsized returns. While Fama was specifically referencing individual securities, it is reasonable to conclude that buying the market at lower P/Bs should thus lead to higher returns than buying at high P/Bs.
As of today, the market’s P/B is similarly situated to where it was when the 1990s bull market began in 1995. It is below the average P/B of the last 24 years and right at the average of this timeframe if you exclude the 1998-2001 bubble years. While not at extremely low levels, the P/B is near the low-end of its range of the prior 24 years. While some may argue CAPE is better at incorporating the mean-regressing nature of the market than P/B, book value itself is a slow-moving metric and gives us a sense of where the tangible worth of businesses stand. Further, changes in book value are far less volatile than changes in earnings, and as a result, book value offers investors a more stable arbiter of value. Altogether, P/B tells a very different story than CAPE.
We do not want to take the extra step of concluding whether the market is fairly priced, cheap or expensive in today’s environment. Instead, our goal is to lay out an additional concept--implied growth--as another contribution to the CAPE Debate, show where the bar is set in terms of future expectations, be slightly suggestive as to which way we lean, but ultimately leave it to you the reader to decide and opine on whether the market’s estimation of implied growth is fair or not. That being said, we do think it’s a stretch to call today’s valuations extreme. The numbers implicit in today’s market price are rationalizable when viewed in the proper context and compared to historical levels of growth, cost of capital and returns.
Earnings and Book Meet at Implied Growth
Looking at P/B in conjunction with CAPE certainly provides better context, and consequently, better predictive power for investors; however, in our opinion, we felt there were still limitations to this approach. What if there were a way to look at earnings relative to book? A way where earnings and book value could be used together to get a sense for where the market’s valuation stands? We could look at ROE over time, which is reflective of the relationship between P/B and P/E, but that datapoint alone looks like the definition of a random walk.
One thing we could do is invert (start with a certain datapoint and work backwards), to figure out what we really want to know: at what level of market valuation can I expect the best future return? There is a formula which allows an investor to figure out what the P/B ratio for a given security should be, if you know the ROE, Implied growth (g), and cost of capital (r). This formula is a derivation of the Dividend Discount Model, which is based on the incontrovertible principle that an asset is worth the sum of its discounted future cash flows.
Justified P/B = (ROE- g) / (r - g)
For the purposes of the market, it turns out, we can actually plug in every single one of these variables to the equation aside for the growth rate. This is extremely valuable, because then we can adjust the formula to solve for what the level of implied growth is, given ROE, cost of capital and P/B. This is an extremely useful metric because it will tell us what level of earnings growth the market is pricing in at this current moment in time. We can then compare our current data point to implied growth historically to provide context. Using the context, we can then judge whether the market is being too optimistic or pessimistic.
As of today, here is the information we know:
Market’s P/B = 2.58
ROE(10 year average)=13.62%
r (WACC) = 7.91% (We have used the Equity Risk Premium as estimated by Aswath Damodaran and added it to the 10 year Treasury yield. See our discussion on WACC below)
When we plug these numbers into the equation above and solve for g, we get a result of g=4.31%.
It’s important to define what exactly this number means. When we talk about growth, we are talking about the implied growth rate of underlying earnings, which means this number is inclusive of the net effect of equity issuance (repurchases). In other words, if companies in aggregate were net issuers of new shares, then this would be a drain on future growth; conversely, were companies to repurchase shares this would be accretive to future growth.
One of the shortfalls of CAPE analysis that @JesseLivermore astutely pointed is how today and yesterday are not exactly the same. Making matters yet more complex is that no two datapoints in the marketplace are stationary on even an intraday basis. The world is dynamic and things change fast. This is but one reason why we like looking at implied growth. Implied growth does something for us that neither CAPE nor any other backwards looking metric tells us: implied growth provides a very clear threshold level for which the future needs to match in order for us to capture our desired return (desired return being the 10-year Treasury plus an Equity Risk Premium). Simultaneously, implied growth tells us what levels of growth will leave us short of our desired return, and what hurdle we need to clear for an outsized return.
The key takeaway here is that in order for an equity investor today to earn his/her cost of capital (7.91%) then earnings must grow at a rate of 4.31% from here on out. In essence, this 4.31% serves as our betting line: if growth hits the over, an investor should earn in excess of his cost of capital; and if growth hits the under, then an investor’s earnings will fall short of the cost of capital. Historically g has been in the range of 5-6%, having averaged 5.3% since 1950. This suggests that in isolation, today’s levels are in-line with the “slow-growth” environment so many market analysts make reference to.
