The Blue Sky Market
It’s fall newsletter time! Three months have elapsed since you read your last Monarch newsletter, and we understand your excitement. It’s like how we feel about corporate earnings reports, which come out every three months. Especially this year, we find valuable nuggets of information in these reports. What was the cadence of sales growth (versus last year) from month to month within the quarter? How about since the quarter ended? How did management adjust to the pandemic? Were they able to wring out efficiencies that would have been harder to pull off in a “normal year?” How do they view supply and demand within their markets and their suppliers’ markets?
We know the subject you really want to read about is our typical definitive, no-holds-barred prognostication on where the market is going. Especially now, given how the pandemic has abruptly upset the economy and how the stock market has raced ahead, seemingly in spite of this. Nonetheless, we want to remind you that we are erudite long-term thinkers, so we are ignoring your plea and instead focusing this newsletter on the supply and demand of palladium.
Just kidding!
Actually, we’re going to start by rehashing a post we made to our website blog a month ago. We use the blog for posting our thoughts on contemporary subjects; customers who have given us an email address receive an emailed link to our posts. On September 1, we penned “Stock Splits: What’s Old is New Again,” regarding the stock split announcements of Apple and Tesla, showing how the stocks traded after the split announcements (they went straight up). If you haven’t read the post, I feel okay playing the spoiler since it is a month old. We were—what’s a nice way to say this—skeptical that these gains were sustainable.
Lo and behold, Apple’s share price appears to have peaked on that day, and fell as much as $30, or 22%. Tesla peaked on August 31 and fell as much as $172, or 34%, in just 5 trading sessions (good thing Tesla split its stock…the drop would have been $860). Both have recovered modestly. Despite the rough September, Tesla is still +412% and Apple +58% year to date.
These stocks have performed like rockets for two main reasons. Many companies have performed better BECAUSE of the pandemic and its side effects, including work from home, avoiding stores by shopping online, spending money to improve residences in the absence of being able to spend money on travel and entertainment, remote education, and health care devoted to fighting covid. Some of the obvious beneficiaries: Amazon and Walmart (the two leading online retailers), Netflix (homebound entertainment replaces live entertainment), Zoom (pure play on remote conferencing), Microsoft (acceleration in companies moving to the cloud, stable revenues of subscription-based cloud software for office workers at home), Home Depot and Lowe’s (home improvement), and Abbott Labs (rapid test for diagnosing covid).
Another less obvious reason is that growth stocks generally trade well when interest rates are falling. The fundamental value of a stock should equal all future cash flows of the company, discounted by “the discount rate.” Fast-growing companies derive much more value from distant cash flows, because they are predicted to be much larger in the future. So the lower the discount rate, the less discounted are those far-off cash flows. And if the company’s business conditions actually improved this year, it shouldn’t be a surprise that growth stocks are up a lot this year. [More later on the discount rate and discounted cash flows…stay tuned.]
But the performance of Apple and Tesla stood out in August, even among other growth stocks. Which is noteworthy because both are indirect beneficiaries of the pandemic, not direct. Over 80% of Apple’s revenues are from hardware: iPhones, iPads, Macs, and peripherals (wearables). Less than 20% are from services, although services have higher profit margins, are far more dependable as source of growth, and are the reason we bought the stock in the first place. Apple’s stores were shut down for most of the 2nd quarter and there was no new iPhone to serve as a sudden catalyst to get people to upgrade during the pandemic. But a few things went surprisingly well: homebound consumers bought more iPads for their Zoom sessions and Mac laptops so they could work from home. In the meantime, people spent more time on Apple devices, so they spent more money on Apple’s services. Add it all up and Apple’s sales rose 11% in the quarter versus the prior year. That didn’t hold a candle to Amazon’s 40% sales growth, or even Microsoft’s 13% growth, but it did look good relative to the pandemic-stricken economy, and was an acceleration from +1% sales growth in the prior quarter. Throw in some enthusiasm around 5G phones next year and there was a forest’s worth of dry tinder for the stock split’s fire.
