The last year has been one for the record books. I don’t need to tell you that. You already know about the global pandemic and unprecedented widespread lockdowns. You already know economic activity dropped more sharply than ever before, and has recovered at a record pace. You know that thousands of Americans have died, millions have lost jobs, and millions more barely recognize their own lives from a year ago.
I don’t need to tell you that Congress responded with the largest stimulus package our nation has ever seen. Or that the Federal Reserve added more than $3T of liquidity to the financial system in a matter of weeks, nearly matching the total stimulus provided in six years following the financial crisis.
You already know that stocks went from all-time highs to a bear market faster than ever before, and recovered almost as quickly. And you know that interest rates are the lowest they’ve been in modern history.
I don’t need to tell you that crude oil traded at negative $40 per barrel. That gasoline usage fell to the lowest level in more than 30 years. Or that air passenger traffic was lower than September 2001.
I don’t need to tell you, because you already know.
But did you know Gold prices reached new all-time highs for the first time in nearly a decade? That copper reached 7 year highs? Or that the price of Lumber tripled in less than 6 months to reach unprecedented levels?
Did you know Personal Income rose a record amount this year, despite job losses? And despite all the forced store closings, Retail Sales in November were still 4% higher than the year before?
Did you know that Housing Starts are stronger than they’ve been since the financial crisis? And home prices are accelerating?
Did you know the U.S. Dollar Index has fallen more than 10%, nearing its lowest level in the past 6 years? Or that the Nikkei 225, Japan’s benchmark stock index, is at the highest level in 29 years?
And, perhaps most importantly, did you know my co-worker for most of 2020 has been a good boy?
Now you do.
Wishing you all a Merry Christmas.
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
The ‘value trade’ has long been the laughingstock of U.S. equity markets. Value has lagged Growth for the better part of 15 years, but could it be time for a regime change?
Value companies are loosely defined as those whose current stock price is below that of their true worth. Their alternative, Growth companies, are marked by high future expectations and high current prices. Standard & Poors uses a handful of criteria – sales growth, earnings growth, momentum, and the ratios of price to sales, earnings, and book value – to create the S&P 500 Value (SVX) and Growth (SGX) Indexes.
Twenty years ago, the world witnessed the bursting of a bubble fueled by foolhardy growth expectations for internet companies. The S&P 500 Growth Index dropped nearly 60% and proceeded to underperform Value for the next 7 years. But the collapse of the global financial system marked a changing of the guard. Since 2007, Growth has outperformed to the tune of more than 100%.
But that trend could finally be weakening. Over the last 4 weeks, Value has led by 7.5%, the best such stretch since 2001. The move confirmed a 6-month bearish momentum divergence in the SGX/SVX ratio, and it occurred near a key extension from the entire 2000-2007 decline. It’s usually better to assume that long-term trends will continue in their existing direction, but were Value stocks ever going to turn the tide, this is how you’d expect it to begin.
If Value is going to outperform, it’ll need some help from its largest sector component: Financials.
Financials are at a similar ‘now-or-never’ level relative to the total S&P 500 Index. They fell back to their 2009 lows early this year, but momentum improved on each subsequent test of that all-important level. Just like the ratio above, Financials have rallied over the last few weeks and could have further to go.
On an absolute basis, the S&P 500 Financials Sector Index is still stuck below its 2007 highs. In early 2020, the group briefly set a new record, but failed to hold the breakout when the global pandemic struck. If we see Financials outperforming for a sustained period again, it’s likely happening when they’re above that 13-year resistance level.
In that scenario, other indexes with heavy Financials exposure could be expected to perform well, too. Small cap stocks are one example. The Russell 2000 fell to 17 year lows against its large cap counterpart early this year, but quickly recovered. November was its best month in decades. Still, the ratio below needs to work its way through a potential area of resistance before we can have any confidence that the longer-term downtrend has run its course.
Trying to identify the moment when Value will make its long-awaited comeback is a bit of a fool’s errand. Trends tend to continue – and they often continue for longer than anyone expects. Plenty of investors have prematurely called for the turn in years past, to no avail. That said, several pieces have fallen into place. It’s now or never.
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
The MSCI Emerging Markets Index is at its highest level since early 2018, and only a stone’s throw from the all-time high set in 2007.
Since the onset of the global financial crisis more than a decade ago, American investors have not been rewarded for geographic diversification. Both international developed and emerging market equities have failed to fully recover their pre-crisis levels, let alone match the returns of U.S. stocks. Market watchers during the mid-2000s might find that hard to believe, and understandably so – EM stocks dominated that era, returning 38% per year from the October 2002 to the 2007 peak. But they’ve gone nowhere since.
A breakout from this decade-long consolidation could be the catalyst to help international stocks outperform once again, but first they’ll need to absorb whatever overhead supply remains. Let’s take a closer look.
