Despite a flattish 3rd quarter for stock prices, a lot happened in terms of new developments and sentiment changes that have might have longer-term implications for investors. In the 1st quarter letter, I hypothesized that tech stocks and the private equity market were getting frothy and that the Uber IPO (initial public offering) would mark the top of a tech bubble. I was wrong. WeWork probably did. Even though WeWork never went public, it tried to launch an IPO by filing a registration statement (called an S-1). WeWork insiders, its handlers and promoters overreached so egregiously with its valuation, and the S-1 revealed a company so fraught with self-dealing and conflicts of interest that the public, who is generally regarded by Wall Street as sheep ripe for fleecing, finally balked. It may be the first company to go from attempted IPO to near bankruptcy in six weeks.
In the third quarter the S&P 500 rose 1.2% amidst hope that the Feds would continue to lower interest rates. As fears of a global economic slowdown took root, however, WTI Crude oil traded down 8.7% even though a drone attack on a Saudi oil facility took half of its production (5% of global production) offline. Safe haven investments moved up significantly with gold up 6.2% and the 10-year Treasury returning 4.4% for the quarter.
IPO Debacles and Speculative Activity
Back in the late stages of the 1999 tech bubble, we saw IPOs roll over before the bubble topped out. The public began to lose faith in the economic future of those dazzling new companies and their prices began to crater after the media hype blew over. Besides the well-known debacles such as Pets.com, Webvan and eToys that faded to zero, previous hot IPOs such as Juniper Networks and Agilent also rolled over. In hindsight, this signaled serious problems for tech stocks in general. Bad IPOs and rampant speculation preceded a terrible time for tech stock investors and growth investors in general. Today, as it was then, the market environment was characterized by the Federal Reserve suppressing interest rates.
Both recently and in 1999, the Fed stuffed liquidity into the financial system. In 1999 it was worried about systemic risk and infrastructure failures from the Y2K problem. Today, the Fed has done the same thing because it saw what happened a year ago when stocks traded down 20% as investors believed it may continue to “normalize” rates and normalize the Fed balance sheet. More recently, (and not to get too technical) there has been a hiccup in the so-called “funding” markets – where banks go to get liquidity to make big payments. There has been a shortage of liquidity, so the Fed has been stepping up to provide it. In fact, in the
period between September 11 and October 16, the Fed has expanded its balance sheet by $276 billion. When the Fed provides liquidity, we get a speculative environment for stocks, which means that more caution is in order for investors with a longer view.
To provide evidence of today’s speculative environment, one need not look further than the financial media and the types of companies that command huge valuations. Uber, a money losing business of the first order, is valued at $45 billion. It is uncertain if it will ever earn a profit…or what its path to profitability is. Yet Mohawk Industries, a company that dominates its industry, has multiple paths to growth, high-quality management, and earned $800 million in the last year is valued at only $8 billion. It makes no sense.
It strikes us as ironic that a failed hedge fund manager, Jim Cramer, became a prominent voice on a major financial network and spends his days publicly opining on investments. On March 29, the day of Lyft’s IPO, Cramer tweeted out “Good Price Lyft -- $87.24.” Six months later Lyft’s stock traded hands for $40, 55% below Cramer’s “Good Price.”
Lyft’s prospectus was littered with terms like “social impact” and “carbon offsets” – terms that ESG (Environmental, Social and Governance) investors want to hear before they plunk down their money. But this is an illusionist trick because while Lyft pays lip service to the environment, it deflects from the real damage taking place – wealth being transferred from Lyft’s drivers and shareholders to its riders. In 2018, Lyft booked $2.2 billion in revenue and lost $911 million. That means if you pay $12 for a Lyft ride, it cost the firm $17. Therefore, it’s economically irresponsible not to sell your car and take Lyft everywhere. How long does that last? Who knows – but as Herb Stein said, “If something cannot go on forever, it will stop.” Either ride-sharing prices go up a lot and people happily pay it, or those companies lose market share and fade away.
The real talent of the tech community is not mastery of technology, disruption of industries, dreaming up new business models or building cultures of creativity. No. It is selling the belief that they are “making the world a better place”. The untold story, however, on how they “make the world a better place” is by hollowing out the middle class. They create companies that use technology to replace labor. And, so far these companies have sustained massive losses due to the unfettered optimism of their hyper-capitalized private equity sponsors that continue to fund them. Private equity firms appear to believe the public will be so enamored of the cool new “disrupting” businesses that they will be willing to take them off their hands for insane valuations in the IPO market. Moreover, many of these new- fangled companies, such as ridesharing, enlist labor as “contractors” rather than employees so the companies don’t have to comply with labor laws or provide costly benefits. This is what the “gig economy” really is.