As for Tesla, where to start? The stock has been Ground Zero for wild stock market speculation since it took off last year. It has done well to grab 2% market share of new car sales, but its stock has done far better…the company’s market cap of $400 billion is more than every carmaker on the planet…combined. Its CEO is adored as a visionary and its products are loved (even if its user ratings rank the lowest of any automaker for product quality by J.D. Power). Electric vehicles (EVs) are essentially a play on alternative energy (wind and solar), because they don’t rely on fossil fuels like gasoline…even if this ignores the inconvenient truth that most electricity is produced by natural gas and coal. The stock’s bump from the stock split announcement coincided with an earnings report which showed the company was profitable for the 4th quarter in a row, which should have convinced S&P to let Tesla into the S&P 500 Index. You read that right: Tesla was not in the S&P 500, despite having the 7th largest market cap in the U.S. at the end of August. Well, it was not (yet) meant to be; S&P subsequently announced its new entries into the index and Tesla did not make the cut. Presumably, this was because the company is only profitable because of tax credits; on an operating basis, the company loses money. These tax credits differ from those earned by car buyers…although the federal tax credit to buy a Tesla expired, it might be reinstated if the White House welcomes a new occupant in 2021. Tesla also needs to regularly borrow more money or issue new shares, which dilutes existing shareholders’ share of the company. Thankfully for Tesla, management had the wherewithal to issue $5 billion of new shares right before S&P announced that Tesla would not be entering the S&P 500. For those who bought new shares, sorry for your loss.
Typically we wouldn’t devote half a page of prime newsletter space to Tesla…although we do try to use these pages to cover issues that are likely on the minds of our readers. But the Tesla story just gets more interesting. Suddenly there are a lot of EV startups. One that has gone public is Nikola (named after the visionary inventor Nikola Tesla…you can’t make this up), which is pursuing an EV for the semi-truck market. The founder was sufficiently convincing in his declarations that he had the technology, and it was proprietary, to bring this snazzy looking product to market. Investors plowed in, ramming its market cap up to $30 billion, despite being years away from producing anything. This exceeded that of Ford, and was nearly as big as GM. Naturally, GM then took an ownership stake in Nikola.
As soon as money poured in, though, a research firm published a bearish piece which was skeptical that its technology was proprietary. More curiously, it also determined that a promotional video showing a prototype of the truck cruising down a highway actually began with the truck getting up to speed by coasting down a hill. Whether true or not, the visionary founder left the company and its stock tanked. In other EV news, the state of California had the gall to announce that by 2035, all new cars sold in the state must be EVs. Yes, at the same time that the state is implementing rolling brownouts because its creaking electrical grid can’t keep up with today’s electricity demand.
This market is a lot to take in, especially the twin dichotomies: economy vs. market and tech vs. non-tech. Let’s think back to a different era—10 years ago. After the 2008-09 financial crisis, our economy recovered slowly, with GDP growing at a subpar 2% rate, unemployment still high, homes still foreclosing, and the general mood of Americans was that our best days were in the previous decade (or the 1990s). Bold visionaries and dreamers were hard to find.
By 2019, however, the tenor in America was startlingly different. Americans were hot for ride-sharing services, and we would soon all be driven everywhere by robocars. Americans were so busy that restaurant delivery was the next big thing…who has time to wait around for food anymore? AI (artificial intelligence) was the next frontier of development. We call this a “blue sky” economy because the sky was the limit on what technology can do for us. And literally so, as the space race was back on. Private companies were preparing to transport passengers to the Space Station, then the moon, and then Mars…even passengers who are not astronauts.
We used the past tense in all of these as a misdirection; these are all still very much the living hopes and dreams of techies, even if many are homebound and not using Uber anymore. Why, in the midst of a debilitating recession, which pushed unemployment up to 20% despite hundreds of billions of government funding to keep people employed, was all this dreaming not washed away as it was in 2008-09? Good question! Was the recession too short to affect the dreamers? Or perhaps it was because tech’s role in the economy was emboldened by the side effects of the pandemic? We’ll go with both, but lean toward the latter.
This matters because investor money reliably flows to what is “working,” which works to pump up the hot stocks even hotter, and the bubble fills with helium until it pops. Here’s another bubbly statistic: if you take all U.S. stocks that had negative profits in 2019, and have a market cap of at least $1 billion, as a group, their stocks are +47% year-to-date in 2020. The question every value investor is asking of him/herself, every day, is what could cause the bubble to pop? [Growth stock investors wouldn’t dream of wasting time on this.] As stated earlier, this pandemic was practically designed to benefit tech stocks. As long as it continues, and as long as our economy (though growing strongly right now) isn’t fully “out of the woods” because the virus is still circulating and still preventing us from fully returning to normal, technological adoption should continue to accelerate. Tough to refute this, but the virus will be defeated at some point.