January 2018 was the last time EM made a serious attempt to reach new highs. The year prior was marked by synchronized global growth and broad-based gains in global equity prices, but it was followed by 2 years of trade-war uncertainty. As geopolitical tensions eased in December 2019, the index broke above resistance and looked poised for more gains. Then a global pandemic struck. The ensuing lockdowns proved more impactful than the trade troubles, as the index broke through multi-year lows. But before March ended, the bottom was in, and now, the index is back above January’s pre-COVID levels.
Only the 2018 highs stand between current prices and the all-time peak. Multi-year support lies just below, and momentum is strong. RSI is holding up near overbought territory and has failed to get oversold on any selloff since the March trough, both signs of strength. We may not see the breakout before the end of the year – we may not see it ever – but perhaps after 13 years, we’ve waited long enough.
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
If you’re in the market to make money, there are really only 3 reasons to buy a stock.
Reason #1: The Stock is Currently Undervalued: “The stock price is currently below the value of the business it represents.”
Defining ‘value’ can be a tricky thing. Intro to Finance 101 at any school in America teaches the value of any asset is equal to the sum of the present value of its future cash flows. Experienced market traders might quip that the value of something is whatever someone else will pay for it.
In the traditional sense of value investing, value is the price at which a company’s stock should trade. To discover value, an analyst tries to consider all available financial information, prospects for both macroeconomic and industry-specific growth, confidence in the management team, and countless other variables, weight each variable accordingly, and arrive at a number that represents the worth of the business in question. If the calculated worth is greater than the price at which a company’s stock price indicates, then the stock is ‘undervalued’. A worth below the indicated price, ‘overvalued’. Not exactly earth-shattering.
Unfortunately, calculating intrinsic value has a few glaring issues in practice.
First, there are countless variables to account for and limited information. Publicly traded companies are required to file detailed financial statements with the SEC, but even those can leave analysts with more questions than answers And analysts don’t just have to worry about business-specific information – external factors like economic growth trends, regulatory dynamics, and interest rates all impact the worth of a company. What’s more, the goal is to calculate what cash flows will be in the future. As if finding a value for all those variables wasn’t hard enough, now the analyst has to predict what each variable’s value will be.
That’s the second problem with valuation: we have limited foresight. For the sake of argument, let’s assume an analyst can reasonably estimate 5 years into the future for a given business. For 5 years ahead, he can put a number to all the variables and calculate cash flows. But anything beyond 5 years – the Horizon of Reasonable Predictability (HRP) – can’t be predicted with any degree of certainty. Still, value is supposed to include ALL of the future cash flows, not just those over the next 5 years. The analyst has to make predictions about something beyond the HRP, knowing full well that he’s just guessing. In the end, the most reasonable thing to do is choose the mid-point of a range of likely outcomes.
So perhaps the biggest problem with valuation is that no one actually knows what the correct value of anything is. Not with certainty, anyway. It’s entirely subjective to the estimates and opinions of the one calculating it. We could ask 1,000 people, all of them extremely qualified, to value the same business, and we’d get 1,000 different answers. At best, an average of those 1,000 answers might represent something close to a company’s true value. But here’s one more dynamic to consider: if you asked them all again a year later, the answers would be different. Valuation is a point-in-time calculation. As time progresses, uncertain things that were previously beyond the HRP become certain, and value changes.
By now I hope it’s clear that even though the precise worth of a business exists, calculating it is virtually impossible. So how is it that legends like Benjamin Graham were able to generate superior investing results through a value investing approach? Because their goal wasn’t to precisely calculate the worth of a business. It was to buy undervalued stocks for the purpose of making money. For that they just needed a general idea of value. When the stock price differed significantly from that general idea, they took advantage by buying or selling, then waited until prices agreed.
On balance, it worked out well for them. Incredibly well. But before you rush off to become the next great investor, there’s a catch: it doesn’t always work. I’m not just saying that valuation is tricky, I’m saying the strategy itself has a flaw. That is, undervalued stocks don’t always go up. So even if you were the greatest analyst in the history of world, if you knew the value of a multi-billion dollar company to the last penny, none of it matters if the stock price doesn’t move towards value. There’s no rule saying it has to. Now, that’s not to say a value-based strategy can’t work. We saw it work for Graham, remember? Over time, stock prices do tend to move towards value. It’s just that over time, value changes!
If value stays constant or rises over time, the job is relatively easy. Buy when the stock is underpriced, sell when it’s overpriced. Retire.
But what if value is trending lower? We can buy when the stock is undervalued, and if prices quickly move towards value, we still profit. But if price takes too long to correct, or if we hold the position for too long, the new value ends up below where we bought it.
If we choose not to sell and take the loss at that point, it’s either because we’re hoping the value will trend up in the future, or alternatively, betting the stock price will become overvalued. The former is unpredictable by its very definition (value already includes everything that can be reasonably predicted, and the change in value will be determined by something beyond the HRP), and the latter is the antithesis of a value investing strategy.
So in summary, Reason #1 for owning a stock has a proven track record of success (see Graham et al), but depends upon an accurate estimation of value and a stock price that converges towards that value quickly.
