The S&P 500 Real Earnings for growth by year have generally been accepted to average out to 10 % over a long period of time, usually 10 years, but how many times has the index actually been in a 2% range of this so-called conservative average? The data shows that since 1989 it has been between this 8% to 12% range 5 out of 30 times. Meaning that the market is on average between the 8% to 12% range, 17% of the time for the last 30 years. The market spent 83% of the time outside the range. In the 30-year period, the range of returns went from a maximum of 261.66%(Dec 2009) and a minimum return of — 79.48%(Dec 2008). The fact that these two figures are a year apart is not a coincidence. It is because these figures were reported by the financial media during ‘The Great Recession’ which is known as the ‘2008 Global Financial Crisis’.
These obscure numbers allow me to segue into the main body of the article that tries to explain these variations in the markets using the science of human psychology, irrationality and business evaluations as its main arguments. Howard Marks wrote in his 1991 memo titled, “First Quarter Performance”;
“The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back”.
How accurate are his statements on the vicissitudes of the securities market? Let’s take a deeper look into some of the common characteristics that determine the general mood of the market participants. The most popular of these metrics used is the Fear and Greed of the market. These two variables were so instrumental to the securities markets understanding of sentiment that CNN developed a Fear and Greed Index that tracks the mood of the market. The CNN team uses 7 different metrics in their calculation for the index, I choose here to ignore the technical details of each metric for simplicity. The first (1) is the price momentum of the S&P500 over a 125Day moving average, (2) the strength of the stocks hitting their 52 week highs ,(3) the number of stocks on the rise and the number of stocks on the decline, (4) they also implement a put and call option ratio comparing the bearish and bullish positions respectively, (5) they measure the demand for high yield or junk bonds and compare the spread with investment-grade bonds, (6) they use the VIX index which measures the volatility of the market, this measurement metric has its own variables in its calculation and finally (7) the spread between stocks and the risk free assets(usually the US Treasury Bills). Below I have taken the liberty of adding an excerpt of the index as of May 21, 2019.
The index is pretty self-explanatory and easy to read and comprehend, as is with most models used to explain human behavior. You will notice the pendulum-like motion of the market in the last 2 years 6 months. The market has spent very little of its time in the happy medium and was in one of two extremes majority of the time. Although a pretty intuitive and inclusive metric, I think it fails to grasp the full range of human emotion and irrationality actually at play. We are complex beings and are driven by different cost and benefit analysis. This index does show the transactional movements of the market but does not accurately show human psychology at play. Here I would like to suggest a range of other emotional characteristics to factor in and I challenge market participants to find a perfect measure for each acting agent:
· between overvaluation and undervaluation
· between optimism and pessimism
· between risk tolerance and risk aversion
· between credence and skepticism
· between faith in value in the future and insistence of concrete value in the present, and
· between the urgency to buy and panic to sell
We are currently at the end of the business cycle, the stock market has broken bullish records and seems to have no end point in sight as the going says on Wall Street , trees grow forever, although a cause of concern from the uncertainties of the US and China Trade war has plagued the market with fear, generally market agents have chosen to ignore the telltale signs of overenthusiasm that has caused various price discrepancies in enterprise valuations. I will offer two cases of mispricing in the market to emphasize my point.
Notes: With these valuations, my associate and I will not make any adjustment to earnings or use any diluted earnings figures. The data we use to value the companies is from the third-party websites like Yahoo.com and SEC filings and we chose to ignore any adjustments because we believe none of the companies can be recognized as sound investments at their current prices and would be better suited for speculative purposes. Normally we would adjust earnings for the non-cash expense(or better known as accounting costs) such as depreciation, depletion, and amortization because they do not actually represent cash deductions from the operating income. The reader will notice we restrain from giving any investment recommendations, although we have done some research on the companies, we feel we have not done enough due diligence in our analysis to warrant such arbitrary recommendations such as buy or sell. This was not an oversight but a calculated decision so as to not have a biased analysis or come to any conclusion about the companies discussed in the article.
The first case is between Netflix, Inc an American media-services provider headquartered in Los Gatos, California, founded in 1997 and Comcast Corporation an American telecommunications conglomerate headquartered in Philadelphia, Pennsylvania.
a) Earnings average per share
NFLX EPS 6-year average — 0.92
CMCSA EPS 6-year average — 2.26
b) Earnings trend
c) Book Value
What is book value telling us?
The book value for Netflix has grown by 275% since 2013 at a compounded annual growth rate of 24.64%, and Comcast has had a book value increase of 47.9% and a compounded growth of 6.75%. The increase in Netflix’s book value seems to be driven by their issuance of new common stock depleting the value of current owners. Their retained earnings continue to grow but are locked up by the treasury as they buy less and less of their outstanding stock. Smart Management usually buys back their stock when it is below par for the benefit of its shareholders, and reduce the amount bought when the stock is overvalued, this is what seems to be happening with Netflix as the stock price sores management chooses to keep earnings locked up. The retained earnings are being kept in the company and not being distributed to the shareholders as Netflix does not pay any dividends.
How Good is management at allocating assets?
How efficiently is management using shareholders money? To answer this question, we look at the Return on Equity, the average for Netflix during the 6-year period is 12.6 % compared to Comcast ROE of 19.26%. Comcast has been able to pay a dividend for the last 10 years and use the retained earnings not distributed as dividends more effectively than Netflix. Comcast has also religiously bought back its stock at a fixed amount for the last 10 years making the shareholders’ piece of the pie more valuable. It has also been able to grow its retained earnings at a compounded annual rate of 13.89% for the last 6 years compared to Netflix’s rate of 32.17%(but none is distributed to shareholders in the form of a cash dividend). Comcast seems to have a competitive advantage as it has been able to have an average gross margin of 69.59% over a 6-year period compared to Netflix’s 31.7%. This figure tells me that Comcast is able to either generate high stable revenues year after year or its ability to keep its cost of goods low giving it the competitive edge or a monopoly in the market.