Investors can then use this benchmark and ask hypothetically: what would my return look like ten years down the line, given different levels of actual realized growth, holding all else constant? Let’s say the growth in earnings actually tracks at 3.31%, falling a full 1% shy of the 4.31% implied in today’s market price. Holding P/B and ROE constant, we can then solve for “r” to get our expected return. With 3.31% growth, we then find that “r”=7.31%. This would leave us 60 BPS of our expected return based on today’s metrics. Alternatively, let’s say growth ends up a full 1% above 4.31%. Solving for “r” we see that our expected return would check in at 8.53%, or 62 BPS above today’s level. Let’s say you were concerned about a rise in interest rates, and wanted to know what implied growth would look like were benchmark rates to rise by 1%, then you could add 100 BPS to the 7.91% WACC, hold ROE and P/B constant and again solve for “g”. We then learn that were rates to rise by 1%, the market would be pricing in 5.93% growth in EPS. We’ll have a deeper discussion about rates below. While we present these as examples, it’s possible for an investor to model out numerous different scenarios using this equation, assuming various paths for interest rates, ROE and/or growth.
There’s an important point to make here: an investor need not make precisely 7.91% over time even if growth were to come in precisely at 4.31% annualized. This is merely reflective of the rate at which intrinsic value will increase by, and what at what level the market would be fairly valued. As we should all know by now, markets often overshoot to the upside and to the downside. There is also a high degree of path dependency depending on when an investor’s capital needs take place. Were all our equation inputs to stay exactly the same for 10 years except for the denominator in P/B (ie were the index price to stagnate, but ROE, WACC and g to stay the same over that time period) then the outcome would be a very cheap equity market, but no actual return on capital over the prior decade. To an extent this is an oversimplification considering an investor would also earn dividends that can be reinvested, thus increasing the overall yield on the portfolio as time marches on; however, the fact remains that it’s certainly possible for the justified value to work out as planned, but at the same time, for Mr. Market to not cooperate.
One more beautiful feature of this equation is that we can deploy it with equal veracity and power in individual stocks or for the broader market, whereas CAPE’s power is confined to the broader market and to a lesser extent, cyclical stocks. There is a second nice element as applied to the micro: the level of implied growth in the market provides us a nice reference point to think about individual company valuations. We can use this level as a benchmark from which to say a given stock is expensive or cheap. If a stock’s expected growth is greater (less) than the market’s implied growth, then that company most likely deserves an above (below) market multiple. But this point is merely an aside.
Micro Factors that Matter in the Big Picture
In the discussion on CAPE, many warning about overvaluation today cite “artificially low interest rates” as distorting the discount rate applied to equity valuations. In the context of CAPE this is a point (albeit one we would still argue is weak). In the context of looking at implied growth, that point is rendered moot entirely. One must be a realist and look at the actual, factual influence that interest rates play in the cost of capital for a company. Low interest rates, as is evidenced in various arena, allow borrowers to tap into capital at a lower cost. Rates at some point will eventually rise and raise the cost of capital. However, given the length of time of low interest companies had ample time to finance themselves cheaply and lock in rates for the long-term. The early years in a rising rate regime will be somewhat mitigated by companies already having secured low rate financing.
Let us illustrate how these low rates work to a company’s advantage. Assume we managed a company and were planning to undertake a new project. From this new project, we expect a return of $100 on an investment funded with $100 of debt (and $0 equity) at a 10% interest rate. If everything were to go smoothly, our return would be $100 minus the cost of our debt, or 10% of $100. We can write this out as $100 - ($100 * 0.10) = $90. Now let’s say interest rates for our company’s debt were to drop to 5%, but our expected return were to stay exactly the same. The math on this very same project would turn into $100 - ($100 * 0.05) = $95. Nothing changed insofar as the opportunities for the business go; however, it would now be able to earn $5 extra on the very same project purely because of the lower cost of capital.
Complain all you would like about interest rates being “artificially” low, but the reality of the situations is clear. So long as companies can and do tap into lower cost sources of capital, then the returns available to those companies will rise accordingly. We will let academics handle the debate about how and why interest rates are so low and instead we will focus on business analysis and looking at the ways in which low interest rates tangibly alter the math in valuing companies.
Stated another way, the change in interest rates is shifting a portion of returns on corporate investment from the pockets of bondholders to the pockets of shareholders. When Siemens did a debt-backed share repurchase, their CFO, now CEO, Peter Loescher had the following to say: “Our plan to swap expensive equity for historically cheap debt capital is being executed in grand style. The fixed interest rates we’ve obtained will ensure that we’ll continue to profit from today’s extremely favorable conditions over the long term.” We see this as a stated corporate objective from many blue chip companies around the world, with Federal Express recently joining the chorus in announcing a simultaneous bond issue and share repurchase. Fedex issued $2 billion in bonds with rates ranging from 4% to 5.1% in order to buy back more stock. Their ROE is currently 9.9%. In 2013, a highly levered company like Tenet Healthcare was able to issue debt at 4.25% and 4.375% and directly use the proceeds to retire debt at 8.875% and 10.00% respectively. The bottom line is that this is valuable to shareholders.