Reason #2:Long-Term Growth “This business will grow over the long-term, and the stock will grow with it.”
Several readers are already confused. Growth of the business? Isn’t that obviously included in the calculation of value, e.g. Reason #1? Well, yes and no. Growth is certainly part of the value framework. But Reason #2 differs in one key aspect: it’s focused on something beyond the Horizon of Reasonable Predictability. In other words, it’s a gamble on the trend in value.
I use the word gamble here for a reason. If it was anything less than a gamble, if the belief in long-term growth could be backed with evidence, then it would no longer be beyond the HRP. To the contrary, a belief backed by evidence is a very reasonable prediction, and thus would be included in value – and value investing was already covered by Reason #1. But Reason #2, making an investment based on unpredictable long-term growth, more closely resembles religious of faith: belief in that which cannot be proven. And that’s part of what makes investing for growth so compelling. Something which can’t be proven also can’t be disproven.
Another appeal of long-term growth investing is that it levels the playing field. The studious analyst has no advantage over the common man, because the difference between worth of the business and stock price is irrelevant. There’s no need to calculate value, because currentprice does not matter. It sounds blasphemous – after all, countless studies have shown expensive, so-called growth stocks underperform over the long-term. I won’t dispute the findings. But I counter that the problem for those so-called growth stocks was not that their price-to-earnings multiple was too big. No, the problem was that they failed to keep growing.
Let’s talk about a company named Amazon.com and the internet bubble of the late-1990s. If you didn’t experience the exuberance of the dot-com era first-hand, you’ve most likely heard all about it. Investors were so excited about the possibilities of this new technology that they were willing to pay exorbitant premiums for any stock name with a .com at the end. Like all bubbles, it ended poorly. Stock prices collapsed. Amazon.com was one of the highest flyers, rising 7100% less than two years after its May 1997 initial public offering. By December 1999, AMZN had a market capitalization of $36 billion. Meanwhile, their income statement for the year showed only $1.6B in revenue, and a whopping $700M in losses. The following year, they proceeded to lose twice that much.
Any cool-headed analyst could see the stock was overvalued at a price of more than 20 times their annual revenues. And when the bubble popped, the stock dropped a breath-taking 95%. But in the years since, Amazon.com has become a household staple. Since the turn of the century, they’ve grown revenues to more than a quarter trillion dollars – an annual rate of 29%. No one, and I mean no one, could have reasonably predicted that kind of growth. If you’d told someone in 1999 that a seller of used books would one day play such an all-important role in the U.S. economy, they’d have checked you in to the nearest mental hospital.
But what if you believed it? What if you focused only on the unknown growth possibilities, and you bought Amazon at the worst time, when it was most expensive, during one of the largest stock market bubbles in U.S. history? You’d have outperformed every major asset class on earth over the next 20 years – even after an initial collapse of 95%. In fact, with the benefit of hindsight, you should have been willing to pay much more! Ready for some stats? You could have paid double the peak 1999 price and still earned an annual 13.8% through September 2020. If your goal was to achieve historical U.S. equity returns of 10%, you could have paid four times more than Amazon’s peak 1999 price. And if instead you simply wanted to match the S&P 500 Total Return Index over that 20+ year period, you could have paid a 900% premium for AMZN on the day of the peak – or $301 billion dollars for a business with $1.6 billion in annual revenues. If a business grows fast enough for long enough, price doesn’t matter.
This investment rationale is a bet on the trend in value rather than the level of value, and the current price of the stock plays no role in the investing decision. To illustrate, let’s look at our value vs. price chart again, this time with value on the rise.
To be clear, expensive multiples don’t equate to great growth. The returns for other high-priced technology companies of the late 1990s, like Intel and Cisco, are far less compelling than those for Amazon. Some investors certainly believed those businesses would generate long-term growth at the time, but history has shown otherwise. Contrarily, General Electric could have been bought at low valuations at points during the late-1890s and early-1900s, but, still around 120 years later, clearly grew for longer than anyone could have reasonably expected. It’s not hard to place faith in the wrong deity.
Thus, the biggest problem with choosing a stock based on Reason #2 is that it’s a gamble on the unknown. The only thing separating one stock from another is our confidence level in something we can’t prove. We can’t know in advance whether we’ve chosen Amazon.com or Pets.com, and more often than not, we won’t know for many years, or even decades, if we guessed right.
Reason #3:TheCatalyst – “I believe this stock is going higher”
The catalyst investing rationale is seemingly the most straightforward. It’s certainly the most simple to explain. The catalyst buyer is completely unconcerned with value of the business, long-term growth, or current price. He’s only concerned with which direction price will go over the relatively short-term.
Let’s use the price vs. value graphic once more to illustrate. The catalyst-focused investor doesn’t rely on the relationship between the two. At times the strategy may appear to align with a value approach, while at other times it seems to run directly counter.
