Tuesday, November 14, 2017

GE and Value Creation (Destruction)

      Perhaps the most common theme of this blog is that value creation comes from lean, well managed companies that have sufficient barriers to entry to be able to produce reliable and growing cash flow streams.  It is much less likely to come from financial transactions and restructurings.  The key is to focus on the details of running each specific business and let the stock market and the macro economy take care of themselves.

       GE seems like a company that should be doing well by these criteria.  It has a dominant market position in a variety of important businesses.  But it has fumbled across the board.  Costs, including overhead and management compensation, were allowed to expand without sufficient justification.  The Board grew to an unwieldly size.  Accounting became so complex that accountability and incentives were compromised.  As a result, in the current year the company managed to see its stock fall 40%.  Quite a miraculous for a large firm in a market that has risen 15%.

      This is a case where stockholders deserve to be angry.  Often collapses in stock prices occur because of factors that management could not anticipate or control like the financial crisis or the drop in oil prices.  But in the case of GE, it is hard to find such explanations.  Management deserves most of the blame.

      In my view, the path forward is not more restructuring, but cost cutting and attention to the details of the individual businesses.  The division that makes locomotives, for example, does not to be sold.  Railroads are four times as efficient as trucks on a ton per mile basis.  As energy costs grow and environmental issues become more pressing, we will need more rail and that means more locomotives.  That is a business that GE should make work.  There are many others.

Monday, November 13, 2017

Education and Social Media

      Becoming educated is not easy or natural for most people.  Were it like learning to walk, we would not need this immense social infrastructure of schools, teachers, administrators, assignments, exams, grading and so forth.  Educating young people requires a lot of pushing, cajoling and enforced discipline.  And it takes a lot of time.

      On the other hand, there are things that are naturally of interest to young people like, cool, gossip, physical appearance, social status and the like.  Those things command their attention without the need for all the outside influence and support real education requires. 

       The economic goal of social media is grab attention and to sell it.  The way to grab attention is to guess what people naturally want to look at and then let sophisticated software continuallly refine the offering in order to keep a person's attention.  You can get a pretty good idea of how this process comes out by looking at the cell phone of a 14-year old (if you can ever get hold of one.)

       From a social standpoint, the process of giving the young what most grabs their attention is a bit like selling drinks to alcohloics.  And great algorithms can be very expert in mixing the most enticing drinks - drinks that can easily crowd out the drugery of learning algebra.

       What does this have to do with a blog on investing?  A lot.  Education is the investment that society makes in its people.  The payoff is a more civil society and a stronger economy.  Social media is reducing the return on that investment but the social media firms do not bear the cost. 

Tuesday, November 7, 2017

Another Indicia of Excess

      Low real interest rates encourage investors to leverage their investments.  As long as prices are rising or stable, this leverage results in higher returns.  But if prices start to drop, it can lead to fire sales and insolvency.  Therefore, you would hope that as asset prices rise investors might conclude that the risk of a collapse was rising as well and cut back on leverage.  No such luck.  As the chart shows, the run-up in stock prices has been accompanied by a marked increase in leverage.  If there is a sudden drop in prices, it could quickly turn into a route.


Monday, November 6, 2017

Bitcoin and the Fed

      At the outset let's be clear on the relation between Bitcoin and blockchain technology.  Blockchain technology is one of the most important economic innovations in decades.  It has the potential to revolutionize transacting and record keeping.  Its developers, if we ever find out who they are, should be at the top of the list for the Nobel Prize in economics.

      Bitcoin applies the block chain technology to a crytocurrency.  For more details on the economics of Bitcoin, I recommend the blog of my colleague Aswath Damodaran.

       The massive price increase in Bitcoin has generated a great deal of attention and controversy.  In my view, Bitcoin is the most sophisticated chain letter in history.  As Prof. Damodaran notes, Bitcoin is not an asset because it provides no cash flow and is not a commodity because it provides no useful service.  It is at best a poor substitute for national currencies.  But despite these deficiencies, it is an ideal vehicle for the development of a speculative bubble because the risk of transacting has been removed.  I am definitely in the camp that Bitcoin is a modern day tulip and is headed to a collapse similar the that which occurred in Holland in the 16th century.