Now back to interest rates (you knew it was coming). The Fed has committed to keeping interest rates near 0% for the foreseeable future, possibly even 2-3 years. What do 0% interest rates mean for stock valuations? A lot. Most investors have a basic understanding that low interest rates are good for stocks for a couple tangible reasons. Companies can borrow cheaply, which lowers their interest expense. Also, bonds don’t offer any yield competition. The average dividend yield for our core stocks is nearly 2.8%, which is double that of the highest-yielding treasury bond (the 30-year, at 1.4%). Historically, treasury bonds have yielded more than stocks. This makes stocks look relatively attractive to investors who might yet pull money out of bonds and put it into stocks, pumping stocks up further until those yields are closer together. For our core stocks to yield 1.4%, they would need to double AND not raise their dividends.
“So you’re saying stocks are still cheap?” Yes, but only on a relative, theoretical basis…given how low interest rates are. There is also a mathematical basis for this. In Investing 101, we learn that the value of a company should equal the sum of all the future cash flows of the company, discounted back to today. The wonky formula for this is:
Bear with us while we explain: Vo is the Value today, Sigma means sum (the infinity sign indicates ALL future cash flows are counted). Each year’s cash flows are “discounted,” meaning their value is reduced by a discount rate (r) to reflect the uncertainty that the cash flow will actually come to fruition. Cash flows in further out years will be discounted more (t = number of years). The discount rate is comprised of two factors: the risk-free rate (either a short- or long-term treasury yield) plus a risk premium to account for the uncertainty of the future cash flows. So, the more certain you are about a company’s cash flows, the lower the risk premium you would add to the risk-free rate. A volatile business, in a boom-bust industry such as energy or auto production, would merit a higher risk premium.
We can all agree that the current risk-free rate is very low; whether it’s 0.1% or 0.6%, both are lower than they have ever been in our lifetimes. Reasonable minds can disagree on what risk premium to apply to certain companies. Now, it’s worthwhile to take a step back at this point to remind ourselves that most investors do not project cash flows for their investments for the next infinite number of years. Most probably do not project a single cash flow, nor attempt to create a discount rate for each of their investments. Does that mean this exercise is irrelevant? No, keep following along.
For the lazy investor who doesn’t want to devote all that time, there is a way out—terminal value. Terminal value (TV) computes the value of all cash flows for you, and relies on one big assumption: that the growth rate (g) will be the same every year:
If you are an unrelenting bull on a stock, you might think the company has the runway to grow forever. You even have room to be conservative…you might think +20% every year is reasonable, but call it +10% so you don’t look obnoxious. Now, what if your discount rate is less than 10%? Combine 0.6% for the risk-free rate and throw on an 8% risk premium. That’s a problem, because (r-g) will be negative. The math error is that the cash flows will grow every year, even after being discounted at the discount rate, and if you take that to infinity, they will grow to infinity. Even if your growth rate equals your discount rate, they grow to infinity.
So, infinite value requires 4 factors to justify: 1) interest rates are really low, 2) risk premium is not high because you don’t see the stock as risky, 3) expected growth is high, and 4) for a very long time. The first is undeniably true today, and you can see how people get easily suckered into believing #3 and #4, especially dreamers. As for #2, this is the most obtuse of the 4 variables, so maybe we should just ignore it.
But seriously, for anyone questioning why the market is back up to its February record high, look no further than this DCF (discounted cash flow) model. If the two main variables that definitely change over time are the risk-free rate and future cash flows, what has changed since February? Well, the entire treasury yield curve is 1.5% lower than it was in February. That can seriously affect (r – g)….if it was 3% before (say, 10 – 7%), now it’s only 1.5%. That argues for double the valuation. How has the long-term outlook for cash flows changed? Before you start extrapolating the 2 most recent quarters to earnings 10, 20, and 30 years from now, remember that the pandemic will end at some point. True, many small businesses have gone out of business. Guess what—that’s happened before in every past recession. People are reluctant to fly. Remember 9/11? Even if you believe World War III will break out someday, we already had 2 of them and moved past them (frankly, war is a stimulant for an economy). So if the only variable that has changed is that the risk-free rate is 1.5% lower than it was just 8 months ago, and 3-4% lower than its long-term average, should you be surprised that stocks are higher?
As we look forward, the risk-free rate will play a significant role in determining how stocks perform. If treasury yields stay low, stock valuations can go higher, although if yields are still low a couple years from now, we probably don’t have a vibrant economy then. If instead the economy is still growing, the Fed should be raising rates or at least inflation concerns will be growing, which should lead to lower valuations for stocks, although higher cash flows. In other words, it will be difficult to have strong growth and near-zero interest rates.