The concept is simple, but the practice is less so. There is a limitless number of inputs to stock price changes. Catalysts, though, are often things that affect human behavior. And human behavior is what directs stock prices on a day to day basis.
It would not be possible to give a detailed explanation of the many areas of catalyst investing. It includes all forms of technical analysis – a wide ranging discipline that focuses on historical price trends and patterns – but also extends to various algorithmic trading strategies, and even headline chasing, among other things.
Making investment decisions guided by Reason #3 is often referred to as ‘trading’. The approach has a mixed reputation in the professional investing community, given a lack of research backing the usefulness of many approaches. It’s certain than many investors, professional or not, have gone bust trying to master the intricate art. But make no mistake, some of the most successful investors of all time have been ‘traders’.
What’s the point?
So now you’ve read about all three reasons to buy a stock. If you’re unfamiliar with the world of investing, these topics may have been new to you. If you’re an experienced investor, perhaps I just told you a bunch of things you already knew, and you feel like you’ve wasted you time. Maybe you did. But I think the process of slowly walking through your investment process and defining your strategy can help you make decisions that are logically consistent.
For instance, if you’re strictly a value investor, as defined earlier, do you consider yourself a short, long, or intermediate-term investor? I think many would define themselves as long-term, but we’ve seen that a longer holding period presents risks to value investing. In reality, the strategy is based on reversion to the mean, which more closely aligns with short and intermediate-term time-frames. So what do you do if price reverts to your estimate of value the day after you buy it? The logical thing to do is sell immediately – your undervalued thesis no longer applies – but the discomfort of incurring a short-term taxable gain or worse, looking like a ‘trader’ instead of a reputable value investor, can cloud a logical decision.
Or for the investor who focuses solely on long-term growth potential. Are you waiting for the next dip to buy? You may get a lower price, but if your belief is in long-term growth, current price matters very little. Your focus is years and decades ahead. If you believe value is rising over time, the last thing you want to do is spend time on the sideline. Waiting for a dip that may or may not come is contradictory to your own thesis.
What about the catalyst trader? Do you find yourself becoming emotional about gains or losses? The strategy is designed to take advantage of other investors’ emotional decisions. Allowing your own emotions to take over eliminates your advantage. Do you continue to hold your position after your original thesis proves wrong, hoping that you’ll get out even? A logical trader should want capital available for the next catalyst, not stuck in a position with nothing but hope for a thesis.
Among the worst things an investor can do is change their strategy to justify a losing position. Often the changed approach is not a conscious effort. It comes about by not having a clear understanding of your own approach. For the value investor who watched the value of the business decline before prices rose to his initial estimate, believing that value will reverse course. For the growth believer who turned out to be wrong, pointing out that the stock is underpriced. And for the catalyst investor, reading up on financial statements after a stock is purchased.
Of course, that doesn’t mean your strategy must be restricted to only one of the three above. They aren’t mutually exclusive. Some guy named Warren Buffett once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Buffett is called value investor, but he doesn’t focus on value alone. He targets good companies – those that will grow for a long time – and tries to buy them at good prices. He combines Reasons 1 and 2, while ignoring 3. Alternatively, many investors use catalyst investing to complement their focus on value. Successfully timing the market mitigates the term risk associated with a value-only approach. But those strategies are defined before a stock is bought, not after.
Catching the bottom of an undervalued stock, with an underlying business that will grow for a long time is the holy trinity of investing. That doesn’t mean you need the whole triumvirate to be successful, though. You just need a mastery one of the three. What’s most important is understanding who you are as an investor and defining your process. Doing that will help you avoid the fatal flaw of allowing emotions to change your strategy.
If you’re in the market to make money, there are really only 3 reasons to buy a stock. If you missed Part 1 or Part 2, be sure to check them out.
Reason #3:TheCatalyst – “I believe this stock is going higher”
The catalyst investing rationale is seemingly the most straightforward. It’s certainly the most simple to explain. The catalyst buyer is completely unconcerned with the first two reasons for buying a stock. There’s no spreadsheets discounting future cash flows, no faith in long-term growth. The only interest is which direction prices will go.
Let’s use the price vs. value graphic once more to illustrate various profitable transactions a catalyst investor might try to make. At times the strategy may appear to align with a value approach, while at other times it seems to run directly counter. It makes no difference, because the relationship between the two variables has no impact on the decision.
The concept is simple, but the practice is less so. There is a limitless number of inputs to stock price changes. Catalysts, though, are most often things that affect human behavior, and human behavior is what drives stock prices on a day to day basis.
It would not be possible to give a detailed explanation of the many areas of catalyst investing. It includes all forms of technical analysis – an incredibly diverse discipline focused on historical price trends and patterns – but also extends to various algorithmic trading strategies, headline watching, and even less sophisticated approaches, like buying the stock your buddy talked about at the bar because ‘it keeps going up’.