      How does the Fed fit in?  In my view, the nearly decade long experiment in negative real short-term interest rates and quantitative easing has led to an almost pathological search for investment return.  And nowhere is that pathology more clear than in Bitcoin.  I cannot get a haircut these days without my barber asking me about Bitcoin.  He says he bought at $3,000 and has more than doubled his money.  I hope he sells soon or he may have to cut a lot of hair.

Thursday, November 2, 2017

Tesla Below 300 GE under 20

      It has been a long time coming but Tesla is finally starting to be valued like and automobile company - which it is.  That means it has to compete with numerous experienced companies in a highly capital intensive industry.  It also has to deal with the same labor relations that other car companies do.  At $300 the valuation still looks high relative to my DCF models, but it is leaving the ludicrous zone.

       GE, on the other hand, is the only major company that I have modeled that is undervalued.  In today's bubbly market, everything I look at seems very expensive.  GE under $20 is starting to look like a bargain.  Maybe not a big enough bargain to pull the trigger, but definitely a big enough bargain to follow closely.

Friday, October 27, 2017

Amazon and GE earnings

    For the third quarter of 2017 GE net income after tax was 1,836 million.  The quarter was universally assailed as a disaster for the company and the stock dropped sharply.  Amazon's net income for the third quarter as 197 million.  On the announcement of that number the stock jumped more than 130 dollars.  If you ever needed evidence on the importance of expectations and the fact that investors take account of the long-term you need look no further.

Wednesday, October 25, 2017

Making Sense of "Short-termism"

            Short-termism just won’t die.  Despite obvious counter examples like Amazon, Tesla and Netflix it clings to its long-term life.  But beyond the counter examples, there is a bigger conceptual problem with the idea of short-termism, namely that it overlooks the obvious fact that all hard information is short term.  Companies report their information quarterly.  All the information from past quarters is old news.  The only new hard financial data the market gets is this quarter’s performance.  It never gets hard data about the “long term.”  Of course, a lot of people have beliefs about what the long term looks like, in particular corporate CEOs.  But those beliefs are probabilistic projections, not data.  The only data are the short-term quarterly reports and possible other releases of financial data.  But by definition all that information arrives “right now” – in the short term.

            Thomas Bayes laid down the basis for understanding how information affects beliefs more than two centuries ago.  Bayes was aware that with regard to the future all we can have are probabilistic beliefs.  He called these initial beliefs the prior distribution.  For example, I have a prior distribution of beliefs regarding what Tesla’s earnings will be over the next five years.  When information arrives, such as Tesla’s quarterly report, Bayes shows how rational actors will revise their probabilistic beliefs.  He calls the revised beliefs the posterior distribution. 

            Bayes theory makes it possible to have a more meaningful discussion of short-termism.  In the context of his analysis, the market would be “too short-term oriented” if investors revise their prior distribution “too much” in response to quarterly information.  This of course begs the question of how much is “too much?”  The most common complaint that executives seem to have is that in response to negative financial information investors revise their long-term beliefs too far downward and as a result the stock price drops significantly.  But the key thing to realize is that investors are still pricing the stock based on their expectations for long-term performance, they have just adjusted those expectations more than the CEO would like.  All valuation is “long term.”  What people disagree about is what that long-term looks like and how those long-term views should be revised as information becomes available.

Tuesday, October 24, 2017

The Market Forest Fire Analogy

      Fire fighters often complain about the downside of fire prevention.  By preventing small fires, the fuel for large ones continues to accumulate and dry out.  Then when conditions are right - hot days and high winds - conflagrations can occur.  This "boom and bust" fire cycle has been a continued problem in my home state of California.

      The interesting question is, does the same logic apply to central banks and asset price busts?  For instance, in the years leading up to 2000 and 2008, central bank policy was loose and asset prices rose sharply.  (Tech stocks in the years before 2000 and housing prices in the years before 2008.)  John Taylor, currently one of the leading candidates for Chairmanship of the Fed, argues that had the Fed followed his rule and tightened in 2004/2005, the housing collapse and associated great recession could have be alleviated or avoided.

      This leads to the question of whether the Fed should target asset prices.  The standard answer has been no.  The Fed should target inflation in consumer prices, but not asset prices.  But in recent times, it has been booms and busts in asset prices that have caused most of the economic damage.  It is not surprising, therefore, that a debate has arisen in academic circles over the targeting of asset prices.  Given my view expressed in this blog that asset prices are again approaching unsustainable levels, driven in my by investors reaching for yield and taking on more leverage, I find the argument that the Fed should pay attention to asset prices increasingly convincing.