The forgotten variable is the risk premium, and even if most investors are not assigning each of their holdings a risk premium rate, implicitly they are. Microsoft is no longer seen as risky because they keep cranking out revenue growth over 10% every year. Migration of software to the cloud is still in the early innings, apparently, so this growth should last a long time. Our biggest utility holding is NextEra Energy, arguably the hottest utility in the U.S., thanks to its mantle as largest generator of alternative energy. This, and a generally favorable regulatory scheme in Florida (its home state), have combined to produce at least 7% earnings growth every year since 2013. While 7% isn’t all that rapid, if you can count on it for a long time, that’s worth a lot in terms of a lower risk premium. By the way, we were on the edge of our office chairs for 6 weeks waiting for a company to follow in Apple’s and Tesla’s footsteps by announcing a stock split, and the parlor bets were flying. One that we failed to consider, but should have (for its expensive valuation and $284 stock price), is NextEra, which was, in fact, the next company to announce a split (4-for-1, effective on 10/19).
Banks, though, we can’t count on them because they are cyclical and suffer loan losses every recession, right? But consider that Lake City Bank has grown earnings at more than 8% in each of the last 10 years except one. Here are its annual EPS growth rates since 2010: 16%, 26%, 14% 8%, 12%, 5%, 12%, 17%, 31%, 8%. This is roughly twice the growth rate of NextEra. Uh oh, earnings are down this year (projected -12%) because the bank has put more money into its loan loss reserve, and because the spread on interest between their depositors and their borrowers is slightly less. Origination fees from PPP loans have helped this year to offset those. Will they be hurt by these factors every year? Frankly we doubt either drag will hurt next year and would see a high probability that both factors turn into their favor. The economy reversed course in May and has been growing strongly since. You can buy LKFN for 14 times depressed earnings and a rare 3% dividend yield. All because investors don’t view banks as growth stocks.
This is a good time to remind you that we always seek to put together diversified portfolios, with the common thread among stocks that they need to be able to grow longer-term. There are companies that make software, electricity, loans, drugs, medical devices, beverages, and toilet paper which will continue to grow over time. Our philosophy on trading is to hold our winners, but if the stock goes up so much that the upside potential shrinks, sometimes we trim the holdings, but still retain a large position. Thus, the weightings in our portfolios will be more balanced, as we sell high and buy low. This generally works, but sometimes it takes longer to work. In 2020, investors have crowded into stocks that have already gone up, which is the opposite of our approach. As of the end of August, Apple alone was more than 7% of the S&P 500. Along with Microsoft and Amazon, the top 3 were 17%. At the peak of the dot.com bubble in 2000, when crowding into hot stocks was rampant, the top 3 were only 12%, as this chart shows:
7% is a really heavy position…our compliance team starts haranguing us when a stock gets anywhere in the ballpark of that number in a client’s account. Just to give you an idea of how much these weightings mean to an index, as of this writing, the S&P 500 Equal Weight Index (all 500 stocks have the same 0.2% weight) is -6% year-to-date, a full 10% worse than the S&P 500. Same 500 companies, but 10% difference in performance. Few markets in the world have performed as well as U.S. large-caps, but these 500 large-caps are down 6%. Even the Dow, which had a 12% weighting in Apple in August, is down.
A couple other fun facts we pointed out in our blog post: Apple’s market cap at its peak exceeded that of the entire Russell 2000 (U.S. smallcaps)…all 2000 stocks. It also exceeded that of the entire FTSE 100 (the largest 100 stocks in the U.K.) and the entire German stock market. Not bad for a company whose cash flows are still below its cash flows in 2015.
In conclusion, if it seems like we are talking out both sides of our mouth in saying that stocks could go a lot higher but they also seem to be very risky, you’ve figured us out! As Harry Truman once said, “Give me a one-handed economist” who doesn’t say “on the other hand…” We know the stock market is a lot more complex and emotional than a discount rate and future cash flows. That’s why anything can happen in the short-term, which is why we want to be prepared for anything, even if we don’t know what it will be. As always, we will keep trying to find good growth stocks, and especially the ones the market fails to notice.
-Written by John Meyer
We want to introduce you to our newest Monarchian, Elizabeth Freck. She works alongside Stephanie Deck as a Client Services Administrator. Elizabeth is a graduate of the University of Evansville with a B.S. degree in Business Administration and Management. She grew up in Marion, Indiana and enjoys traveling and spending time in the garden.
Elizabeth recently moved back to the Hoosier state after working in Naples, Florida in the hospitality industry. She replaces Debbie Meyer who moved back to Florida. While we miss Debbie, we are excited to welcome Elizabeth to the Monarch team.
