Monday, May 21, 2018

Beware the 10-year real interest rate

       With regard to valuing companies, the 10-year real interest rate plays a key role.  It is foundation on which discounts rates are built and the higher those discounts rates, the lower the value of a company's stock, everything else held constant.  Ever since the financial crisis, the 10-year real rate has been close to historical lows.  Unlike many real rates, the 10-year real rate can be observed directly because the Treasury issues 10-year Treasury Inflation Protected Securities, commonly referred to as TIPS.  The graph below shows that prior to the crisis the TIPS yield moved randomly around a yield of about 2.0%.  Then, during the crisis, it plunged and continued down until it reached negative territory in 2012 and 2013.  Needless to say, everything else held the same, this was good news for stocks.  And the news has remained good to this day.  The TIPS yield has remained below 1%.  But it is rising.  With the economy strong, there is every reason to believe that the TIPS yield will return to more typical historical levels of around 2%.  If that happens, the implications for stock prices are clearly bearish.  A higher TIPS yield also means higher rates on Treasury securities acrosss the board.  That is a big issue for government borrowing.  Even with record low rates, the Treasury is running big deficits.  With higher rates it is, "Katie, bar the door."  Investsors should be cautios.

Tuesday, May 15, 2018

Competition, Regulation and Valuation - The Impact

       In the last post, I talked generally about competition, regulation and valuation, but did not offer any data to illustrate.  The valuation data, shown below, are dramatic.  The lines plotted in the graph are paths of wealth per dollar invested over the period from January 1, 2013 through May 9, 2018.  Recall that a path of wealth differs from a price line because it also accounts for the impact of reinvesting dividends.  Including dividends is important to avoid comparing apples and oranges when looking at the performance of stocks, because some do and some do not pay dividends.  In the present case, none of the FANGs pay dividends while both Verizon and AT&T pay substantial dividends.

         The results shown in the figure are striking.  Whereas the FANGs, who thus far have faced little competition or regulation, have appreciated dramatically, with Neflix rising a remarkable 2,500%, Verizon and AT&T have been stuck in neutral.  The only return investors have received are the dividends.  In fact, in the case of AT&T the stock price at end of the period was actually less than at the beginning, so the total return was less than the dividend yield.  The point is that there is a limit to how far such revaluation can go.  As the later Herbert Stein said, if something cannot go on forever, it will stop.  As the regulatory environment evolves, Google and Facebook may start to look more like Verizon and AT&T.  With their current high valuations, that is a reason for investors to be cautious.

Monday, May 7, 2018

Competition, Regulation and Valuation

       AT&T has a market capitalization of 196 billion.  Facebook book has a market capitalization more the 2.5 times greater.  Why the difference?  Both can be seen as operating in businesses that have natural monopolies.  The difference is that AT&T has been around for a century and the regulators have caught up.  For decades now, the ability of AT&T to take advantage of the natural monopoly in telecommunications has been constrained by various forms of regulation - particularly anti-trust.  The current lawsuit over the acquistion of Time Warner is just the most recent example.

        Facebook also has a natural monopoly related to the network effects associated with social media.  This allows them to play a central role in buying personal data from consumers and selling it to advertisers.  The purchase price is the free service the company offers.  This business model is much newer than telecommunications and it has left regulators in its wake - just as AT&T did it the early years of its operation.  But eventually the regulators will catch up.  They will become concerned about the natural monopoly.  They will worry about the operation of a market in which consumers "sell" their personal data without understanding fully what they are doing and whether they are getting fair compensation in the transaction.

       The same lag is true of other "technology" companies like Uber and Air BNB.  To date they have been large exempt from the detailed regulations imposed on hotels and taxi companies.  This exemption has played a big role in supporting their sky high valuations.

        For investors considering buying stock in companies like Facebook at today's lofty prices, the key is spending the time trying to understand how regulation will evolve.  Yes, a natural monopoly could be incredibly valuable if it were allowed to expand unchecked, but that has never happened.  In businesses from railroads, to oil, to telecommunications, growing power has been met with added regulation.  It would be foolhardy to assume that something similar will not happen to today's tech giants.