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.

Sunday, August 6, 2017

Private Firms and Climate Change

         In this essay, I mean private firms as opposed to public organizations like Department of Energy and the United Nations, not private firms versus publicly traded firms.  The point of the essay is to argue that private firms should not attempt to react to climate change in setting their corporate policies.  This has become a point of contention because private firms have been under pressure by both sides of the spectrum to make business decisions with an eye toward their impact on the environment and the climate.  In my opinion, that is not wise for two reasons.  First, climate issues are immensely complex involving aspects of fundamental science, economics and statistics.  Second, and even more importantly, climate policies by their nature involve tradeoffs among a large number of competing groups of people.  For instance, requirements that a certain fraction of energy come from renewable sources tends to benefit the rich at the expense of the poor who may not be able to pay for more expensive power.  These tradeoffs involve not only people alive today, but many future generations. 

            The simple fact is that private firms, even the most sophisticated private firms, have neither the knowledge nor the standing to make decisions based on their impact on climate.  Attempts to do so, beyond engaging in public relations efforts to appear green, are almost certain to be counterproductive and unfair to various groups of people.
 
            Only national governments, or international organizations have the knowledge and the proper standing to determine climate policy.  They do so by setting the rules of the game through regulations and impacting market prices through taxes and subsidies.  Private firms, in turn, should take those rules as given and do the best they can for their investors and customers.  If it is concluded that under a certain set of rules insufficient effort is being made to limit the production of greenhouse gases, then the rules need to be changed to produce different incentives.  Private firms could then react to the new rules.  However, private firms should not base decisions on their perceptions of how those decisions will affect the climate.  If they did so, the result would be a hodge-podge amalgam of idiosyncratic decisions made by people not adequately trained and without the proper authority to make them.

            More specifically, climate policy depends on the answers to four groups of questions – none of which private firms are in a position to answer.

1.  Does human activity have an impact on the accumulation of greenhouse gases?

2.  Assuming the answer to question one is yes, what will be the impact of the human caused increase in greenhouse gases on global temperatures going forward?

3.  What will be the costs and benefits associated with rising global temperatures?  How will those costs and benefits be distributed across groups of people alive today and across future generations?

4.  What will be the costs of policies designed to combat rising temperatures?  Who should bear those costs?

            Questions one and two are difficult ones that require scientific specialists that virtually no private firms employ.  Questions three and four are exactly the type of questions that private firms should not be trying to answer.  Trading off the welfare across diverse groups of people is an issue that can only be tackled by governments, to the extent it can be tackled at all.  Asking private firms to address it through their climate related decisions is not only folly, it is altogether inappropriate.

            Finally, I claim that my conclusion is independent of views regarding the appropriate climate policy.  Both those who believe that aggressive steps must be taken to combat global warming and those who feel the problem is no more than a minor annoyance should agree that the debate requires a public forum and should not be held in the boardrooms of private firms.

Saturday, August 5, 2017

What We Learned From Tesla's Earnings Announcement: Almost Nothing

      I was hopeful to gain insight into Tesla's fair value from the company's earnings announcement.  No such luck.  The value is still based on speculative growth options whose value depends more on sentiment than hard analysis.  The big questions remain unanswered.  Do a vast number of Americans really want an all electric sedan?  What price are they willing to pay for it?  Can Tesla profitably produce the cars at that price?  If so, will it cannabalize the Model S?  What are the cash flow implications for building, servicing and powering all those cars if the Model 3 is a success?  None of these questions were answered.  What's worse it looks like it will be six months, at least, until we start to learn the answers.

      In the meantime, there were some curious financial details associated with the announcement and the manner in which Tesla "beat" the streets earnings forecast.  Those will be addressed in an upcoming post.

Thursday, July 20, 2017

And Then You Pull the Switch

       A great many tech companies, Amazon is the most famous example and Snap is one of the most recent, are valued on what I call an "and then you pull the switch" basis.  By this I mean during phase one the company's goal is to build market share.  During this phase, the market focuses on subscriber growth and locking in subscribers, not current cash flow.  Then in some future phase two, the company is assumed to "pull the switch" and start making big profits from those locked in subscribers.  Ironically, 20 years after its IPO, Amazon is still widely interpreted as being in phase one.