The lower gross margin figure shown by Netflix reflects that there is a chance for their market share to be taken by other bigger well-established companies like Comcast and Disney. Which is currently taking place as these big players like YouTube and Disney set up their own online streaming websites. The only edge that Netflix might have are their original series and movies, but this is hard to calculate and for now, we will just assume it is part of the goodwill which is an arbitrary figure. The quantitative figures show that fundamentally Comcast is a superior company, but the market has valued these two enterprises to be about equal(In terms of market capitalization) and this is just one example of many businesses that seem to be overvalued because of the enthusiasm in the market and future expectations for Netflix to continue to grow its earnings at 32%.
The second Example is between Tesla and General Motors and credit for this analysis should go to my friend Ivan Simonenko. I decided to ask him to help me with my evaluations because of his keen eye to spot good business in the automobile industry which is part of his circle of competence. If I had done the research, I would have overlooked intrinsic data in my evaluation
*the actual P/E for the company is -33, meaning the company is currently not making any money
First, a couple of words about the industry in which both companies operate. Car manufacturing is extremely competitive and capital-intensive business. Honestly speaking, I think one of the worst businesses to be in. Due to high competition, companies can’t easily increase prices on their products, and constantly have to spend money on Research and Development just to stay alive thus, profit margins rarely exceed 5%. With not that much money coming out of the business, and a constant need for capital to build new production facilities, these companies have to borrow. Average Debt to Equity Ratio for the automaker is 2.5, meaning that borrowed amount is on average more than 2 times that of a company’s Book Value. Combination of large debt, low profitability, and cyclical product demand make this business extremely risky.
The gross profit margin for both of them over the past 6 years was around 20%. This might be a result of efficient production, or above average pricing power. In either case, high margins decrease the likelihood of them going bankrupt and translate in higher profits with less capital invested, which is good news for investors. Net Income margin for Renault is around 5.6% and is negative 11% for Tesla. Even though Tesla never really made any money, the company recently started showing a positive Cash Flow from Operating Activities. There is a clear demand for the company’s products, but Operating Expenses are still too high for it to be profitable. The solution here is to scale production (or come up with a fancy car with very high pricing power). Still, even if Tesla starts making money, for it to be as profitable as Renault, it has to more than triple its production and significantly decrease its debt level.
Debt and Capital Expenses:
Renault has a lower debt burden than Tesla. Its D/E equals 1.47 while Tesla’s equals to 2. Thus, a higher proportion of Tesla’s capital is derived from debt. Renault’s Interest Coverage ratio (EBIT/interest expense) is 15.65 while Tesla can’t currently pay interest on its debt using its profits since it doesn’t generate any. A rather interesting fact is that having significantly larger total debt (around $60 B comparing to $12 B), Renault is still paying less in interest expenses than Tesla ($260 mill comparing to $662 mill). Even if Renault’s profits fall by 1500%, it still will be able to pay interest on its debt. In a meanwhile, Tesla might need to come up with some creative ways to solve this uncomfortable situation (perhaps consider refinancing).
“Back up plan” (Liquidation Value):
Renault as a business has way more valuable assets than Tesla. Its liquidation value is $38 B ($17.7 B of which are Cash and ST investments). Not bad, considering that business is currently selling for just $18.5 B. Tesla’s liquidation value is $4 B ($2 B in Cash and ST investments), and is currently selling for $40 B. A healthy amount of cash will help the company cover its fixed costs in the period of prolonged loses, which is unavoidable for any automaker. Obviously, if those businesses close down and give away all their tangible assets to shareholders tomorrow, Renault shareholders would be better off. However, this event seems to me highly unlikely.”
The examples I used are meant to emphasize just one side of the pendulum and that’s the greed, enthusiasm, etc.… side because this is the current business environment, we are in. Many cases of the opposite side can be drawn from history where people were fearful and believed the world as we know it was coming to an end. Take for example Germany after the World War during the 1918 to 1925 period wherein the post-war phase it entered a depression and a balance of payments crisis. Since it lost the war it was heavily indebted to the emerging foreign powers the likes of the USA. During this period GDP dropped by 5%, unemployment up by 16% and Equity markets lost 97% of their value, it took Germany 15 years for their GDP to reach the prior peak. Because they lost the war their economy was plagued with pessimism and undervaluation’s and high inflation(over 10 000%)besides all this because of coordination between policymakers and the private sector their economy has recovered and is now the juggernaut of the European economies.
The world has always been a very competitive place where the smartest people use capital in the most interesting ways depending on how they feel. I believe there are only two things you can control in life and that’s (1) how much you pay for things(transactional costs) and (2) how you react to stimuli the world presents to you (Emotional Intelligence). The vicious cycles of the economy as a whole can be devastating during the depressions and wonderful during the reflationary periods and one can never predict nor control these trends, your only job is to react accordingly and understand where you are in the current market and allocate your assets accordingly. The market will always swing because of; overvaluation and undervaluation of the capital markets; between optimism and pessimism by investors, creditors and the government; between risk tolerance and risk aversion by investors; and between credence and skepticism by the media and there will never be a full proof way to understand and predict how all market agents think and behave. All these players add to the velocity of the pendulum and as we swing from one side to the other, the energy that got us to the peak of the business cycle will take us right back to the bottom of this cycle.