If you are spending time arguing whether low interest rates are justifiable, you are mistaking the forest for the trees and failing to see that companies are actually capitalizing on the status quo in order to drive shareholder value into the future. If you are able to hold ROE static but send WACC lower, then all of a sudden, you have created extra value for shareholders. This is the outcome of the point we were making above about companies capitalizing on the low cost of interest rates.
The Historical Context of Implied Growth
To construct a chart of implied growth for the S&P 500 since mid-2000, we had to come up with a cost of capital to plug into the equation. The first thing we did for cost of capital was using Aswath Damodaran’s Equity Risk Premium and adding that to the 10-year Treasury yield at each point in time. Each datapoint uses the rolling 10 year average ROE for the S&P 500 and the TTM book value for the purposes of P/B. We plugged in the known numbers to the equation above and solved for implied growth on a rolling basis.
Since something like the cost of capital can be highly subjective and very noisy from day-to-day depending on changes in the market’s price and equity risk premium, we decided to take a second look using the historical long-run return on equities. We did this because we thought it would be important to try and drown out some of the “noise” in the data created by these fluctuations. That was done by taking the actual annualised equity return for that particular data point going back to 1929 and then adding the spot ten year yield to approximate a “historical wacc.” For example, to get the equity risk premium for the year 2001, we took the total annualised returns of the S&P 500 from 1929 to 2001 and subtracted the total annualised returns of the 10-year Treasury over that same time period to give as an approximation of the actual excess return earned by equity holders over that time period. For the WACC, we then added that number to the 10-year spot Treasury at that point in time.
This is what we found using both WACCs:
Low P/B inherently means that the implied growth sets a lower hurdle for an investor to earn their cost of capital. This is so even when combining a low P/B and a historically average ROE. From both of these charts it becomes pretty obvious just how obscene the implied expectations were in the indices in 2000. Especially considering that eps growth has averaged 5.3% since 1950. 2011 is another interesting data point, During the European debt crisis sell off, the S&P was pricing in close to 0 eps growth despite actual robust eps growth and a bounce back in ROE’s. In fact, the orange line shows clearly that for much of 2011 and 2012, markets were pricing in zero earnings growth in perpetuity. This is consistent with much of the rhetoric. While the popular discussion has shifted towards “multiple expansion” being the sole driver of equity returns in 2013, it’s important to consider the context: equities went from pricing in absolutely no growth, to pricing in fairly modest growth assumptions.
It is with this implied growth equation we can see very clearly exactly what people are referring to when they say “multiple expansion” has been the driver of returns. Interestingly, since the bounce-back from the Great Recession began, the 5% threshold for implied growth has been strong resistance for equity markets. Each time implied growth has reached those levels, markets have either sold off or gone sideways. In light of the aforementioned 5.3% average annual growth since 1950, this market action is consistent with the “low growth” environment theme, as equities have basically been ping-ponging between zero implied growth and 5% ever since the bounceback from crisis began.
It’s also worth pointing out how despite the S&P 500 being higher today than it was in 2000, the implied growth is much lower. Through this, we can visualize how the market’s multiple has compressed over time. In valuation theory, another way to breakdown value is to think of the equation Current Value = Tangible Value + Future Value. When implied growth is lower, then the future value portion of this equation is also lower, but the tangible value level is higher. Tangible value includes the present asset base of the company and the value of the company’s sustainable earnings level. Here we can see pretty clearly the impact that increasing capitalizations of corporations can have on the question of fair value, something that CAPE simply cannot and does not do.
Disclosure: Both authors are long shares of Siemens (NYSE: SI)
This post is co-written by Elliot Turner and David Doran
There’s a popular view going around these days that biotech is in a bubble. Jim Grant was the first that I know of who publicly expressed this view, and he rationalized his argument asserting the Fed’s zero interest rate policy was distorting markets without even a cursory mention of the specific developments which have transpired in the biotech sector over the recent past. Several smart market participants who I respect greatly have echoed this perspective. I want to use this post to dispel that notion.
I’m a humanities, not science guy. I also am a generalist, not a biotech investor. I have some exposure to the sector and don’t plan to increase or decrease that exposure any time soon. That being said, I will leave the science vague and hope someone more knowledgeable and with more skin in the game can expand on this argument. As recently as the late 1980s, the drug discovery process was entirely centered around literally sifting through dirt in order to find molecules that may hold some therapeutic power. The science was simply a matter of “leaving no stone unturned” in a quest to find anything that just might work. In the late 1980s, there was a pivotal moment where drug discovery evolved to a process of learning how diseases and ailments operated on a molecular level and then working backwards via inversion to find proteins which could positively change the active mechanism of the problem. If you are interested in this development and its business effect, I strongly recommend the book Billion Dollar Molecule by Barry Werth.
