Sunday, October 22, 2017

2 + 2 = 7 In the Market

       Amazon trades at a P/E of 250.  Facebook is 40.  For Air BNB, Tesla and Uber the P/Es are undefined because they don't have profits yet.  The list goes on for many tech companies.  The high P/Es reflect the rapid expected growth in profits and cash flow as companies like these disrupt the businesses of traditional firms.

       While all this disruption has been going during the recovery from the financial crisis, real economic growth has been sluggish - averaging about 2%.  That is a particularly low rate for an economic recovery.  Nonetheless, the S&P 500 has risen by a factor of about 4 - ignoring dividends!  That increase is not due to tech companies alone.  Prices and valuations have risen pretty much across the board.  As the Economist reports, P/Es of old line industries like hotels, credit cards, consumer proucts and so on are all well above historical averages so the market is expecting meaningful growth there too.  This leads to the question, who does the market expect tech companies to disrupt.  If the overall economic growth remains near 2%, the only way for tech company profits to growth far in excess of that is to take business from old line firms.  But those old line firms are also expected to grow faster than 2%.  It is as if 2 + 2 = 7.  That arithemetic is another reason why I am worried about current market valuations.

Friday, October 20, 2017

Steve Ross' Lament

     In a book published in 2005, the great financial economist Steve Ross lamented that the finance profession could not understand what moved the market.  By this he did not mean the inability of the profession to predict the market, he knew there was a theory that explained why that was not possible.  Namely that the market reflects available public information, so it should only move significant when new information arrives.  But by definition new information must be unpredictable, otherwise it would not be new.  What Prof. Ross lamented was the inability of financial research to explain what had moved the market after the fact.  As an example of Prof. Ross' lament, Cutler, Poterba and Summers, Journal of Portfolio Management, (1989) and Cornell, Journal of Portfolio Management, (2013) attempt to related the largest moves in the overall market to the arrival of value relevant information.  To emphasize, these are the largest moves of the entire market observed over decades.  If anything should have an obvious explanation it would be such moves.  But no luck.  Both papers conclude that a majority of even the largest market moves cannot be tied to value relevant information.  (Of course, the financial press tends to come up with non-value relevant explanations like profit taking but that is just after the fact rationalization, not a meaningful economic explanation.)

     I bring all this up because I have no explanation for the continued advancement of the aggregate US stock market.  Those who follow this blog will remember that six months ago, I wrote that I felt the market was becoming overvalued.  I was not alone.  Howard Marks, the founder of Oaktree and a savvy investor, distributed a memo to his clients wringing his hands regarding the overvaluation of most major asset classes.  Unfortunately for me, I put my money where my blog was and reduced my exposure to the market.  Now six months later the market is even higher.

     Here is my after the fact rationalization - not to be confused with a verifiable economic theory.  Investors have concluded that the risk of equity investing has fallen and thus they require a smaller risk premium.  This translates into a lower discount rate and, thereby, higher stock prices.  If my speculation is right, the reaction of investors is not without reason.  Market volatility has been close of an all-time low for a year now.  As of this writing, there have been only  two days on which the S&P 500 declined by 1%, or more in the last six months.  In the last two months, the S&P 500 his risen (generally to record highs) on 75% of the trading days.

     My suspicion is that this could all change drastically.  Investors may be thinking that they can ride the trend upward and sell when it reverses.  But when it reverses, that is when there are a couple of days with sharp declines, who are the buyers going to be?  Because there must be a buyer for every seller, it may take large price drops to clear the market.  Of course, this is all my speculation but that speculation is currently impacting the way I manager my fund.

Tuesday, September 5, 2017

A Crack in Apple's Secrecy Wall

       One of the themes of this blog is that Apple succeeds in spite of their dedication to secrecy, not because of it.  The benefits provided by splashy announcements of "secret" new devices like iPhones are more than outweighed by the costs of preventing brilliant, creative people from sharing and vetting their ideas with the broader community.  Well AI is causing a crack in the wall.  The AI community, including its academic component, is so commited to openness and transparency that Apple is having a hard time recruiting top people.  Today's Wall Street Journal reported that Apple is considering a more open policy for AI research.  I see this as a big plus for Apple, not a risk.

Saturday, August 12, 2017

Diversity at Google

            The brouhaha at Google regarding corporate “diversity” reminds me how confused I seem to be about this whole issue.  In a nutshell, there are four things I find to be particularly perplexing.

