Wednesday, June 21, 2017

VIXED

        The risk of investing in the overal stock market is measured by the market "volatility."  That volatility is measured the annualized standard deviation of daily stock market returns.  During the years from 1962 to 2016 the average standard deviation has been approximately 15.50%.  Of course, it was much higher during crises and lower during quiet time, but on overall average 15.50%.

         To compute historical standard deviation requires data past data on returns, but there is another way to get an estimate of how volatile the market returns are expected to be on a forward looking basis.  That can be done by solving for the volatility that equates the market prices of options on the S&P 500 index to theoretical prices derived from option pricing models.  The Chicago Board Option Exchange computes the number on a daily basis for S&P 500 puts and calls with a maturity of 30 days.  That number is referred to as the VIX index.  Like the S&P 500 index, options and futures are traded on the VIX index.

         The reason for all this background is that despite what seems like a turbulent situation in Washington and around the world, the VIX index is currently trading at all time low of about 10.80%.  What's more it has pretty much been stuck as this level for about the last six months.  Now you may think that such a low level is not sustainable and the volatility should tend to rise back toward its historical average.  If that is your conclusion, you are not alone.  The figure below shows the futures curve for the VIX.  To a high degree of approximation, futures prices can be interpreted as the market's expectation of the future level of the index.  The figure shows the expected volatility rising steadily to 16.94%, a level higher than the historical average, by next February.  Note this means that you can't make money betting on the increase because the market prices have already impounded the expect rise.  Ironically, the market has been expecting such an increase for the last six months while the VIX has remained locked at record lows.  As a result, the people who made money during that time were those who bet against the anticipated increase.

         My advice for now is to watch the VIX index closely.  In future posts, I will explore some of the investment implications of its record setting behavior.

Thursday, June 15, 2017

Is the Fed Responsible for the Chaos at Uber?

      Uber is awash in easy cash.  Private investors have pumped money into the company on increasingly generous terms with surprisingly few constraints for years.  Why?  Because with real interest rates so low and monetary policy so loose, they were reaching for return anywhere they hoped  they could to find it.

       In this respect, Uber is not alone.  Snap was able to go public on terms that gave shareholders remarkably few rights.  The values of major tech stocks like Google, Apple, Facebook, Netflix and Amazon have all soared to record highs.  In such an environment, one fears another "Minsky moment."  It is time for the Fed to change course.  It is reassuring to see that Janet Yellen is apparently thinking the same way.

Saturday, June 10, 2017

Come on Analysts, Do the Analysis

            As a manager of a small hedge fund, I like to compare my views on the valuation of common stocks to those of other analysts in order gain perspective.  This turns out to be a remarkably frustrating exercise.  Here is the problem.  Ultimately, the assessed valuation of a stock depends only on two factors:
1.  The size and timing of the future cash flows (what I call the cash flow profile) the analyst forecasts for the company.
2.  An assessment of the appropriate risk adjusted rate for discounting those forecast cash flows.
Everything else affects assessed valuation only to the extent that it alters those two factors.  So naturally I look for other analysts’ opinions regarding those two factors to compare with my own.  And I virtually never find them.  This is not to say that I can’t find opinions.  The internet is awash in opinions, but those opinions, even in the case of many Wall Street analysts, are almost never translated into the two factors that matter.
            Take Tesla as an example.  Given the celebrity of Elon Musk and the immense run-up in Tesla’s stock price there is an active debate regarding whether the stock is fairly valued.  Unfortunately, that debate is usually couched in terms of vague and incomplete verbal analyses such as, “The Model 3 is a game changer that could support a stock price as high as $500” or “Tesla cannot be valued as a car company because it is an energy technology company.  When seen it this light, its stock price is understandable.”  And on and on.  Lots of words, but no cash flow profile and no discount rate.
            Fortunately, there are exceptions to this rule.  One that stands out is the blog of Prof. Aswath Damodaran.  For the companies he analyzes, Prof. Damodaran not only provides the cash flow profile and the discount rate, along with explanations and calculations showing how he arrived at each, he posts a complete Excel spreadsheet that combines them in a discounted cash flow model that produces his value indicator.  Of course, this careful work does not mean Prof. Damodaran is always right.  Read, for example, his posts on Valeant.  But it does makes it possible for the reader to compare their own opinions with his and to use his spreadsheet to alter the assumptions to assess the impact on valuation. 
            One reaction to analysis such as Prof. Damodaran’s is that forecasting cash flows years into the future is speculative.  Of course it is!  No one ever said valuing stocks is easy.  There is simply no way to avoid the difficulty of long-run cash flow forecasting.  It can be hidden behind vague and incomplete verbal analysis, but that does not make the opinion more accurate or less speculative.  It just makes it more vague and incomplete.
            So I say, Come on analysts, do the analysis.  Follow Prof. Damodaran and let us see the valuation implication of your views.  That requires spelling out their implications for the cash flow profile and the discount rate.  Words without translation into a cash flow profile are pretty much empty words.