Saturday, May 5, 2018

Elon Musk and the Car Business

       Elon Musk deserves immense credit.  The time of the electric car had arrived but it needed a catalyst.  Mr. Musk provided it.  As the late David MacKay made clear in his wonderful book, Sustainable Energy- Without the Hot Air, electric cars have a host of advantages over internal combustion engines, not the least of which is that they do not throw away kinetic energy in city driving.  But being the catalyst for a new innovation and running a mass market car business are two separate things.  One involves far-sighted thinking and the willingness to take major risk.  The other involves the blocking and tackling of efficiently producing and servicing millions of cars.  Mr. Musk is a great visionary.  However, as his recent press conference revealed, he is not much for blocking and tackling.

        It is for blocking and tackling reasons that I have been saying for years that Tesla is overvalued.  Yes, electric cars are way of the future, but in my view Tesla will not be a big part of that future.  It reminds me of an innovation that has played a huge role in my life, and those of anyone else who does valuation, - the electronic spreadsheet.  The father of the electronic spreadsheet was Dan Bricklin who came up with the idea while he was an MBA student at the Harvard Business School.  When I teach my valuation class at Caltech, no one has heard of Dan Bricklin despite the fact that every student makes daily use of his innovation.  His company, Visicorp (the product was called Visicalc), was not so good at blocking and tackling and went bankrupt in the face of competition.  I fear the same fate for Mr. Musk.  I have owned three Teslas and love electric cars.  But I have had to deal with innumerable glitches.  As the competition comes on stream with a vicious focus on blocking and tackling, Mr. Musk may want to step back in time and study what happened to Mr. Bricklin.

Saturday, April 7, 2018

How Low Can Tesla Go?

        Given my writings on Tesla, a common question I am asked is how low can the stock price go.  To answer the question, let me first put aside the possibility of a takeover.  In that case, zero comes into play.  Tesla has over $10 billion in debt and it is not clear that the company is worth more than that as an operarting entity.  Yes, the company's cars have been a great innovation, but so was air travel.  And as Warren Buffett observes virtually every airline went bankrupt.  Tesla has not proven that it can profitably make, sell and service cars so bankruptcy is something to worry about.

         However, I do not think it will come to that because before the company collapses someone with deep pockets and a lot of cash, think Google or Apple, will buy it.  Given Tesla's brand name and technology, a company with sufficient resources and greater focus on the blocking and tackling of doing business should be willing to buy it - but not at anything like $300 per share.  In my view, $100 per share would be the most a buyer would be willing to pay and $50 is more likely.  So if you ask how low Tesla can go, my best answer is $50 per share.

Thursday, March 29, 2018

Corporate Stakeholders and Corporate Finance - The Case of Tesla

      Way back in 1988, Alan Shapiro and I published a paper called "Corporate Stakeholders and Corporate Finance."  The point of the paper was to highlight a manner in which corporate finance policy could have a major effect on corporate value - in contradiction to the famous Miller-Modigliani theorem.  The paper proposed that corporate finance affected value through its impact on corporate stakeholders, particularly customers.  Our point was that customers would shy away from a company in financial distress because they feared the products would be terminated, support and repairs would be withdrawn, and second hand prices would plummet, if the financial distress worsened.  This leads to a downward spiral.  If customers stay away, revenues drop and the financial crisis becomes more acute, leading to further loss of customers.  The implication is that companies that want to keep their customers need to be sure to have plenty of financial slack so that customers do not have to worry about the company's future.

      That leads to Tesla.  With cash dwindling and debt ratings falling Tesla is headed for possible financial distress.  For the first time, potential customers are lighting up the internet with concerns about buying cars from a company that might not be able to support them.  It is not yet a Cornell-Shapiro downward spiral yet, but it is something to worry about.

Wednesday, March 28, 2018

The Tesla Meltdown

      If you have followed this blog for the last couple of years, you have heard me harp on how difficult it was to reconcile Tesla's market price with fundamental value.  Tesla kept sailing along at a market price of abour $350 despite all the issues I stressed which included: the company's lack of experience with mass market production and service, no proprietary technology, numerous successful competitors with decades of experience, the need to grow rapidly while maintaining margins, the need to raise more capital, and so on. 