            First, if it our belief that people should not be judged according to criterion like race and gender, then why are we judging them that way?  Why is diversity defined in terms of variables that supposedly don’t matter?

            Second, in response to the first question, one possibility is that certain groups bring unique perspective to the corporate enterprise that helps promote the company’s success.  However, even assuming that is so why should the criterion by which groups are defined be variables like race and gender?  If the goal is to incorporate different viewpoints, I have found far more differentiation in perspective between fundamentalists and atheists than between men and women?  That finding, if true, implies that diversity should be defined along religious lines.  The same could even be said of political beliefs.  It seems clear, however, that opening the door to corporate political “diversity” would be a nightmare.

            Third, what is wrong with the simple criteria that all people be treated fairly in terms of their ability to do the job?  In that case, all a company has to do is make sure that variables like race and gender do not affect hiring, evaluation and promotion.  Companies should not be in the business of making social policy (just as I argued early they should not be in the business of making climate policy) because they lack both the training and the standing.  Those are issues best left to governments.  Companies can benefit society by offering the best products and services they can at competitive prices not by deciding what social groups, if any, require special treatment.

            Fourth, if there is a group that has been discriminated against so that their compensation and promotion fails to reflect their marginal product that is a great business opportunity.  When Jeff Bezos concluded that traditional retailers were not taking full advantage of the internet his solution was to start Amazon, not lobby Walmart.  In the same fashion, if good people can be hired at a bargain prices because of bias there is an opportunity to create value by hiring them in droves. 

Wednesday, August 9, 2017

What is the True Range of the Tesla Model 3?

      In December 2016, I published the results of tests I performed on my Tesla model S.  At that time, I wrote (the link is below),

I charged my Tesla fully at which point it said I had a range of 238 miles and then ran it down to a range of about 30 miles several times.  The first piece of bad news for Tesla owners is that while my range dropped an average of 208 miles, the car only traveled an average of only 144 miles – less than 70% of the promised range.  To cover those 144 miles, I used 51.2 KWH of electricity which comes to 2.80 miles per KWH .

       It is surprising that there is been so little written about actual range versus "stated" range.  Perhaps it is the case that many owners of the Model S and X, like me, come from families with several cars and do not rely on the Tesla for long trips.  But as a mass market car, the Model 3 is likely to be different - buyers will rely on it as their primary car.  If actual mileage in typical driving turns out to be only 70% of the stated range there could be quite an uproar which could come back to haunt investors as well as car owners.

Link to December article

Tuesday, August 8, 2017

If Apple Wants to Buy a Car Company

       There has been a lot of speculation about Apple buying Tesla.  While the mixture may be intriguing, Apple should bear in mind Warren Buffet's warning that no asset is so good you cannot overpay for it.  At a market cap of over $61 billion Tesla is already very richly priced without adding an acquisition premium.  So if Apple wants to buy a car company, why not Ford?  Ford's market cap is only $41 billion - much less than Tesla and a pittance compared to Apple's cash.  Plus Ford makes and sells a wide variety of vehicles all of which could benefit from Apple's technology.  Admittedly, Ford has a lot more debt than Tesla but the interest payments would be no sweat for Apple.  In short, if Apple wants to buy a car company why not buy one that makes a lot of cars and sells for a low price.  For that matter, Apple could even consider GM.

Government and Climate Change

       In a previous post, I argued that private firms should not base decisions on their assessment of the impact on climate.  The reason was that climate change is not only complex from a scientific, economic and statistical standpoint, but that it involves tradeoffs between conflicting groups of people that only governments should address.  There is a fly in the ointment.  Virtually all the economists whose work I follow argue that the best way to address climate related externalities is with a carbon tax - a view with which I heartily agree.  The problem is that a carbon tax does not offer a lot to politicians.  Not only is it likely to be unpopular, it removes the opportunity to use climate change as a reason to engage in a host of pork barrel programs that can advance one's political career.  In my home state of California, for example, we have dozens of special programs and subsidies designed to "combat climate change".  Few, to my knowledge, have been subject to any rigorous cost benefit analysis.  For instance, there are credits that are given to "zero emission vehicles" but not hybrid plug-ins.  This despite the facts that zero emission vehicles are not zero emission because most of California's electricity comes from carbon fuels and that many plug-in hybrids actually produce less greenhouse gases (taking account of electricity generation) than ZEV muscle cars like the Tesla model S and X.