Today we are undergoing another profound change and the catalyst was the mapping of the human genome. Not long ago, Peter Thiel and Marc Andreessen debated whether there was real innovation happening in our economy today. Surprisingly not even Andreessen who took the “yes there is innovation” side of the debate even mentioned genomics and the impact it’s having on people’s lives around the world. The only real mention of biotech was Thiel’s complain about the FDA getting in the way too much, though if anything, this is not borne out by what has transpired these last few years. The problem for biotech is that its impact is very intangible compared to the Smartphones we all carry in our pockets everywhere. Genomics has greatly accelerated the process and efficiency of drug discovery. The results are evident, though people don’t see or feel it. In 2012 new drug approvals by the FDA hit a sixteen year high. Although 2013 did not see a new high in approvals, it did see the largest aggregate market opportunity for new approvals. I will oversimplify to make the point very clear: let’s say the average drug development timeframe was 10 years and has now accelerated to 5 years. Drug development inherently becomes worth more money if the time to earning first cash flows is cut in half.
This above provides some justification for why “this time is different.” Things can be different and still a bubble though, so to try and further dispel this notion I want to point out two anecdotal examples for why the bubble assertion is wrong. Again I want to qualify that overvalued and/or overextended does not mean something is a bubble. For starters, let me borrow Robert Shiller’s definition of a bubble: (as paraphrased by me from Shiller’s panel at the Economist’s Buttonwood Gathering) a bubble is a price-mediated feedback between prices and market participants, with excessive enthusiasm, media participants, and regret from those who are not involved. The “psycho-economic phenomenon” is a defining characteristic that becomes ingrained in a culture and is related to long-term expectations that cannot be pinned down quantitatively. Let me offer the following chart, and you tell me where there's a bubble:
Simply put, we see none of this. Biotech has barely reentered the market participant’s conscious despite the big players returning to top line growth for the first time in years following their patent cliff. There are few if any stories in mainstream media about biotech billionaires at all. If you want to see hype, look no further than social media companies. Do we see anything remotely resembling an awareness in the masses that biotech has been a strong sector? I get asked all the time by clients about Tesla, Bitcoin, Twitter, etc., and I’ve never once been asked about biotech. And yes I think Tesla, Bitcoin, and Twitter prices comfortably fit Shiller’s definition of a bubble.
So let me offer two anecdotes on price and valuation in biotech to provide some context to this discussion.
1) Regeneron: In 1991 is considered common knowledge that Regeneron was a bubble, was insanely priced and was unsustainable. Here’s what the pundits were saying at the time (and do read that link for it's quite telling how similar the complaints are today): “Regeneron is a real long shot for investors: With no potential products even slated for clinical trials, the company is a good 10 to 12 years from delivering a marketable product…. ‘These are companies that have no product, and no prospect of revenue for three years or more. It only makes sense for them to make money when investors are in a feeding frenzy.’”
Fast-forward to today and an investor in Regeneron’s IPO is up ~1,789% in 23 years compared to ~390% for the S&P 500. This alone does not prove biotech is not a bubble but it highlights an important point that is fairly unique to this sector: even if you pay a high starting price, when you are right you will make multiples of your money. Simply put: bad investments in biotech will be worthless and successful investments will be worth multiples. The starting point matters little.
2) Incyte: This company is experiencing a wave of success, up a cool 207% over the past 52 weeks. Their first approved product, Jakafi earned $235.4 million in revenue in 2013 and is still growing today. In the pipeline, Incyte is working on one of the first treatments for pancreatic cancer which actually improves patient survivability. This first big spate of commercial success and big pipeline expansion would have a rational observer expecting this company to be way above record high levels, especially if we are in a bubble, right? Wrong.
In 1999 a shares of this stock were changing hands below today’s prices, though well above where INCY was upon earning its first real evenues. Back then there weren’t any signs of imminent success to be found. It’s definitely much easier to call something a bubble in hindsight, but the magnitude of the differences between then and now is striking. The fact that 1999 is still so fresh in many market participants’ memories is probably a powerful force in the proliferation of bubble assertions today.
Preclinical biotechs are valued based on odds of approval, the size of the market opportunity, the percent of the market the treatments can capture and discounted to today based on the time it will take to earn positive cash flow. It is unquestionably silly when biotechs surge in unison riding the wave of one company’s success. What happened in the wake of Intercept’s NASH primary endpoint success is not rational, and many companies did not deserve the pop they received. But that happens all the time in markets even when there is no bubble.