Making investment decisions guided by Reason #3 is often referred to as ‘trading’. The approach has a mixed reputation in the professional investing community, given a lack of research backing the usefulness of many approaches. It’s certain that many investors, professional or not, have gone bust trying to master the intricate art. But make no mistake, some of the most successful market participants of all time have been ‘traders’, rather than sophisticated fundamental investors.
What’s the point?
So now you’ve read about all three reasons to buy a stock. If you’re unfamiliar with the world of investing, these topics may have been new to you. If you’re an experienced investor, perhaps I just told you things you already knew. But identifying your own strategy is important for both the rookie and veteran. Without it, you risk making decisions that are logically inconsistent.
For instance, the strictly value-based approach, as defined earlier, is not a long-term strategy, despite conventional wisdom. Many such investors prefer to think of themselves as long-term, but we’ve seen that a longer holding period presents risks. In reality, the strategy is based on reversion to the mean, which more closely aligns with short and intermediate-term timeframes.
Alternatively, the investor who focuses solely on long-term growth potential shouldn’t be waiting for the next dip to buy. It may yield a lower purchase price, but if belief is in long-term growth, current price matters very little. If you believe value is rising over time, the last thing you want to do is spend time on the sideline. Waiting for a dip that may or may not come contradicts the growth thesis.
What about the catalyst trader? Their biggest enemy is emotion. The strategy is based on taking advantage of other investors’ emotional decisions, so allowing emotion to cloud their judgment eliminates their advantage. A logical trader should follow a system with clearly-defined rules and avoid holding positions after the initial thesis has played out.
Among the worst things an investor can do is change their strategy to justify a losing position. Often the changed approach is not even a conscious effort. It manifests itself when we don’t have a clear understanding of our own approach. It’s not uncommon to see an underwater value investor, who watched value fall to price, turn to faith and believe that value will reverse course. Or a growth believer who turned out to be wrong, pointing out that the stock is underpriced. Even catalyst investors can be convinced to read financial statements if a stock moves against them. When egos get in the way, investors will make any excuse to avoid admitting they were wrong. The best defense is to know the pitfalls of your chosen strategy before a decision to buy or sell is ever made.
Of course, that doesn’t mean your strategy must be restricted to only one of the three above. They aren’t mutually exclusive. Catching the bottom of an undervalued stock, with an underlying business that will grow for a long time is the holy trinity of investing, but any combination will do. Some guy named Warren Buffett once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Notice his dual focus: company and price. He targets good companies – those that will grow for a long time – and tries to buy them at fair prices. He combines Reasons 1 and 2, while ignoring 3. Alternatively, many investors use catalyst investing to complement their focus on value. Successfully timing the market mitigates the term risk associated with a value-only approach. Several combinations are possible, and a single investor can even use a different strategy for each position. But in each case, it’s imperative that a thesis be defined before a stock is bought, not after.
What’s most important is understanding who you are as an investor and having the discipline to both define your process and stick to it.
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
If you’re in the market to make money, there are really only 3 reasons to buy a stock. If you missed last week’s post about Reason #1, be sure to check it out here.
Reason #2:Long-Term Growth “This business will grow over the long-term, and the stock will grow with it.”
Several readers are already confused. Growth of the business? Isn’t that obviously included in the calculation of value, e.g. Reason #1? Well, yes and no. Growth is certainly part of the value framework. But Reason #2 differs in one key aspect: it’s focused on something beyond the Horizon of Reasonable Predictability. In other words, it’s a gamble on the trend in value.
I use the word gamble here for a reason. If it was anything less than a gamble, if the belief in long-term growth could be backed with evidence, then it would no longer be beyond the HRP. To the contrary, a belief backed by evidence is a very reasonable prediction, and thus would be included in value – and value investing was already covered by Reason #1. But Reason #2, making an investment based on unpredictable long-term growth, more closely resembles religious faith: belief in that which cannot be proven. And that’s part of what makes investing for growth so compelling. Something which can’t be proven also can’t be disproven.
Another appeal of long-term growth investing is that it levels the playing field. The studious analyst has no advantage over the common man, because the difference between worth of the business and stock price is irrelevant. There’s no need to calculate value, because currentprice does not matter. It sounds blasphemous – after all, countless studies have shown expensive, so-called growth stocks underperform over the long-term. I won’t dispute the findings. But I counter that the problem for those so-called growth stocks was not that their price-to-earnings multiple was too big. No, the problem was that they failed to keep growing.
Let’s talk about a company named Amazon.com and the internet bubble of the late-1990s. If you didn’t experience the exuberance of the dot-com era first-hand, you’ve most likely heard all about it. Investors were so excited about the possibilities of this new technology that they were willing to pay exorbitant premiums for any stock name with a .com at the end. Like all bubbles, it ended poorly. Stock prices collapsed.
Amazon.com was one of the highest flyers, rising 7100% less than two years after its May 1997 initial public offering. By December 1999, they had a market capitalization of $36 billion. Meanwhile, their income statement for the year showed only $1.6B in revenue, and a whopping $700M in losses. The following year, they proceeded to lose twice that much.