       In short, climate change is such a large, complex and important issue - economists call it the mother of all externalities - that it opens the door to unprecedented levels of pork barrel politics.  Hopefully, much of that will be avoided, but our track record is not a good one.

Monday, August 7, 2017

A closer look at Tesla’s Q2 earnings “beat” by Andrew Cornell

         Tesla reported Q2 earnings after the bell Wednesday and shares rose 20 points following what was widely described in the press as an earnings “beat” on both revenue, 2.8 billion compared to an expected 2.5, and a loss per share of -1.33 compared to an expected -1.82.  In their letter to shareholders Tesla claimed an increase in vehicle deliveries of 53% compared to the same quarter last year.  Tesla CEO Elon Musk reiterated the production schedule for the Model 3 and expected that Model 3 margins would up 25% at the end of next year.

         Closer analysis of Tesla's quarterly earnings, however, reveals the quarter may not have been as significant of a “beat” as the headlines indicated.  A large portion of quarterly earnings and revenue can be attributed to a $100 million of ZEV credits.  Because Tesla only makes electric vehicles, they accumulate a surplus of ZEV credits which can be sold to other auto makers.  ZEV credits are government subsidy that costs Tesla nothing.  Consequently, the sale of credits contributes $100 million to both quarterly revenue and profit.  Without the sale of those credits, Tesla would have lost an additional 61 cents a share for quarter which would put quarterly losses at almost exactly what analysts estimated.

         Tesla’s claim of a 53% increase in deliveries for the quarter doesn’t look nearly as good when comparing to recent quarters.  In last year’s Q2 delivery report Tesla claimed a "steep production ramp up" resulted in high production during the last few weeks of the quarter so that many vehicles “in transit" and would be delivered and counted in the third quarter.  Consequently, Q2 2016 deliveries totaled 14,370 compared to Q3 at 24,500 when both Model X and S production lines were working at full capacity.  Had Tesla compared sales to Q3, the 53% increase becomes a 10% drop in deliveries.  Comparing deliveries to the most recent previous quarter gives Tesla a drop of 12%.  It appears Tesla is taking advantage of a weak 2016 second quarter to make their latest quarter look comparatively better.

        Following the July 3rd release of their 2017 Q2 delivery and production count, Tesla’s shares dropped from 375 to 310.  Several days later in a press release, Tesla once again highlighted vehicles in transit as an explanation for the lower than expected delivery numbers.  The company stated that vehicles “in transit”, 3,500 in total for Q2, would be counted in the 3rd quarter delivery numbers.  Adding 3500 cars to Q2 turns a disappointing 22,000 deliveries into a new quarterly record of 25,500.  What Tesla didn’t tell investors in the press release was that having vehicles in transit wasn’t unique to the second quarter.  The 3,500 vehicles in transit being applied to Q3 were more than offset by 4,650 vehicles in transit from Q1 that were counted in Q2.  The details are shown in the graphs below which show Tesla's reported deliveries by quarter and deliveries by quarter when vehicles in transit are added to the current quarter.

Sociobiology and Social Media

        Evolutionary biology suggests that between the ages of 12 and 25 people tend to be intensely interested in two things: social status and sexual selection.  This makes perfect sense.  As people enter prime reproductive age, status and sexual standing are the two things that have the greatest impact on successfully passing their genes to future generations.  It is no surprise then that people of that age are intensely social and make massive use of social media.  The hard question is what does it mean for investing in social media?  Despite their intense focus on social sorting, young people do not control most of society's resources and constitute only a sliver of total consumption.  Nonetheless, the idea is that if a company like Snap can attract a huge following among the young, those customers will stay with the company throughout life.  But there is a problem.  As you age matters of social and sexual status become settled.  People begin to realize that others are not that interested in them and they are not that interested in most others.  As a result, their interests in social media change.  The voracious appetite for right now interaction that disappears is replaced by the desire to keep in touch with family and close friends.  The very features that made a social site cool when you were young, becomes an irratating pain in the neck as you age (and as your consummable income increases).

       I am not sure what all of this means for investing in social media companies like Snap but I think it is something that cannot be overlooked.