This is not a great time to pile into biotech, as some of these favorable developments discussed above have been reflected in prices. A bubble means run for shelter and seek cover, and that too is inappropriate right now. Something that is overextended is not necessarily also a bubble. It’s very possible, almost probable that biotech will go down 15% before going up from here. The fact of the matter is that biotech is the same as it ever was. The big boys are priced in-line with the market and have no premium attached to their multiple, and the small companies that investors get “right” will be worth multiples of what they are today, while the wrong ones will be worthless.
Thanks to my buddy who helped me pull this together so quickly today, you know who you are!
Disclosure: No position in any of the stocks mentioned, though a small portion of the portfolio is long specific biotech stocks.
Last week we were greeted with writings from two of the best investors and thought-leaders: Howard Marks of Oaktree and Murray Stahl of Horizon Kinetics. The decades of wisdom acquired by both Marks and Stahl now share with us youngens via these readings is a gift we must all take advantage of. I am about to grossly oversimplify the points from both of these greats in order to riff off of it into a point of my own. I give this warning both to preempt any complaints about my simplification, and as a suggestion to do yourself a favor and read what both of these gentlemen have to say before going one sentence further here. If you are kind and/or interest enough to return to this site, once done with those piece, please feel free to do so.
Since I received a link to Marks’ memo first, my evening reading started there and proceeded to Stahl’s piece. This was a fortunate coincidence. Marks lays out the case for the role luck plays in living life and attaining success in financial markets, tracing it to the idea markets are mostly efficient, but for those areas with a “lack of information…and competition.” Meanwhile, Stahl examines what he believes to be one of the single largest sources of market inefficiency today in what he calls “indexation.” After reading both pieces, I couldn’t help but think: “we are lucky to be investors in markets in this era of indexation.” This one thought struck me as the perfect conjunction between the two pieces.
Stahl has used the word “indexation” to explain the phenomenon whereby more assets and managers are investing in indices and ETFs which are designed to “provide portfolio exposure to very specific criteria, such as an asset class, an industry sub-sector, a growth metric, a stock market capitalization band, and so forth.” Over time, Stahl has discovered and invested in several of the inefficiencies resulting from such a phenomenon, including the “owner-operator” whose major stockholder manages the company, spin-offs designed to streamline business operations, etc. I recommend reading Stahl as to why these opportunities arise in today’s market.
Why do I say we are lucky to invest in this era of indexation? Because, as Stahl argues, indexation is an incredible source of market inefficiency. As more and more dollars seek out exposure in the broadest of ways, there is ample opportunity for those of us who seek to “turn over as many rocks as possible” to find the right opportunity. Two of my favorite setups fit this bill, although I never specifically delineated these ideas in writing as an outgrowth of indexation. This is so because both setups existed as long as there have been markets, and are in many respects traceable to behavioral traits of human beings. What has changed is that indexation provides a natural outlet through which these behavioral weaknesses are even more pronounced than in years past. I have named these setups “Guilty by Association” and “I’ve got a Label, but I don’t Subscribe.” While there are similarities between the two, they deserve to be thought about separately.
"Guilty by Association"
When a company is “Guilty by Association” they are treated in the same way as another, more identifiable peer group or index solely by some kind of perceived proximity. These tend to be situations that are more macro in nature, where a broader problem is reflected upon a specific company or sector. Some examples might be helpful.
During the crisis period in Europe, all European stocks were hit with equal force. The market “threw the good out with the bad” so-to-speak. One particular class of opportunities we spent considerable time on (and ultimately made significant investments in) was businesses listed in Europe, with a revenue base that was largely global. In other words, these were companies that traded in Europe, though they did the majority of their business outside of Europe itself. In these situations, there was selling, even from investors not situated in Europe, due to fears about the Eurozone’s viability. Yet, these companies themselves were in a position where if the Euro actually collapsed, they were unlikely to be significantly impacted in a negative way. In other words, they were “Guilty by Association” with the currency in which their shares were priced.
Another example would be the hatred of muni bonds in today’s environment. This entire asset class is hated due to concerns about Detroit’s bankruptcy and Puerto Rico’s solvency woes. Because Detroit and Puerto Rico are municipalities, conventional investment wisdom beholds that municipal bonds in the general sense must therefore be in trouble. This kind of extrapolation is abundant and wrong.
Indexation impacts these areas because people who invest in broad-based ETFs or indices sell their exposure entirely, in order to avoid the perceived fear. In doing so, the selling of the basket forces mechanical selling of all the subsidiary components without consideration for which specific constituents are and are not impacted on a fundamental level by the fear. Thus, the good that gets thrown out with the bad and is “guilty by association.”