The “gig economy” means that investors should expect more flat-to-negative real income growth, increasing wealth inequality and a shrill political environment. We should expect continued full employment with a Fed that is fixated on the direction of the stock market to guide interest rate policy. With an active Federal Reserve fueling private equity investors, new businesses such as GrubHub and Lyft will keep popping up to provide those with a car and a phone a “job.” In today’s low interest rate and low return environment with heavy pension liabilities for states, municipalities, public employees and large corporations, we should expect to continue to see institutional investors making large allocations to investments that provide “alternative” returns, such as private equity. This creates a cycle where capital will continue to sponsor new businesses that incumbents have trouble competing with – the so-called “disruptors”. It’s difficult for incumbents to compete with businesses that are funded by sponsors that don’t care how much money they lose because, after all, it’s other peoples’ money. The sponsors simply care about how well the technology story “sells” and how viable their “exit strategy” is. That will work until it doesn’t.
The recent hammering of IPOs due to Silicon Valley’s overreach may begin to call into question the prices assigned by the market to those highflyers. That, in-and-of-itself, could lead to a broader risk reappraisal (aka a selloff) of growth stocks in general. This is not an environment dissimilar to late 1999/early 2000.
Growth v. Value
One of the untold stories of the market of the last eleven years is the outperformance of “growth” stocks vs. “value” stocks. Value stocks tend to be out-of-favor companies that trade with low values relative to the profits and cash flow because they may not be growing much. Growth stocks, on the other hand, tend to not trade in relation to the business’ current profits and cash flow at all because there is a perception that those businesses’ revenues will grow significantly to make up for today’s shortfall. Even in 2019, the S&P 500, which is dominated by growth stocks, is up 20% for the year, while Berkshire Hathaway, the paragon of” value investing,” is up less than 2%.
It is beyond the scope of this letter to explain all of the reasons for this, but we believe much of it ties back to heavy Fed interventions through interest policy and open market operations. Some of it has to do with the popularity of index investing and the proliferation of ETFs, some of it has to do with the belief in the scalability of technology and preference for the non-capital intensity of tech businesses, some of it has to do with the “cool” factor and the hype of Silicon Valley promoters, and some of it has to do with a perception of scarcity because there are significantly fewer (half as many) public companies now than there were 20 years ago (due to mergers, acquisition, go-private transactions, de-listings, bankruptcies, etc.)
Today, after this long period of significant outperformance of the growth stocks, the disparity between the values of growth stocks and value stocks is larger than it was at the top of the tech bubble in early 2000. As shown above, the ten years following the top of the tech bubble in 2000 was a fantastic time to be a value investor and a horrible time to be a growth investor. It was also a great time to own some foreign stocks, energy stocks, gold and other investments that had been out of favor for a decade. For those who recall 1999 - 2000, the top of the tech bubble was marked by continuous financial media coverage of cool new
technologies, disruptive industries, IPOs, Silicon Valley and how easy it was to make tons of money. Sound familiar?
What We Are Doing
Value, by definition, exists in areas where most people aren’t excited. By corollary, there is little value in what is hyped up and popular. Therefore, what is hyped up and popular carries more risk. How much more risk we can’t say for sure, but given that growth stocks’ P/Es (price-to-earnings ratios) trade at record levels, the risk is significant. Because we are playing the long game and want to take as little risk as possible in order to make money for you, we will stick with our discipline and own investments that may not be popular, but that we believe have strong underlying businesses and attractive prices. As you know, we believe deeply that the goal in investing should be to avoid a permanent loss of capital by avoiding speculations such as Uber or GrubHub -- bad businesses with crazy-optimistic valuations. This is consistent with Charlie Munger’s reflection that he and Warren Buffett got filthy rich by being “not stupid” rather than being “incredibly smart.”
We understand that there is a lot of focus on the Trump Administration and its drama. We see that mostly as white noise. Whether there is a trade deal with China or not, we believe the market impact of that will be short-lived. We fully expect Trump to continue tweeting about how a fantastic deal is right around the corner, without one ever materializing. The stock market, being dominated by algorithmic traders, will respond accordingly. The election, in some respects, will be a referendum on whether the American people want to continue down this path to try to extract better trade terms with China, or not. The bigger factors for investors will be inflation and what the Fed does with policy going forward, the valuation risk in growth stocks (and how that plays out), and the global economy. We believe there are a lot of positive factors at work such as residential real estate looking good, autos rebounding, the global economy bottoming out and value stocks looking super attractive, so any bear market may be limited to highflyers and growthy stocks such as it was in 2000 - 2002.
We recently wrote a presentation on growth vs. value stocks that we gave to a group of local investors. We are happy to share that presentation – just email us. Please also feel free to call us if you have questions on Highgate, if you would like to discuss investment markets, specific investments, growth vs. value investing or our investment strategy. We are always available at 303-968-1230, email@example.com or in person at 100 Fillmore St., 5th Floor Denver, CO 80206 or 0197 Prospector Rd., Ste. 2104A Aspen, CO. 81611.
We hope that you have enjoyed the fall season so far and we wish you the best for the upcoming holidays. Thank you for your interest in our communications. We work hard every day in order to make high-quality decisions for our clients, to be informative and thoughtful in our communications and to deliver a superior experience. We hope to hear from you soon.
John Goltermann, CFA, CPA, CGMA