       The critical valuation question is whether there will actually be a phase two in which the company pulls the switch and raises prices to customers and advertisers and, thereby, starts generating big cash flows or whether counterparties will pull their on switch and jump to another company.  I think Netflix is particularly vulnerable in this respect.  I do not see the customers being locked in sufficiently to justify the company's massive multiple of 230.  It is too easy for customers to switch if Netflix raises prices.

       In all of this it is critical to remember that value comes from cash flow, not customers.  For a comapny to have huge value today with small current cash flow, the switch they are planning to pull must be a big one indeed.  And when that big switch is pulled all the customers must stay with the company.

Wednesday, July 19, 2017

What is Driving the Aggregate Market Up?

       In a rational economic model, there must be new news about expected future real cash flows for the market to rise substantially.  I say real cash flows because in rational models inflation appears in both the numerator and denominator of a DCF model and cancels out.

        What is it about economic expectations that keeps the market rising?  Quite frankly, I don't have a clue.  It seems to me that all potential good news about the recovery, about Trump, and about growth was more than discounted months ago.  If anything, the new news seems to be that growth is more anemic than was previously anticipated and Trump is performing more poorly than hoped.  I keep thinking this has to end.  And end unpleasantly.  But day after day I am surprised as the market inches upward.

Tuesday, July 18, 2017

Even the Best Companies can be Overpriced

        Amazon, Netflix and Google.  Three great companies whose products I use with regularity.  They are profitable.  They are growing.  They have a dominant market position.  They have great management.  They are innovative.  For all those reasons, they should trade at a high price.  The question is how high.  And no matter how good a company is there comes a point where it is too high.  In my view, all three have reached that point.  This is not to say I would recommend being short.  Who knows how long the enthusiasm will last?  But at current prices, I would not touch any of them on the long side and would take profits on outstanding positions.  For Amazon and Netflix in particular, the P/E ratios are astonishing - 192 and 241, respectively!  Those sort of multiples imply market expectations of extraordinarily rapid growth in future cash flows.  It is hard for me to see those multiples expanding further and easy for me to see them contract considerably.  At this level, the risk/return tradeoff is far too weighted on the side of risk.

Wednesday, July 12, 2017

True Believers and Stock Pricing

            Back in 1977 Edward Miller wrote an article that still resonates today and provides insight into what I call “true believer” stocks like Tesla and Snap.  To see how Miller’s analysis works, take a look at the graph below.  The y-axis of the graph shows the estimated value of the company.  This varies from investor to investor.  The x-axis shows the number of shares investors are willing to hold.  The number of shares outstanding (net of any held by index funds), N, is depicted by the vertical line.  The key component of the graph is the downward sloping line.  This shows how many shares investors are willing to hold as a function of price.  As the price declines, more and more investors are willing to hold the stock.

            Market equilibrium exists when the N shares are held.  The graph shows that this occurs at a price, P.  This would be the market price.  Notice that P is above valuation of the median investor, M.  Miller’s key insight is that as long as the outstanding shares, N, are held by a relatively small number of “true believer” investors (small compared to all possible investors), the price will exceed the average assessment of value.  In that sense, the company will be overpriced.

            If price exceeds the average assessment of value, why don’t the pessimistic investors sell short?  Well some do.  For instance, Tesla and Snap are among the most heavily shorted large cap companies.  But even for those two companies, the short interest is only about 20% of the shares outstanding.  In terms of the graph, short selling moves the vertical line for N to 1.2*N.  That is still an amount of shares that can be absorbed by true believers.  (Why there is not more short selling is a question I postpone for another day.)


            By true believers, I mean investors who think that the subject company has growth options that will “disrupt business as usual” and “change the world.”  The problem with such investors is that it is hard to know what they base their beliefs on, or, more importantly, what would cause them to abandon them.  As I have stressed in earlier posts, beliefs regarding growth options can change overnight and if they do a death spiral can result.  Without the ability to sell securities at high prices to true believers, the company becomes starved for cash, operations run into difficulty, key people leave, customers flee, etc.  It is the story of eToys, My Space, and Groupon that has happened so many times.