      For years, none of this seemed to matter and then it did.  In a space of about two weeks Tesla suddenly fell to $250 on no major fundamental news - no revelations about the Model 3, no sales data for the S and X, no admission that more capital would have to be raised, no major introductions of new cars by competitors.  Suddenly confidence just seemed to sag.  This is what I find so interesting and frustrating about companies whose values are based on optimistic projections without a reasonable tie to fundamentals.  They can sail along for years, causing many shorts to give up and cover, and then in a flash sentiment changes and the price drops.  It will be interesting to see how low Tesla can go.  Even a price of $250 is difficult to justify from a discounted cash flow perspective.  If people stop believing in the magic of Elon Musk $150 is a real possibility.

Sunday, March 11, 2018

The Bubble Wars

            A war continues to rage amongst finance professionals regarding the commonality of bubbles.  The problem is that present value relation can be interpreted as an identity.  There are always discounts rate and cash flow forecasts that can justify any price.  Therefore, a non-bubble story can always be constructed post hoc to explain any observed data.  The question, therefore, comes down to how reasonable are the required discount rates and cash flow forecasts.  That immediately suggests a laboratory environment in which information can be controlled.

              The need for a controlled environment was not lost on Vernon Smith who designed a series of classic experiments for which he was awarded the Nobel Prize.  It has been known at least since the work of Tirole (1982) that a critical source of bubbles are the beliefs of investors about the information and behavior of other investors.  To examine, the potential impact this source, Smith controlled the information carefully in his classic experiments.  Each of his  experiments had 15 trading periods during which investors could buy or sell a security.  The experiments were run in a double-auction setting in which the only source of cash flow from the security was a dividend paid at the end of each trading period.  Every participant was told that the security pays a random dividend with four equally probable outcomes in each of the 15 periods and becomes worthless at the end of the experiment. Hence, the fundamental value for a risk-neutral trader is each period’s expected dividend times the number of remaining periods. Even though there is no asymmetric information, and every trader knows that there is no asymmetric information, there is vigorous trading and prices evidence bubble like behavior.  More specifically, there is typically an initial boom phase that is followed by a period during which the price exceeds the fundamental value, before the price collapses towards the end of the experiment. A string of subsequent articles by Smith and others generalized the experimental environment and showed that bubbles still emerge after allowing for short sales, after introducing trading fees, and when using professional business people as subjects.

            Smith’s results are virtually impossible to explain without an appeal to bubbles.  The cash flow probability distribution is set and everyone knows what it is.  Time discounting is irrelevant over the course of a two hour experiment.  If there is risk discounting, it too should be constant over the life of the experiment.  The fact that prices frequently boomed and collapsed reveals that even in this tightly controlled environment, participants were speculating about and trading on the beliefs of counterparty investors and the associated behavior of prices.

            Despite Smith’s findings many financial economists dismiss his results as an artifact of the laboratory environment.  Such a conclusion seems odd, because Smith set up the experiments to reduce the likelihood that a bubble would arise.  For a real security, there is no common knowledge of the probability of distribution of future cash flows and there is no immediate horizon such as the end of the experiment.  In such a setting, it becomes much more likely that investors will speculate about and trade on estimates of the beliefs of other investor and the associated behavior of prices.  Or, to be more blunt, they will buy a security with the belief that they can sell it for more in the near future, independent of an assessment of the security’s fundamental value – that is they will attempt to ride the bubble.

            So how do you decide whether in any particular case whether a sharp run-up in price is the result of a bubble or is due falling discounts rates and rising cash flow expectations.  Quite frankly, there is no general solution.  Indeed there cannot be one because it all depends on whether the changes in discount rates and cash flow expectations required to rationalized a price run-up are reasonable.  That is why the war regarding the commonality of bubbles persists. 