Now any level-headed analyst could see the stock was overvalued at a price of more than 20 times their annual revenues. It became even more clear when the bubble popped, and the stock fell by a heart-stopping 95%. But in the years since, Amazon.com has become a household staple. Since the turn of the century, they’ve grown revenues to more than a quarter trillion dollars – an annual rate of 28%. No one, and I mean no one, could have reasonably predicted that kind of growth. In fact, if you’d told someone in 1999 that a seller of used books would one day play such an all-important role in the U.S. economy, I suspect they’d have checked you in to the nearest mental hospital.
But what if you believed it? What if you had ultimate faith in the unknown growth possibilities, and you bought Amazon at the top of one the largest stock market bubbles in U.S. history, right before the bubble popped? You’d have outperformed every major asset class on earth over the next 20 years – even after an initial collapse of 95%. In fact, with the benefit of hindsight, you should have been willing to pay much more! Ready for some stats? You could have paid double the peak 1999 price and still earned an annual 13.8% through September 2020. If your goal was to achieve historical U.S. equity returns of 10%, you could have paid four times more than Amazon’s peak 1999 price. And if instead you simply wanted to match the S&P 500 Total Return Index over that 20+ year period, you could have paid a 900% premium for AMZN on the day of the peak – or $301 billion dollars for a business with $1.6 billion in annual revenues. If a business grows fast enough for long enough, price doesn’t matter.
This investment rationale is a bet on the trend in value rather than the level of value, and the current price of the stock plays no role in the investing decision. To illustrate, let’s look at our value vs. price chart again, this time with value on the rise.
To be clear, expensive multiples don’t equate to great growth. The returns for other high-priced technology companies of the late 1990s, like Intel and Cisco, are far less compelling than those for Amazon. Some investors certainly believed those businesses would generate long-term growth at the time, but history has shown otherwise. Contrarily, General Electric could have been bought at low valuations at points during the late-1890s and early-1900s, but, still in existence 120 years later, clearly grew for longer than anyone could have reasonably expected. It’s not hard to place faith in the wrong deity.
Thus, the biggest problem with choosing a stock based on Reason #2 is that it’s a gamble on the unknown. The only thing separating one stock from another is our confidence level in something we can’t prove. We can’t know in advance whether we’ve chosen Amazon.com or Pets.com, and more often than not, we won’t know for many years, or even decades, if we guessed right.
Check in next week for Part 3!
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
If you’re in the market to make money, there are really only 3 reasons to buy a stock.
Reason #1: The Stock is Currently Undervalued: “The stock price is currently below the value of the business it represents.”
Defining ‘value’ can be a tricky thing. Intro to Finance 101 at any school in America teaches the value of any asset is equal to the sum of the present value of its future cash flows. Experienced market traders might quip that the value of something is whatever someone else will pay for it.
In the traditional sense of value investing, value is the price at which a company’s stock should trade. To discover value, an analyst tries to consider all available financial information, prospects for both macroeconomic and industry-specific growth, confidence in the management team, and countless other variables, weight each variable accordingly, and arrive at a number that represents the worth of the business in question. If the calculated worth is greater than the price at which a company’s stock price indicates, then the stock is ‘undervalued’. A worth below the indicated price, ‘overvalued’. Not exactly earth-shattering.
Unfortunately, calculating intrinsic value has a few glaring issues in practice.
First, there are countless variables to account for and limited information. Publicly traded companies are required to file detailed financial statements with the SEC, but even those can leave analysts with more questions than answers And analysts don’t just have to worry about business-specific information – external factors like economic growth trends, regulatory dynamics, and interest rates all impact the worth of a company. What’s more, the goal is to calculate what cash flows will be in the future. As if finding a value for all those variables wasn’t hard enough, now the analyst has to predict what each variable’s value will be.
That’s the second problem with valuation: we have limited foresight. For the sake of argument, let’s assume an analyst can reasonably estimate 5 years into the future for a given business. For 5 years ahead, he can put a number to all the variables and calculate cash flows. But anything beyond 5 years – the Horizon of Reasonable Predictability (HRP) – can’t be predicted with any degree of certainty. Still, value is supposed to include ALL of the future cash flows, not just those over the next 5 years. The analyst has to make predictions about something beyond the HRP, knowing full well that he’s just guessing. In the end, the most reasonable thing to do is choose the mid-point of a range of likely outcomes.
So perhaps the biggest problem with valuation is that no one actually knows what the correct value of anything is. Not with certainty, anyway. It’s entirely subjective to the estimates and opinions of the one calculating it. We could ask 1,000 people, all of them extremely qualified, to value the same business, and we’d get 1,000 different answers. At best, an average of those 1,000 answers might represent something close to a company’s true value. But here’s one more dynamic to consider: if you asked them all again a year later, the answers would be different. Valuation is a point-in-time calculation. As time progresses, uncertain things that were previously beyond the HRP become certain, and value changes.
