On the surface, middle of the road performance for stocks in the quarter indicated relative calm. Especially coming off strong performance in the first half of the year, there was little cause for concern.
Performance was choppy in the quarter, however, as steady, modest gains were repeatedly undermined by significant losses. In addition, a quant quake came out of nowhere and led to massive outperformance of value over growth for a short period of time. Also, out of nowhere overnight repo rates spiked higher until the Fed intervened. Gold prices rose steadily. Under the surface, something seems to be amiss. What is that something and what does it mean for investors?
For a growing number of investors, the answer is a short one: Stocks have overshot their fundamentals and a market crash is imminent. Such concerns are serious partly because they come from some highly respected players and partly because if true, there would be serious consequences for investors. However, stocks have been highly valued for a long time and for the past ten years bumps in the road have always been smoothed over by central banks. Is anything different this time?
It helps to establish some perspective. One of the more prominent themes over the last ten years has been the outperformance of growth stocks relative to value stocks. Rick Friedman of GMO points out that "Over the past 12 years ... value stocks have underperformed". John Pease, Friedman's colleague at GMO adds, "All in all, it has been a harrowing decade for those who have sought cheap stocks."
This recent underperformance of value provides a notable break from its historical pattern. Friedman continues:
"Historically, buying companies with low price multiples has delivered substantially better returns than the overall market, with the added benefit of lower absolute volatility. From the inception of the Russell 3000 Value index through 2006, value stocks outperformed the broad market in the U.S. by 1.1% per year starting in 1978."
Dan Rasmussen, founder and portfolio manager of Verdad Capital Management, described just how unusual this performance has been in the September 20, 2019 edition of Grant's Interest Rate Observer:
"What has been abnormal ... is the remarkable performance of growth stocks. That has really been driven by the very largecap tech companies, which have had this amazing combination of high growth, high profitability, high and sustained growth, high and sustained profitability (and starting to actually dividend out money). That historically is very, very anomalous. You don't typically see the largest stocks grow the fastest."
Indeed, Friedman explains that the reason value stocks tend to outperform is because they offer an attractive tradeoff: "While value companies did in fact under-grow the market, their cheaper valuations, higher yields, and a number of other factors more than made up for their weaker fundamentals." The "engine of returns behind value portfolios", adds Pease, is "the replacement process, whereby a formerly disappointing company sees its fortunes change and its prices respond (à la General Electric in the 80s)." In short, notes Friedman,
"Investors systematically underestimate the ability of weaker and distressed companies to mean revert to profitability and reasonable growth levels. Instead, they overpay for growth by extrapolating relatively strong growth too far into the future. "
Pease notes, "In the last 13 years," however, "rebalancing has disappointed somewhat," and with it, the primary mechanism by which value tends to outperform. Friedman adds that factors that typically inhibit the most outlandish expectations for growth have been unusually weak:
"Of late, expensive stocks have remained expensive for longer than usual. Typically, high growth companies are unable to sustain excessive growth rates for long periods. In the last decade, however, the growth universe has been more retentive than in the past."
So, one thing that is amiss is exaggerated expectations for growth. One exercise I regularly perform is to identify market-implied growth rates by matching discounted cash flows with current market prices. A couple of patterns are clear. One is that the prices of a lot of companies assume growth rates that are much higher than those that can be sustained by internally generated cash flows. In other words, the company's growth is entirely dependent on access to outside capital.
Another pattern that is evident is that many implied growth rates are so high as to defy all practical constraints on growth. Historical experience, competitive response, industry size, economic growth, regulatory response, input costs, input availability, discretionary income, changing tastes and preferences, and real cash flows (as opposed to non-gaap earnings) all provide practical limits on growth for various businesses. It usually doesn't take a ton of math to identify a ballpark range of growth estimates that is reasonable for a company.