"I've got a Label, but I don't Subscribe"
This is the micro twin of “guilty by association.” Since so much money is moving into ETFs, and ETFs are trading with all kinds of sector and niche labels, there is pressure to fit each and every company into some kind of cookie-cutter genre. These labels impact how analysts and investors alike think about specific companies. Stocks get assigned to analysts based on the “sector” they cover, and many investors invest in sectors or companies that are in accordance with a specific mandate. I had been planning a blog post for a while called “Beware of Labels,” but I think all of those points would better fit the context of this post. One of the biggest misnomers in today’s markets is the “technology” label. Mr. Market today dumbs "technology" down to mean: a) any company that is on the Internet; and/or, b) any company that makes hardware.
In my opinion, there simply is no such thing as an Internet company. There are retail companies who operate on the Internet (and at this point is there a single retail company who doesn’t operate on the Internet?), there are B2B companies who use the Internet to offer their services, there are financial platforms who provide web-based platforms. To ascribe the label “Internet” to one company and not another is merely referential of the fact that some companies are old and some companies are new. And even that is an oversimplification, for there are older Internet companies that are still called as much, despite being more analogous to marketing companies. And yet somehow, all these various, wide-ranging businesses end up with the “Technology” label despite the fact that their differences are far more pronounced and abundant than their similarities.
In a perfect world, we would throw away the technology label and call these companies what they are, whether that be media, retail, etc., but this isn’t a perfect world and that creates opportunities for us investors seeking out inefficiencies. Heck the “Telecommunications” sector is somehow a sub-sector of “Technology” and includes a company as old as AT&T (though I am aware AT&T today was actually one of the Baby Bells who ended up swallowing Mama whole). The biggest impact labeling has is in how analysts model these companies and the types of investors who are drawn to (or pushed away from) different sectors. We all know how popular comparables analysis and that too gets incredibly misleading when similarities and differences are conflated with one another.
An example of this would be my investment experience with Google. Over the past few years, Mr. Market has called Google an “Internet stock” and a “one-trick-pony” at that. To that end, analysts and investors alike oversimplified in comparing Google only to other Internet stocks, and in a perceived battle against Apple, this same community viewed the company as out of its league (See GigaOM, CBS News and HBR on the "one-trick-pony"). I took a different perspective: Google is more akin to a media company whose advantage lies in the infrastructure and distribution side. Wikipedia describes media as “the storage and transmission channels or tools used to store and deliver information or data.” This certainly seems like an apropos description of Google, and it’s more clearly reflective of who pays Google money at the end of the day--advertisers, much like how we think about “traditional” media. If you think about Google this way, and realize one of the company’s crucial advantages is in how it stores, aggregates, categorizes and distributes information, it’s clear that Google does and can do far more things than “just” search. YouTube is a natural fit in this type of company, more so than just an Internet or search company, and as such, it leverages the advantages of Google’s platform while also leaving open the opportunity for Google to naturally segue into other areas altogether. Within that context, Google looks far less like a one-trick-pony, YouTube’s valuation becomes increasingly important (see my writeup on the importance of YouTube), and the company is in fact more diverse and capable beyond “just” search.
Labeling is a human endeavor; something we do in many disparate fields. One of the most well-known is the biological taxonomy (I think every adult still remembers “King Phillip came over for good spaghetti”), which is an organizational hierarchy. While labels have always been used in stock markets, only now are they actual forces behind the mechanical allocation of capital. This is so due to the proliferation of ETFs and “indexation.” Even in biology, there are blurred lines between different species, etc. This is but one reason why we have seen a great increase in spin-offs: when some companies who are thought of and thus modeled “that” way, have a subsidiary that doesn’t fit the bigger mold, that subsidiary tends to be “underappreciated” by Mr. Market.
A lot of people, myself included, like ripping on the Efficient Market Hypothesis. This is certainly not without merit; however, as Marks emphatically argues, there is much truth and wisdom in the idea that market participants are in fact really good at incorporating known information into the price of securities. When we look to make investments, we must then do what Marks’ implies in another of his spectacular memos, by asking ourselves “what is the mistake that makes this a mispriced investment opportunity?” With these two examples based on the problems associated with Stahl’s “indexation” we have two areas in the abstract within which we can identify mistakes. To that end, we are lucky to live in this era of indexation for how it exposes the market to repeatedly and mistakenly misvalue companies.
Disclosure: Long Google
Happy New Year to everyone out there! The blog here has been quiet for a few weeks, though that is about to change. My recent writing efforts have been focused on our RGA Investment Advisors' 2013 year-in-review and 2014 Investment Outlook and I wanted to share that here:
This is the story of the financing behind what at separate points in time was once the world’s largest IPO and the largest real estate deal ever. Even more, this is the story about an undertaking which actually changed the course of world history. This is also the story of French capitalism and American socialism. Let me explain, drawing heavily from The Path Between the Seas, an excellent book, one I highly recommended, by David McCullough on the construction of the Panama Canal for the relevant history.