By now I hope it’s clear that even though the precise worth of a business exists, calculating it is virtually impossible. So how is it that legends like Benjamin Graham were able to generate superior investing results through a value investing approach? Because their goal wasn’t to precisely calculate the worth of a business. It was to buy undervalued stocks for the purpose of making money. For that they just needed a general idea of value. When the stock price differed significantly from that general idea, they took advantage by buying or selling, then waited until prices agreed.
On balance, it worked out well for them. Incredibly well. But before you rush off to become the next great investor, there’s a catch: it doesn’t always work. I’m not just saying that valuation is tricky, I’m saying the strategy itself has a flaw. That is, undervalued stocks don’t always go up. So even if you were the greatest analyst in the history of world, if you knew the value of a multi-billion dollar company to the last penny, none of it matters if the stock price doesn’t move towards value. There’s no rule saying it has to. Now, that’s not to say a value-based strategy can’t work. We saw it work for Graham, remember? Over time, stock prices do tend to move towards value. It’s just that over time, value changes!
If value stays constant or rises over time, the job is relatively easy. Buy when the stock is underpriced, sell when it’s overpriced. Retire.
But what if value is trending lower? We can buy when the stock is undervalued, and if prices quickly move towards value, we still profit. But if price takes too long to correct, or if we hold the position for too long, the new value ends up below where we bought it.
If we choose not to sell and take the loss at that point, it’s either because we’re hoping the value will trend up in the future, or alternatively, betting the stock price will become overvalued. The former is unpredictable by its very definition (value already includes everything that can be reasonably predicted, and the change in value will be determined by something beyond the HRP), and the latter is the antithesis of a value investing strategy.
So in summary, Reason #1 for owning a stock has a proven track record of success (see Graham et al), but depends upon an accurate estimation of value and a stock price that converges towards that value quickly.
Check back next week for the Part 2!
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
Ask a market analyst which sector is the most boring, and there’s a good chance they’ll tell you the Utilities. Given the mature and heavily regulated nature of their collective businesses, the group tends to be little less ‘high flying’ and a little more ‘under the radar’. Occasionally, though, Utilities garner attention for their relative stability and attractive payouts, and can outperform for extended periods.
That’s been the case over the last few weeks:
The relative strength since the S&P 500 peaked on September 2, 2020 has brought Utilities back to a key level vs. the rest of the market, and how prices respond to it could have broader implications for the future of equities.
The level in question was last approached in 2018, when 4 consecutive attempts to break below it were rejected. After the sellers were finally exhausted, Utilities finished that year with a 25% relative rally, and then spent the next year stuck in a sideways channel. When the coronavirus took hold, it looked as if Utes were poised to rally again as they broke to their highest level against the S&P 500 since 2016. Growth stocks were less inclined to agree; over the next 6 months, Technology, Consumer Discretionary, and Communication Services stocks ripped to new all-time highs, while the ‘boring’ Utilities were left in the dust. Relative to the S&P 500, Utes cruised right through their 2018 lows. But thanks to the September reversal, Utilities have recovered.
So is this a false breakdown, destined to be the mirror image of March’s failed rally? Are Utilities set to lead for the coming months? If they continue to rip higher relative to the rest of the market, it’s most likely happening in an environment where risk continues to come off of the table, and stocks as an asset class are falling.
Or is this nothing more than a backtest that confirms resistance at the 2018 lows? A rejection here could be an all-clear signal, indicating that the rally in growth stocks is back on.
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
The ongoing economic recovery from the COVID collapse will star in the role of determining future corporate earnings growth. But the trajectory of the U.S. Dollar will play a key supporting role.
The U.S. Dollar Index has fallen 10% from its March highs. After rising steadily for 2 years, the index was near the high end of its 5 year range when the pandemic hit. An initial rally proved short-lived, and the reversal brought the Dollar back to the bottom of the channel. Since the end of July, the index has consolidated at support, while momentum has steadily improved. Earnings watchers should be mindful of how the currency resolves from this pattern.
Exchange rates affect earnings in two primary ways. The first is simply through a function of accounting. U.S. based companies with international business segments must translate the earnings of ALL their segments to a single currency. Consequently, changes in the relative value of the USD affect the translated value of incomes. Take for example a a foreign business segment that earns 100 ‘bucks’, where the current exchange rate is 1 ‘buck’ for 1 U.S. Dollar. Thus, those 100 ‘bucks’ are worth $100 in earnings to the U.S.-based business. Now let’s assume in the next period, the ‘buck’ weakens against the Dollar – instead of a 1:1 exchange, it takes 1.25 ‘bucks’ to make $1. The foreign segment again earned 100 ‘bucks’, but now they’re worth only $80 in earnings to the U.S. business. Earnings fell 20%. A key point in this example is that the reported earnings changed, but the economics of the business didn’t. Remember that international businesses aren’t actually trading all their ‘bucks’ for dollars at the end of each accounting period. In both cases, they’ll still have 100 ‘bucks’, all else equal. Of course, all else is never equal, so let’s talk about the second way currency movements affect earnings.