Thursday, June 8, 2017

What is a "Technology" Company from an Investment Perspective

       When most people are asked what a technology company is, they think of computers, software or bioscience - companies with a lot of PhDs doing complicated things.  But that definition applies to companies not that are not commonly thought of as "technology" like those involved in oil fracking.  From an investment standpoint, I argue that a technology company is defined by two characteristics: miniscule marginal costs and network effects.  Facebook is a perfect example in both respects.  With regard to marignal costs, what does it cost them to add one member or one advertiser?  With regard to network effects, people want to be on Facebook because other people they know are there.  These two characteristics are so important from an investment standpoint because they allow for rapid and massive scaling at remarkably little costs.  Hence, the massive market capitalization of successful technology companies.

        Notice by this definition, Tesla is not a technology company.  That is primary reason why I have such a hard time explaining its valuation.

One final word on Tesla

       One thing I have not discussed regarding Tesla is risk.  In my view, the risk for anyone buying the stock north of $350 is extraordinary.  What will happen, for instance, if the Model 3 turns out to be a modest success with very small profit margins?  Put simply, the company's cash flow situation will become critical, particularly if the Model 3 cannabalizes the more expensive and more profitable Models S and X.  Under such circumstances, the stock price could easily drop more than 50%, supported at that level by a potential buy out.  My point is that this possibility is not a "lightning strikes" consideration.  Given the demand for electric cars and the move away from sedans, I see it as a real possibility.  So the downside risk at current stock price levels is extraordinary.  And I do not see any upside potential.  But I have been wrong about the upside before.  However, it is critical to remember that for the foreseeable future Tesla has to make money by making, selling and servicing cars.  That is not a technology business like UBER where the marginal costs are close to zero.  Building and servicing cars costs money and there is no evidence that Tesla is any better at it then established competitiors.

Wednesday, June 7, 2017

Was I wrong about Tesla

       With Tesla hitting new highs over $350, it seems only fair to admit that I was wrong when I thought it was overvalued at $300.  But was I wrong?  The truth is I don't know.  TWhile the stock has run-up further, it has done so without the release of any fundamental information that would alter my valuation.  The Model 3 is still an unreleased four door electric sedan.  The battery and solar panel business are still highly competitive and not very profitable.  The logistical problems of manufacturing and servicing the new Model 3s remains.  So before I finally fall on my sword on this one, I need some actual information.  Hopefully, that will be forthcoming in the next couple of months, but who knows.  It is possible that the hype will continue to year end even if the Model 3 appears in only modest numbers.

Wednesday, May 31, 2017

The Mystery of Tesla

       The Model 3 will be coming soon.  The Model 3 is a cheaper version of the Model S, a four-door electric sedan.  A car design not very popular in America or elsewhere in the world.  It is unclear that Tesla can sell it at a price that will make a meaningful profit.  Meanwhile, the company is involved in the highly competitive home solar business for which government subsidies are coming under fire and the highly competitive battery business.  In many investors' minds this somehow adds up to being the next Amazon.  The stock has risen nearly 70% since December 2015 on virtually no fundamental news.  I can see why Mr. Musk suggested that the stock was overpriced.  It will be a very interesting next few months as the Model 3 actually begins to appear.

Monday, May 29, 2017

Tesla, Ford and GM

     Recently, the fact that the market capitalization of Tesla passed that of Ford and GM attracted a good deal of attention.  In some quarters, it was taken as evidence that Tesla was overvalued.  How could a company the manufactures a small fraction of the number of vehicles be "worth more" than Ford and GM?

     While I agree that Tesla is overvalued - my DCF models suggest values of abour $170, not in excess of $300 - comparison of market capitalizations is not the appropriate benchmark.  Instead, what should be compared are the operating values of the companies or what is often called enterprise value.  The enterprise value equals the value of the equity plus debt minuses cash and short-term securities.

      The table belows shows the calculation for all three companies.  As advertised, the equity value of Tesla exceeds that of its competitors.  However, the enterprise value of Tesla is less than half that of Ford and GM.  Therefore, while it might be right to conclude that Tesla is overvalued, that conclusion should not be based on a faulty comparison.


