Speculating in Market Excesses
We are sometimes asked why we can’t participate in all of the runup in the stock market when prices are going up. First, for many of our clients we are not trying to outperform the index with their full portfolio as they are also concerned about the downside and so we have bonds to smooth out the ride. Bonds will not outperform stocks in the long term but are needed for this smoothing effect. Secondly, even for those clients where their portfolio is 100% stocks (and for all clients that have not constrained us) we are diversified across the world and will not have performance that will be better than the best performing global index in any one year. We believe that this diversification is important in the long run as we do not know when one index will outperform another. When the market that is performing the best is the U.S. market we get asked this question more regularly as most investors have a bias to believe their home market is the best.
Another area that may cause our performance to differ from indexes is that we utilize high quality active managers for most portfolios. Although we expect their performance to add value in the long term there can be periods where they will not. This is true because in the long term the value of the index should be based on the companies that comprise it and these companies being valued themselves based on the businesses profits, revenues, and growth in the future. To illustrate why the current value of an index and by extension of the U.S. market might not be justified we will go over some current market excesses that we believe exist.
We have talked about Tesla in the past as an example of a market excess. To us Tesla does still seem like an example of this but it has real products and real revenue so sometimes the valuations that it is afforded look justified when we talk to people about it. Also, Tesla has looked like a poor investment for a number of years and yet the price still has gone up. So when we mention it as an excess we sometimes hear the comment that we were “wrong”. However, we would argue that this analysis of right vs. wrong can only be judged if the analysis that led to the decision was faulty not just the outcome. Elon Musk has admitted that the company was around a month away from bankruptcy at points in its history. This is hardly the type of investment that seems beneficial to someone trying to compound capital and avoid permanent loss. We believe that this is the goal of our clients.
Instead of focusing on Tesla for this blog posting we wanted to focus on some lesser known companies that don’t get the focus of Tesla but where the excess may be easier to visualize. Take for instance FuboTV, which has a market capitalization of $2.6 billion. FuboTV is a recent startup for streaming TV, with a focus on live sports. Competitors would include ESPN+, SlingTV, and Hulu Live. Each of these competitors have much larger resources than FuboTV and several are backed by large entertainment conglomerates (as an example, ESPN+ and Hulu Live are owned by Disney). The positive story is that streaming video is the way of the future and that eventually cable TV will go away. Last quarter FuboTV did add 445,000 subscribers.
At first glance this sounds great until you hear that the company lost millions of dollars, despite the recent positive news flow. Even at full buildout, meaning that if everything goes extremely well and FuboTV gets the subscribers it wants to (not a surety by any means), analysts expect the business will have a $0 profit margin on subscriptions. This means that the company will have to find earnings from other sources outside of just growing subscriptions. So investors are betting billions for a company with no current profit and no definite plans on how to get there, outside of some remarks about entering sports betting! Speaking of sports betting, DraftKings is now a $19 billion dollar company, based on the potential of this market. However, despite the potential, DraftKings itself continues to lose millions of dollars a year. This is hardly a great market for an upstart company like FuboTV to join. Not even to mention what DraftKings itself should be worth.
For comparison, Lions Gate Entertainment has a market capitalization of $2.2 billion. Lions Gate owns the Starz premium cable brand, has 17,000 films or TV shows in its library including popular films like John Wick and The Hunger Games and popular TV shows like Orange is the New Black. Last year the company had $3.5 billion dollars of revenue. Entertainment libraries are extremely valuable as the content for streaming has to come from somewhere. So Lions Gate looks like it could have potential as a standalone company or could be acquired by a larger streamer as a way of getting its content on the cheap. However, it is considered an old line entertainment company since it produces movies for theaters and Starz is a cable channel as well as being a streaming option. Investors currently do not want to own old companies that may have to transition to new models. They want to own new companies that are in hot industries. A company like Lions Gate Entertainment isn’t receiving the press that FuboTV is, but the latter is losing millions of dollars while the former is earning billions of dollars of revenue.