We live in a competitive global society, where information is more readily available than ever before. Thanks to the internet, consumers can compare similar items from dozens of suppliers with ease, and, more often than not, the lowest price wins. For global businesses, the consequences are clear: they have to buy and sell products at competitive prices or risk financial ruin. Given that many supply chains are global in nature, exchange rates play a major role. Let’s use another example. Assume a U.S. based company sells ‘widgets’ for $1. A foreign-based company purchases widgets and uses them to make their own products. Assume the exchange rate of ‘bucks’ to Dollars is again 1:1, and the foreign business uses 100 ‘bucks’ to buy 100 widgets. Now imagine the ‘buck’ weakens (Dollar strengthens) again. The foreign business can only afford to buy 80 widgets with their 100 ‘bucks’ now. They have a decision to make: accept only 80 widgets and sell fewer products to their customers, spend 125 ‘bucks’ to get the 100 widgets, or find someone else to supply widgets for a cheaper price. If they can, they’ll choose option 3. In this example, there is an economic impact from the currency movements – demand from overseas falls when the domestic currency strengthens.
In both cases though, a rising USD is a headwind for international corporate earnings. Conversely, a falling Dollar provides a nice tailwind.
So how much of an impact can currency movements actually have on stock market indexes? According to FactSet, about 40% of S&P 500 revenues come from overseas. That’s certainly large enough to be material to index earnings power.
And historically, it seems clear that the performance of the trade-weighted U.S. Dollar is related to corporate earnings growth. Check it out:
We shouldn’t expect this relationship to be perfect (the earnings growth of 500 diverse businesses obviously depends on more than simply the value of one currency relative to another), but it’s certainly one to keep in mind.
Uncontrollable government policies and unpredictable changes in consumer behavior will present plenty of challenges for U.S. businesses over the next year. Continued weakness in the Dollar would be a welcome respite.
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
COVID hit the U.S. Energy sector hardest of all earlier this year. With global activity grinding to a halt as a result of widespread shutdowns, demand for crude oil disappeared. In a market where supply and demand are held in a delicate balance, oil prices predictably fell. But the extent of the decline was nearly unthinkable.
Light Sweet Crude Oil trades on the Chicago Mercantile Exchange (CME) in the form of a futures contract. Unlike stocks, which are shares of ownership in a company, futures contracts are legally binding agreements to buy or sell a particular asset at a predetermined price and date. They’re incredibly useful for producers and consumers of commodities. (Consider a corn farmer, whose livelihood depends on the price he receives. Instead of going to market at harvest and hoping for the best, he can sell a futures contract for corn several months ahead of time. He may not receive a higher price, but the certainty of price allows him to plan accordingly.) But the futures markets aren’t limited to just producers and consumers. Speculators, whose only concern is to profit from changes in price, necessarily provide liquidity to the markets. However, they take care to never be long or short a futures contract at its settlement day, lest they get a bushel of wheat delivered to their front door.
And so the price of crude oil went negative in April 2020.
Oil demand fell faster than producers could slow production, and oil inventories rose rapidly – so rapidly that the world ran out of places to store the stuff. As the May contract neared settlement, those who were long contracts got caught holding the bag. Either they took delivery themselves – an impossibility for speculators – or they paid any price to find someone who could. The day before settlement, West Texas Intermediate traded at a previously inconceivable negative $40 per barrel.
Energy stocks took a similar path after the onset of the virus, dropping 62% from their January highs. But by the time prices reached their lows in mid-March, momentum was already improving. The signal was confirmed by another positive divergence – as oil prices fell below $0, the price of Energy stocks continued to rise. The rally was on, and in less than 3 months, the Energy sector had doubled from its low.
For everyone watching in real-time, that was a tremendous show of strength. Energy outperformed every other sector over the period, and the eye-popping returns were hard to ignore.
Subsequently, the U.S. stock market has looked past the coronavirus and reached new all-time highs. Meanwhile, the Energy sector has done nothing but fall. Just last week, it breached an interim support level and dropped to 5-month lows.
Mr. Market decided to remind us of an all-important concept in technical analysis: Every trend change starts with a mean reversion, but not every mean reversion changes the trend. By definition, a trend is more likely to continue than to change. In this case, Energy stocks reverted to the mean and nothing more.
If you’re wondering why this principle applied to Energy, but not Technology, or other sectors damaged by the pandemic, consider this: Energy stocks were in a downtrend for more than 5 years before anyone had even heard of COVID-19.
The coronavirus exacerbated the half-decade trend, but it didn’t create it. Alternatively, every other sector was at or near multi-year highs in January.
None of this means that Energy has to go down and break the March lows. That could certainly have been the bottom. But with prices below a falling 200-day moving average and setting incremental lows, this sector is not in an uptrend.
Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.