Sunday, May 28, 2017

Investment Performance

     Superior investment performance relative to a given benchmark can be attributed to some combination of three basic drivers.  The first is investor skill – the ability to find and exploit mispricing as it arises.  The second is valuation changes combined with an investment strategy that diverges from market capitalization rates.  For example, a manager who tends to purchase large cap growth stocks will outperform its benchmark, assuming its benchmark is broader than large cap growth stocks, when the valuation of those securities rises.  The final is bearing risks that are not captured in the benchmark.  For instance, a value manager who is measured against a CAPM benchmark will outperform, on average, if there is a risk premium associated with holding value stocks that is not captured by the CAPM benchmark.

     What distinguishes the three drivers is that they have markedly different implications for whether the observed historical superior performance can be expected to continue.  If performance is attributable to skill then clearly it should persist as long as the skillful managers run the portfolio, but with a caveat as described by Berk and Green (2004).  Berk and Green note that skillful investment managers have an incentive to capture the return on their skill.  There are two ways to do that – by charging higher fees and by accepting added funds to manage.  The first method reduces the net performance, but not the gross performance.  The second, however, could eliminate much of the gross outperformance because as funds under management grow it becomes increasingly difficult for even a skilled manager to earn superior returns.

     To the extent that superior performance was a result of valuation changes, and to the extent that the manager continues with the same investment strategy, superior performance should not be expected to continue. Over the horizon on which most managers are evaluated, typically three years or more, there is no evidence of momentum in stock prices.  In fact, academic research suggests that there is a slight tendency toward mean reversion.  This implies that to the extent the past performance was a result of valuation changes, managers who outperformed in the past can be expected to slightly underperform going forward.

     Finally, if historical superior performance was the result of bearing a price risk that was not reflected in the benchmark, that performance should be expected to continue.  However, it is somewhat misleading to call it superior performance.  Investors who interpret the higher returns as evidence of skill will be disappointed in those states of the world when the risks they did not recognize they were bearing are realized.



Saturday, May 27, 2017

DCF Analysis and the Allocation of Capital

            Much of this blog has focused on fundamental valuation as an investment tool that can be used to identify mispriced stocks and, hopefully, make superior returns.  While important to individual investors, there is another aspect of fundamental valuation that is more important from a social perspective.  Remember that in a market economy the social function of the financial market is capital allocation.  There is no central planner to decide how much money should be allocated to social media, versus electricity transmission, versus automobile manufacturing as so on times thousands. 

            To see how DCF analysis plays a central role in the allocation of capital imagine a thought experiment in which a fresh $1 million is injected into the capital market.  Where does it get allocated in a competitive market?  The answer is to that activity which investors conclude has a present value of expected future cash flows most in excess of $1 million.  That is to the activity that has the greatest DCF value.  So DCF analysis is not just a tool for making money.  It is a critical part of the process by which society decides what things are worth doing.
  

Tuesday, April 4, 2017

Time to Sell Apple

      I have been back and forth on Apple many times in this blog.  One constant theme, however, has been that the company needs to innovate aggresively on all fronts.  With the stock price at record highs and, in my view, innovation at a low point, the risk-return trade off from owning the stock has turned markedly negative.

       Apple finally did come clean today and admit that the company dropped the ball on the MacPro, but not until more than three years had passed.  During those three years, the company basically deserted the high-end creative users who relied on Macs and sang their praises.  Though not as long in the tooth as the MacPro, the iMac is long overdue for a major upgrade.  Microsoft's new Surface Studio far surpasses the iMac.  That's right Microsoft is making better more innovative computers than Apple!  Even the new Mac books, though beautiful computers, did not break much new ground and Microsoft is gaining in that space too with its Surface Books and Tablets.

      iPad innovation has also slowed.  The only innovative feature of the model that was introduced last month was the price.

        You might say, "who cares," Apple makes most of its money on the iPhone.  But the iPhone is a computer.  In my opinion, all the products fit together and make up a "computer culture."  That culture should lead to innovation on all fronts.  At Apple that no longer appears to be the case.

Saturday, April 1, 2017

Learning from Investment History

      Perhaps the most important lesson I have learned from studying investment history is not to trust what I learn from investment history.  Some recent research I just completed with Rob Arnott and Vitali Kalesnik of Research Affiliates underscores this lesson.  The work relates to the relation between the political party in power and average stock market returns.

      In a provocative paper, Santa-Clara and Valkanov (2003) presented evidence that stock market returns are much higher under Democratic presidents than Republican presidents.  Their work was updated by Pastor and Veronesi (2017), who find that the effect is even stronger when the data are extended through the end of 2015.  Given the strength of the results, Pastor and Veronesi go on to develop a model based on time varying risk aversion to explain the pattern.  They hypothesize that when risk aversion is high, voters are more likely to elect a Democratic (left leaning) president; when risk aversion is low, they elect a Republican (right leaning) president.  Because, risk aversion is higher under Democrats, this results in a higher equity risk premium, and, therefore, higher average returns.