Another example is the valuations placed on special purpose acquisition companies (SPAC). These investments are effectively blank check companies formed to find opportunities within the market. Several of these have chased acquisitions within the electronic vehicle market and have been richly rewarded. Luminar Technologies is one of these companies and it is in the hot industry of making lidar sensors. These are some of the devices that could be used in self driving cars. Many different companies are working on lidar, including some of the biggest companies in the world like Texas Instruments and Toshiba. Interestingly, Elon Musk of Tesla believes that lidar is not a technology that will be adopted on a large scale as it is too expensive and has technical limitations.
The company lost $72 million on $11 million worth of sales last year. The company expects to produce losses for the foreseeable future. Despite this it currently has a market cap of $10 billion dollars! By comparison a company called Acme United that makes safety kits for industrial use and has the popular consumer brands of Camillus (knives), Cuda (fishing equipment), and Westcott (scissors) has a market value of around $100 million on $157 million dollars in sales and growing sales at 17% and earnings at 49% last quarter. Just like with Lions Gate Entertainment, the fact that Acme’s products are in the old economy (knives have been around for thousands of years and safety kits for at least a hundred) means that investors don’t want to pay anything for its growth.
We could also point to a company like Graham Holdings which owns Kaplan University, a large educational institution with a focus on online learning, as well as several other old like companies like automotive dealerships and broadcast TV. This company is afforded a market value of $2.6 billion despite producing $2.9 billion in revenue and around $200 million of cash flow a year. It’s common for investors to choose a company such as Luminar Technologies which is in a highly competitive industry, has lost money on a consistent basis only for the reason that it’s in a “hot” market over companies that are growing, have real profits and revenue that is not fully reflected in the price of the stock. Which would you rather choose as an investor?
Some of the examples of market excesses mentioned above are found in the Nasdaq or the S&P 500 indexes. It’s not uncommon when looking at the performance of the Nasdaq or the S&P 500 over the last year or two to see their upside being driven by companies like these. However, we believe that investing in these stocks are like playing the lottery or gambling at a casino and not like investments. Just because the company has had a lucky streak and has gone up in value does not mean that it can’t come back to earth just as quickly. Nikola Corp., an electrical vehicle manufacturer has been on a consistent down streak from June of this year, going from $65 dollars a share to $15. At it’s high, the company was valued at $24 billion. The company has had several setbacks in the production of its vehicles and investors turned on what had once been a hot stock.
We think that this shows how investing in these stocks can be similar to playing roulette; when the wheel has landed on black for the past three spins it is no more likely to land on black on the next spin. If the company is not producing a lot of current earnings or cash flow there is no way of knowing what a fair price is or when the losses will stop. What is the real value of Luminar, mentioned above? With negative earnings and losses expected it could just as easily go out of business as stay at the current price or go higher. We don’t know when a rotation will occur to stocks with more attractive valuations but we believe that it will as this has happened before and calmer heads prevail in the long run. When this occurs it is likely to be swift leading to large losses for investors that followed the hot trends. We believe that rather than trying to be part of this trend following and making bets on which companies will or won’t go up we will be more successful in the long run by letting our fund managers find companies like Wells Fargo, Cisco, or Intel that have been neglected by the current market and are now priced as if there will be severe setbacks in their businesses. The companies have real revenue, earnings, cash flow and assets that our managers can value. We can therefore come to a price that seems fair and decide whether the stock is a good value or not. With the companies like FuboTV or Luminar there is no current earnings or cash flow analysis that can be done.
We hope this helps illustrate the difference between investing and speculating, as well as illustrating some of the extreme stock market prices we see today. We believe that this helps show why active management applying a disciplined valuation based framework may be able to outperform an index. This is not going to happen when the market is like it currently is and is rewarding speculation. However, it can work and has worked in the long term for many of our active managers.
If you have any questions or would like to discuss this more with us, please contact us.