On November 17, 1869, the Suez Canal opened to remarkable fanfare. The event instantly made Ferdinand de Lesseps an international hero. de Lesseps work wasn’t done with this one accomplishment. To that end, he used his position of fame in order to attempt to conquer an even bigger task: building a canal to connect the Atlantic Ocean and Pacific Ocean in Central America.
The Suez Canal had been built with private money and existed as a publicly held corporation (public as in freely liquid ownership amongst private citizens, not government ownership). de Lesseps saw the Central American project similarly, and felt its financing via private money was an important and “American” way to pursue the undertaking. Private financing was a strategic move, for at the time, the U.S. government still took the Monroe Doctrine declaring the Western Hemisphere the American domain very seriously. It was also a sentimental move which de Lesseps spoke about tying the importance of private capital with the notion that it would merely facilitate him as “but an executor of the American idea.” (McCullough, David (2001-10-27). The Path Between the Seas: The Creation of the Panama Canal, 1870-1914 (Kindle Locations 1754-1757). Touchstone. Kindle Edition.)
This made sense on several levels. The U.S. stood to benefit substantially from the completion of a “path between the seas,” as the book bearing that title explains:
A Wall Street man named Frederick Kelley calculated that a canal through Central America could mean an annual saving to American trade as a whole of no less than $ 36,000,000— in reduced insurance , interest on cargoes, wear and tear on ships, wages, provisions, crews—and a total saving of all maritime nations of $ 48,000,000. This alone, he asserted, would be enough, irrespective of tolls, to pay for the entire canal in a few years, even if it were to cost as much as $ 100,000,000, a possibility almost no one foresaw. (Ibid, Kindle Locations 457-460)
Americans had plenty of experience with private capital invested in Panama. At one point, the Panama Railroad was the highest priced stock on the New York Stock Exchange, and its shares paid an average 15% dividend over its publicly traded period (here's a fun list of "amazing facts" on the Panama Railroad). When de Lessing commenced the Panama Canal project, it was to be the single largest financing in the history of the world, up to that point. Much was on the line alongside the money, including de Lessing’s legacy as a man who could build the impossible, and French pride as a global engineering powerhouse. Further, this was about capitalism and democracy, two ideas rapidly changing the world at that time, and the “limitless expectations associated with venture capitalism—pionnier capitalisme. The talk was of ‘the poetry of capitalism’ and of ‘the shareholders’ democracy.’”
As history would have it, the French, capitalist version of the Panama Canal wasn’t meant to be. For the French, the financial losses were drastic, as was society’s backlash. This is embodied in the aftermath of the Panama Canal Company’s failure, which today in France is known as “L’Affaire Panama.” Over 100 French legislators were accused of corruption and several governments collapsed. In the aftermath, anti-Semitism spiked sharply due to various conspiracy theories, ultimately climaxing in another French affair, “L’Affaire Dreyfus.”
Amidst the chaos in France, a successor to the Panama Canal Company was established in order to dispose of the company’s remaining assets, including its equipment, land rights, railroad ownership and digging completed to-date. The U.S. government emerged as the best, most logical buyer, eventually completing a deal with historic implications:
The purchase of the French holdings at Panama was the largest real-estate transaction in history until then. The Treasury warrant for $ 40,000,000 made out to “J. Pierpont Morgan & Company, New York City, Special Dispensing Agent,” was the largest yet issued by the government of the United States, the largest previous warrant having been for the $ 7,200,000 paid to Russia for Alaska in 1867. Participation by the house of Morgan had been agreed to by both the buyer and the seller and in late April, prior to receipt of the Treasury warrant, J. P. Morgan sailed for France to oversee the transaction personally. His bank shipped $ 18,000,000 in gold bullion to Paris, bought exchange on Paris for the balance, and paid the full sum into the Banque de France for the account of the Compagnie Nouvelle and the liquidator of the Compagnie Universelle. On May 2, at the offices of the Compagnie Nouvelle on the narrow, little Rue Louis-le-Grand, the deeds and bills of the sale were executed. On May 9 in New York the United States repaid the $ 40,000,000 to the house of Morgan. Morgan’s fee for services, charged to the Compagnie Nouvelle, was $ 35,000. With the $ 10,000,000 paid to Panama and the $ 40,000,000 to the Compagnie Nouvelle, the United States had spent more for the rights, privileges, and properties that went with the Canal Zone— an area roughly a third the size of Long Island— than for any actual territorial acquisition in its history, more than for the Louisiana Territory ($ 15,000,000), Alaska ($ 7,200,000), and the Philippines ($ 20,000,000) combined.” (Ibid, Kindle Locations 6847-6851)
Since this is the story of the financing of the construction of the canal, we’ll willfully ignore some of the “diplomacy” and its associated costs. The U.S. commenced construction in 1904 with the government overseeing a team of private contractors. One such contractor that emerged as an important American industrial power was Bucyrus Corporation (now part of Caterpillar). Bucyrus’ steam-shovels became the standard during the construction of the Canal and they did their job magnificently. A second contractor with massive success was the General Electric Company:
For the still young, still comparatively small General Electric Company the successful performance of all such apparatus, indeed the perfect efficiency of the entire electrical system, was of the utmost importance. This was not merely a very large government contract, the company’s first large government contract, but one that would attract worldwide attention. It was a chance like none other to display the virtues of electric power, to bring to bear the creative resources of the electrical engineer. The canal, declared one technical journal, would be a “monument to the electrical art.” It had been less than a year since the first factory in the United States had been electrified” (Ibid, Kindle Locations 10237-10242)
Unfortunately, the vast majority contractors the government hired couldn’t do their jobs all that efficiently. In 1907, the Army Corps of Engineers, under Major George Washington Goethals (yep that’s where the bridge got its name), took control of oversight and construction of the canal.