     But there is reason to be suspicious.  Two key events are responsible for much of the differential return under Democratic and Republican presidents.  Specifically, the fact that Republicans were president during the two great crashes beginning in 1929 and 2008 and, not surprisingly, Democrats were president during the subsequent recoveries explains a majority of the differential.  Had the order been reversed, the effect would be largely eliminated.  This suggests the finding may be serendipity.

      To see if the results for the US were chance events, we turned to international data.  Our study covered Australia, Canada, France, Germany and the UK because we had good data on the political parties and stock market returns for those countries.  We examined whether the US pattern - high returns when the "liberal" party was in power relative to the "conservative" party - held in the international context.  For the five countries as a group, we found no relation between the the party in power and stock market returns.  From our perspective, history once again threw investors a curve ball.  What appeared to be a significant relationship between between the market and politics based on US data turned out to be a mirage.

Tuesday, March 28, 2017

Revisiting Tesla

        In honor of Tesla approaching new highs, I went back to a Aswath Damodaran and I wrote in early 2014.  At that time, we were trying to explain the run-up in Tesla's stock price for the 30s to over $250.  We failed.  We found that the most optimistic DCF model that we could defend did not lead to a value exceeding $100.  To get to that level we had to make aggressive assumptions regarding growth in revenues and profits.  How aggressive?  By 2016, we projected that Tesla would have revenue of about $7 billion and operating profit of about $200 million.  Those projectsions rose to $11.5 billion in revenue and $450 million in operating profit in 2017.

        In fact, Tesla's actual revenue in 2016 was $7 billion, close to our projection, but the company's had an operating loss of $667 million.  Despite the introduction of the Model 3, the company is almost certain to lose money again in 2017.

      All this has had no effect on the stock price.  Tesla today, from a valuation standpoint, is Tesla 2014 all over again.  The value depends on the massive and profitable future growth.  This waiting for Godot type of valuation is not unique to Tesla.  Amazon, now more than thirty years old, still trades at a P/E of over 170 based on future growth expectations that have continued to ramp up over time despite the relatively low level of earnings and earnings growth.  But Tesla is not Amazon, it is primarily an automobile manufacturer and as such has to make cars profitiablely and in volume.  That is not something that can be postponed indefinitely a la Amazon.  By December, we should finally know where Tesla stands.


Wednesday, March 15, 2017

This Time is Different

        Though attempting to time the market is hazardous at best, there is one guide I use - the notion that "This time is different."  I take this as a guide because in my view it virtually never is.  In the depths of the depression and the during the crash of 2008/2009, many people thought the world had changed for the worse.  In 2000, it was the reverse - the world was changing for the better.  In retrospect, it was not changing very much at all.  From my standpoint, it is reasonable to be wary about the Trump rally for the same reason.  Rationalizing the high current level of stock prices because President Trump is going to deliver to a new world of tax reform and reduced regulation is an exercise in what I believe is undue optimism.  The status quo is much stronger than most people give it credit for.  So when you hear, the phrase "this time is different" the best reaction is generally no its not.  And the best investment advice as well.

Tuesday, February 14, 2017

Valuing Trump

        On November 7, 2016, Bloomberg reported that the value of all United States equities was $23.742 trillion.  By the close on February 14, 2017, the value had risen more than $2.375 trillion dollars.  Quite a specular dividend for the American people.  The increase, furthermore, was based on little fundamental economic news other than the election of a new President.
        Needless to say, there has been a good deal of speculation as to why Donald Trump appears to have created $2.375 billion in new stock market wealth.  One hypothesis is that the run-up is due to the expected passage of tax reforms and a cutback in costly regulation.
        Another theory, not so flattering to Mr. Trump, is that his administration is sufficinetly disorganized that little will be accomplished but that slowing things down in Washington is bullish for American business.
         Whatever view you take to explain the Trump value creation it should give Democratic leaders pause.  They have pillored Trump as incompetent, uninformed, dishonest, and on and on.  But if they are right, and Trump is the disaster they say he is, then how do they explain the wealth creation?  It seems to suggests that even a disaster like Trump is good for American business if he gets the country off the regulatory road the Democrats were following.  It might be a good time Deomcratic leaders to rethink some of those policies before another election rolls around.