As it turns out, the top-down evidence of unrealistic growth expectations corroborates the bottom-up observations. Rasmussen notes:
"You're at this point ... where the spread between the valuations of growth stocks and the valuations of value stocks is near all-time highs. The two times it has been this high in the past 50 years are 2000—the height of the tech bubble—and 1973—the height of the Nifty Fifty boom."
One implication for investors, then, is the risk of exposure to exaggerated growth expectations is high right now. That risk may well be greatest in the IPO arena. Grant's surveys the "abnormal" IPO landscape by way of statistics from Jay R. Ritter, chaired professor at the Warrington College of Business at the University of Florida:
"81% of firms that went public in 2018 showed GAAP losses. To date in 2019, 74% of companies debuting in the public-equity market have been similarly loss-making. Each figure is substantially higher than the 39% average of profitless new public companies that IPO-ed between 1980 and 2018."
While these numbers portray an exceptional level of enthusiasm for IPOs, cracks have been emerging. The high-profile offerings of Uber and Lyft have both performed poorly and more recently, Peloton fell immediately from its offering price and has remained weak. Obviously, something has changed. Richard Waters from the Financial Times ascribes such weakness to a diminishing desire to believe "airy promises". In other words, the market finally seems to be pushing back on exaggerated claims for growth.
"Airy promises" are not the only thing amiss in the IPO market, however. As Waters also notes, the easy cash available for many IPOs "has bred bad habits." The poster child for bad habits is WeWork. When WeWork started the IPO process, its valuation was targeted at $47 billion. After a great deal of pushback ahead of the roadshow and several price cuts, the IPO was finally pulled.
Not only is the company not going public, however, now it is in serious risk of going bankrupt. The FT reports, "Last week rating agency Fitch downgraded WeWork’s credit rating to CCC+, a level at which 'default is a real possibility'. It said 'the risk that the company is unable to restructure itself successfully has increased materially'." How in the world can a company go from hot IPO prospect to bankruptcy candidate in a couple of months?
While WeWork provides plenty of entertaining drama, it also provides instructive lessons for the broader market. Importantly, all the information necessary to assess WeWork as a fragile financial proposition and a low-grade credit was available for all to see prior to its aborted IPO. There were no surprising revelations at the company. The only thing that changed was how people chose to evaluate the same body of information.
An important part of that body of information, as is the case with many younger companies, is the founder, Adam Neumann. Well known for his quirkiness, outlandish proclamations, and use of recreational drugs, Neumann also successfully crafted himself as a visionary. The balance between visionary and crackpot, however, is often a very tenuous one as Scott Galloway describes:
"Since people want abnormal results, they try to find abnormal thinkers. But no one should be shocked when people who think about the world in unique ways you like also think about the world in unique ways you don’t like. If you want the party, you also get the hangover. Big, bold, visions are important and should be celebrated. But they have to be matched with stable, reality-based operators who have equal power if those visions are to have a fighting chance at surviving outside incubation."
He elaborated on this tenuous balance in a separate interview in which he was blunter in his assessment: "The lines between vision, bullsh*t, and fraud are pretty narrow.”
Galloway's evaluation is not just that of some aggrieved tech investor who lost money either. He was actually a CEO during the internet boom of the 1990s and saw all-too-well what can happen when self-indulgence and fantasy are not only not constrained, but actively encouraged. As he puts it, "If you tell a 30-year-old male he’s Jesus Christ, he’s inclined to believe you."
Ostensibly, the task of constraining leaders who are naturally inclined to push limits is at least partly that of the board. Among the reasons to have a board is to ensure good decision making and to maintain corporate decorum. That didn't happen with WeWork. According to Galloway:
"It’s safe to assume that board members already knew all of the details about Neumann’s antics ... his hard partying and yoga babble were seen as features, not bugs, until the market threw up on it. Now, all of a sudden, the board is acting shocked. The board didn’t fire this guy; the board enabled him ... Basically, as long as people were willing to buy into this charade, they [the board members] kept it going as long as the music kept playing."