Let’s take a step back and think about where things were here. What started as a privately financed enterprise collapsed miserably, taking down the entire French economy and nearly the entire French empire with it. In the wake of this collapse, the American government took over the project and outsourced its completion to private contractors. Over three years, these private contractors failed to meet their deadlines, effectively forcing the U.S. government to take over the project entirely. When this happened, the military’s oversight of the project worked so well that some feared this would tip the U.S. towards socialism. These fears were discussed openly in prominent intellectual circles, with complaints like the following:
When these well paid, lightly worked, well and cheaply fed men return to their native land [warned a New York banker], they will form a powerful addition to the Socialist party . . . . By their votes and the enormous following they can rally to their standard they will force the government to take over the public utilities, if not all the large corporations , of the country. They will force the adoption of government standards of work, wages and cost of living as exemplified in the work on the Canal. Yet how could it be socialism, some pondered, when those in charge were all technical men and “little interested in political philosophy,” as one reporter commented. “The marvel is,” wrote this same man, “that even under administrators unfriendly or indifferent to Socialism , these socialistic experiments have succeeded— without exception.” (Ibid, Kindle Locations 9562-9568)
Instead there was to be no such thing as Socialism in America, but there are many lessons we can learn from today, here are just a few:
1) de Lesseps, the Frenchman behind their canal effort, was a figure reminiscent of the likes of Steve Jobs and Elon Musk for his capacity to “do the impossible” and change the world. Before de Lessep’s started the Panama Canal project he was a man who “could do no wrong.” People who buy into that mentality blindly, based not on sound economics, but rather a combination of nationalist pride and belief in an individual are setting themselves up for financial problems. This immense, almost super-natural belief in the capacity of French engineering to overcome all problems led to crucial blind-spots that Mother Nature exploited.
2) One of the decisive differences with the American and French efforts was William Gorgas’ initiative to rid the Canal Zone of malaria. Many viewed the fight against malaria and yellow fever as costly wastes of resources in an expensive undertaking. It was not without conflict that Gorgas was able to undertake his nearly “impossible” task of eradicating the mosquito-wrought region of these illnesses, yet without this colossal effort the Panama Canal itself would never have been built. For these cost-based concerns, a focus on public health was inconsequential to the private endeavor, until the problem became too severe and the entire project collapsed under this weight. Meanwhile, for a government to send its own emissaries to a region rife with deadly illness meant the potential for severe backlash from various groups. Truth be told, a healthy environment and a healthy workforce is crucial for large-scale successes.
3) The question of public vs private is the wrong one altogether, as efficiency matters first and foremost. The French went about the project privately. The U.S. went about it largely privately at first, and then with complete government oversight and execution. Today’s discourse here in the U.S. would have one believe the Americans are born capitalists and the French are born socialists, but that was not always true. American success happened independent of any public vs private debate, with both significant public and private rewards as a result.
4) Public benefits are also private and vice versa. The completion of the Panama Canal had an unquestionably awesome effect on the rise of United States in the 20th century--both militaristically and commercially. But, even with the project under control of the U.S. government, American industry benefitted tremendously. This was a major catalyst in General Electric becoming the behemoth it is today.The Panama Canal was one project, and it alone helped the United States become the dominant global naval power. It is not an understatement to say that without the Panama Canal, American history would be decisively less grand. At the same time, American industry used the canal to buy and sell goods into the global market at an accelerating rate. Though its opening was followed by World War I, the Great Depression, the rise of protectionism and then World War II, so this commercial benefit of increasing global trade was not evident for decades down the line. Time and subsequent innovations were important factors in perceived failure turning to success. Today, as it undergoes its largest renovation to date in an attempt to double the volume of goods which can pass between the Atlantic and Pacific, the Panama Canal remains a vital artery for global trade and its benefits are enjoyed by both the public and private alike.