Tesla has almost caught Ford

     Given its run-up in the last few weeks, Tesla's market capitalization is within a hair's breath of Ford.  (Note, however, that market capitalization is not enterprise value because it is based only on equity value.)  This run-up, once again, has occurred without there being any meaningful fundamental news.  What has soared, is what has soared in the past, belief that Mr. Musk is about to deliver something sensational.  This time, however, there may be finally be a resolution.  As the year, wears on Mr. Musk will either produce the Model 3 and sell it at a profit or he will not.  For the first time in its history, Tesla will begin to trade, at least in part, on the basis of its actual financial performance, not its future growth options.  When it does so, I still find it hard to believe it will command a market cap equal to that of Ford.  But we shall see.

Wednesday, February 1, 2017

Fitbit - Valuation is the ultimate question

       In this blog, I have gone on and on about how Fitbit did not have adequate barriers to entry.  But that begs the question, what is meant by adequate?  The answer is adequate to rationalize the valuation.  At valuations of $50, as it was long ago, or even $40, $30 or $20, the answer in my view was not adequate.  At $10, however, the answer becomes I don't know.  And below $6, where Fitbit is trading now, the answer is yes.  Fitbit has become a value stock.  It trades at a P/E well less than the market.  For that reason, I can finally reverse myself and say that Fitbit, which I picked on for so long, looks like a good investment as long as you pay less than $6.

Tuesday, January 24, 2017

Tesla is at $250 - Again

        Once again the stock is hitting $250.  And once again, the fundamentals are largely unchanged.  Time to write some more options.  The auto business remains low margin with high fixed and capital costs.  To make matters worse, delivering the Model 3 at $35,000 seems like a real stretch.

Sunday, January 15, 2017

The Next Computer Revolution and Its Investment Implications

Begin with two facts.  One: computers continue to evolve and improve at an astonishing rate.  Two: people are not getting any smarter.  These two facts have driven and will drive much of the success in the computer, software and social media industries, among others.  Consider, for example, the move from DOS and UNIX to windows based interfaces in the 1980s.  The more intuitive, easy to use windows interface, had a dramatic impact on how, and how much, people used computers.  That translated into increased demand for a host of new services and products.  But even windows computing is far from natural.  People don’t communicate by moving things across screens – they watch and talk.
Like the last revolution the next one will be based on a fundamental change in the human-machine interface.  People want to interact with machines the way they interact with other people.  Amazon’s Alexa is the tip of the iceberg. 
Developing an interface that is natural and “human” will require not only new devices, like virtual reality headsets, but immense improvement in software.  That means, no doubt, a good deal of trial and error.  In that context, investors should not see “failures” like Google glass as a reason to forego investment.  The long-term race to a new interface will be won by companies that are creative experimenters.  By its nature, creative experimentation requires failure.  In my view, investors should avoid companies that have not had some significant failures.  It means that are not pushing the envelope.  Given the complexities involved in AI, future failures are likely to be even more spectacular, but staying the course and failing to fail is likely to lead to the most spectacular failure of all.
The bottom line question is what this all means for investment decision making.  Of course, if I knew (which I don’t), I would be placing my orders not writing this article.  Nonetheless, there are two points worth making.  First, the development of effective AI interface will almost certainly require a collaborate effort.  Creative, technically gifted people, like the students I teach at Caltech, will want to be part of that collaboration by sharing their ideas and insights with others.  That cannot be done within the confines of companies that requires strict secrecy.  Yes, I have Apple in mind.  Apple has walls of secrecy preventing the exchange of information within the company, let alone with researchers in the outside world.  In my view, such a policy will be a disaster for Apple as we move into the world of AI.  Because of it, Apple will lose the gifted, creative people who will lead the next revolution.  If that happens, Apple’s products will fall behind those of its premier competitors.  Therefore, given its current market value of almost $650 billion, Apple is not a company you want to own as long as it clings to this policy. 
One company to watch is Essential, Andy Rubin’s latest start-up.  Andy has been one the tech industry’s most innovative people for close to three decades.  He was a developer of some of the first digital assistants, but is best known as the father of Android.  Essential plans to release new cell phones based on what is described as a breakthrough AI interface.  While some of that may be hype, Essential is certainly on the right track and Andy’s talents are undeniable.  Even if Essential does not succeed itself, the company could have a big impact on both the mobile technology and social media.

Friday, January 13, 2017

Apple's Culture of Secrecy

     I have long stated I think it is highly costly and unnecessary for Apple to maintain such a strict culture of secrecy.  I see it as a reason that their rate of innovation has slowed.  As an investor, I have urged the company to rethink the policy.  Now the costs are becoming more obvious.  The following is worth a read.

http://appleinsider.com/articles/17/01/13/culture-of-secrecy-key-to-swift-lead-chris-lattners-decision-to-leave-apple-for-tesla---report