            To examine a particular case, figure 1 plots paths of wealth for the CSRP market portfolio, Disney (arguably Netflix’s primary competitor) and Netflix for the period from January 1, 2015 to March 6, 2018.  The run-up in Netflix is clearly extraordinary.  The figure shows that during the period, the market advanced 36%, beating Disney that rose on 16%, but Netflix rocketed up 566%.  The run-up occurred despite the fact that the stock price on January 1, 2015 already impounded a lot of expected growth – the P/E ratio at that time was 102.

            So can discount rates and cash flow expectations explain the Netflix run-up without a bubble?  Discount rates do not work.  Changes in the risk-free rate or the equity risk premium would also have affected the market and Disney as well, but neither came close to matching the performance of Netflix.  It is possible that the beta of Netflix dove, but Figure 2, which plots the rolling six-month betas of Disney and Netflix, puts that hypothesis to bed.  The betas fluctuate quite a bit due to measurement error, but there is no observed tendency of the Netflix beta to fall, if anything the reverse is true.  In fact if any beta fell, it was that for Disney.  That leaves revision in cash flow expectations as the only possible non-bubble explanation.  Was the news during the period sufficiently positive that even from a starting point with a P/E of 102, it justified the price of Netflix rising by a factor of 6.66?  Our answer after reviewing all the news releases is no, but we recognize that our conclusion requires an interpretation of the news and interpreters can differ.  That is why the bubble wars continue.  However it is worth keeping in mind that a bubble does not have to be responsible for the entire increase.  Fundamental information likely explains part of the rise, but if it does not explain all the increase, what is the alternative to a bubble?  Saying it is “sentiment” is just another word for bubble – price increases that cannot be explained by fundamentals.

            Netflix is admittedly an extreme example.  Run-ups of that magnitude are rare.  The problem is that for smaller run-ups, it becomes more difficult to distinguish bubbles from rational valuation changes due to changing discount rate and cash flow expectations.  Prof. Smith’s experiments imply that bubbles are common, but he had the luxury of knowing the fundamental value of the securities.  Without that information, and with the possible exception of extraordinary examples like Netflix, the bubble wars are likely to continue.    

Thursday, March 1, 2018

The Market Can Stay Irrational Longer Than You Can Stay Solvent

     This famous old Wall Street warning is worth bearing in mind as we explore the possibility of bubbles. Because there remains no theory that explains how a bubble starts or when it will end, it is possible to be right in the assessment that current prices are irrationally high due to a bubble and still be wiped out as the bubble inflates further.

     A telling example is stock market performance during Zimbabwe’s hyperinflation in 2008 and 2009.  The hyperinflation is well-known.  Their stock market bubble less so.

     The figure below  shows the performance of the Zimbabwe overall stock market, in blue, while the currency was collapsing (in red, a rising exchange rate means that the currency is tumbling). The scale on this graph is quite astonishing.  During the three months from the beginning of August until the end of October, the currency fell from 10 to 1000 per US dollar, a 100-fold currency collapse in just three months.  Did this hurt the stock market?  Hardly!  The stock market rose 500-fold in just eight weeks, during which time the currency fell ten-fold.  So, In US dollars, the market rose an astounding 50-fold in eight weeks. In the next two weeks, the stock market plunged 85%, even as the currency tumbled another three-fold.  Again, adjusted for the tumbling currency, the stock market dropped 95% in two weeks.

     That’s when the currency and the stock market stepped up the volatility another order of magnitude.  When the hyperinflation went into overdrive, with purchasing power falling ten-fold in less than a week, the stock market fell 99% (99.9% adjusted for the tumbling currency) in that same week.  The stock market then ceased to exist. 

      Suppose an investor had the clairvoyance to know that the market was going to tumble 1000-fold (in US dollar terms, after adjusting for the tumbling currency), in the next three months.  And, suppose there was a way to short-sell that market.  This would seem to be a “can’t lose” proposition.  Even with prescience, knowing that the market was going to zero in three months, the investor would have first lost 50 times our money, and quite possibly bankrupted, before being proved correct!

     This is one of the most challenging attributes of bubbles.  They are hard to transform into profits, even for investors who correctly discern them, because the late stages can take valuations into the stratosphere.