Two other elements come into play in facilitating such excesses. One is the cyclical view towards charismatic leaders. There are times when dynamic founders are replaced by more experienced managers to run a business as it matures. Recently, however, founders have been allowed more latitude to stay in power longer.
The excesses are also partly a function of the marketplace as Galloway explains:
"It’s frothy, and there’s more capital than operators. Any operator who has a vision and can promise the potential and convince people they can be the next Google or Facebook can attract billions of dollars right now. The reality is there’s more money out there."
All of this provides useful context from which to evaluate market conditions. First, there are clear analogies with the subprime crisis. As long as things are working, the vast majority of actors are making money. As long as people are making money, there is little incentive to change things. Positive feedback loops ensure the good times run longer than they should.
This creates an interesting possibility. What if the thing that is amiss is simply an increasingly sober evaluation of existing conditions? What if investors have become less willing to dismiss math as some kind of weird science and more inclined to seriously apply it to growth expectations? What if, in the context of weakening growth, investors are less willing to believe in "vision" and "airy promises" and more inclined to manage downside risk? What if a bubble is bursting, but it is not one of stocks per se, but one of bullsh*t?
This would have major implications for investors. First and foremost, any exposure to bold visions, airy promises, and barely credible growth expectations would need to be re-evaluated and re-calibrated. How many of those growth estimates are realistic? How many are off by a long shot? How many are not even possible? How many are only possible if funded indefinitely with free capital? Such scrutiny is even more likely to increase as earnings growth declines, global growth slows, geopolitical tensions rise, and as the credibility of central bankers fades. The result is likely to be a major rotation from growth into value.
Such a rotation would affect more than just growth investors; it would also have a disproportionate impact on broad index investors. Since capitalization weighted indexes overweight stocks that are overpriced and underweight stocks that are underpriced, broad indexes have become increasingly comprised of inflated growth stocks. That exposure becomes especially painful when the process reverses.
To the extent the primacy of bullsh*t diminishes or even vanishes as a determinant of stock prices, it will also have a significant impact on strategies for investors and advisers. When BS is ascendant, investors need only follow the same trends that everyone else does; it is no more complicated than that. Valuation, however, is a fundamentally different exercise. Determination of reasonable growth estimates is subject to all kinds of research, analysis, and judgment. This will create new opportunities for stock selection, but in doing so, will also leave a lot of people bereft of necessary analytical and investment tools.
Finally, the bursting bubble of BS also has implications for risk management. When the inflated expectations facilitated by BS are the norm, there is little reason to worry about how inflated the expectations are. Rather, the main concern is regarding the catalyst that could change things. The current environment provides many good examples including trade wars, election outcomes and the potential for a recession.
Focusing on a catalyst is a poor way to manage risk for a number of reasons, however. It is very hard to imagine all possible catalysts. Often, catalysts have a different effect than supposed. Thing can happen randomly. Further, the world is a complex place; oftentimes there is no particular, recognizable catalyst at all.
The thing that can usually be judged with far greater confidence than a catalyst is downside risk. You usually have a pretty good idea of what you can lose if things go bad. With that in mind, imagine playing a game of Russian roulette with your investment portfolio. You have one chamber of a gun loaded that you know can destroy your savings. Why would you focus on what might cause the barrel to stop spinning at the filled chamber rather than avoiding the inherent risk of the situation altogether? In other words, if stocks are significantly overvalued, why accept so much risk?
In sum, it is fair to say that something is amiss in the investment landscape. If that something is a bubble in BS rather than a bubble in stocks, the fallout will likely be different. Rather than one big, sudden crash, it will be more like a process of individual balloons popping over time as particular manifestations of BS get called out and re-calibrated. As this happens, it will create a great deal of pain for sure, but there will be opportunities. The best vantage point will be that from security-specific analysis.
©2018 Arete Asset Management | Baltimore Investment Management | See our Disclosures
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