High Valuations Are Actually a Green Flag
Some businesses deserve a premium and they shouldn’t be ignored.
October 2024
When it comes to stock picking I often tell myself two things. One, I’m not smart enough to time the market. And two, why should I act like I know more than the market at any point in time. I tell myself this because I believe markets are mostly right. They’re efficient enough to sniff out a winner and assign it a premium. To a certain extent, these premiums, shown by high price to earnings ratios should be intriguing to an investor. This should be your conviction that the stock will continue to do well. Not a sign to run to the hills.
I look at the Mag Seven stocks and see a multiple no less than 24x net earnings. Each stock embodies it’s own industry and is the outright leader. In my view, that is how we have arrived at the mag seven names. These are high profitable businesses and control significant market share resulting in high multiples. An old approach would be to ignore these valuations and find lower PE multiples. But if I subscribe to the notion above about the market finding a winner and knowing I will never be smarter than it, a lower valuation might want to give someone a reason to pause. Market’s are efficient. What does it know that I don’t? Google is last in the pack among it’s peers trading in the Mag Seven. I think this reflects the risks at stake given antitrust and its search dominance threatened by Chatgpt. On the contrary Nvidia comes in on the higher side of the group’s multiples and that is for good reason. They are the only game in town for AI chips. $250 billion a year is flowing directly into Nvidia’s pockets from hyperscalers like Amazon, Microsoft and Google in the form of an asset light, high margin business model. This deserves a high multiple.
Below is what I think about when assigning a higher or lower multiple on a business.
Sector, scalability, addressable market value, earnings growth can all determine the premium. Think buzzy areas where the wave is now, and building momentum for strength. Tech in 2016/17 or investing in oil production/commodities in 2015/16. The wave was not commodities at the time, it was tech. Yes, the names were expensive but the growth, market position and sector were appealing. If you ignored names like Netflix or Amazon because of their multiple then you would be ignoring them today as well because they never got cheaper. Looking back, their high multiple was the indicator for their continued success. There was fortunes made while tech names were trading at seemingly eye popping valuations. What is your platform to scale? This is essentially asking what your earnings growth is going to be, so the market can assign the correct premium given your cash flow, revenue growth and sales. Are you in heavy infrastructure that takes 10 years to design, build and put to market? Or are you a SaaS business with a recurring revenue model. Can you show traffic metrics, sales growth within the first 2-3 years? Is there a network effect with the product(s)? Total addressable market is also important. Are you in a market that is grossing $1 billion in sales each year or $100 billion?
When companies can be price makers instead of price takers, they can dominate their markets. When their products have passed the tipping point their growth can go into orbit. Showing growth can solve all your problems. Investors are willing to let profitability take a backseat when there is growth. But what if you have growth and profitability? That is how the market has developed the big 7 tech names. Markets reward a high margin and profitable business, see above Nvidia. I can't blame them.
Steve Miller Band’s Lesson to US Steel: Take The Money and Run
September 2024
Ask the two presidential candidates and the current administration what they think about and Nippon acquiring US Steel and the answer is clear: not a chance. Nippon is giving US Steel and the entire US steel industry an opportunity. Right now it looks like politics are going to throw it away. I fear what sort of messaging this sends to one of our biggest allies.
To oppose this acquisition on grounds of national security says we really don’t trust you. That’s a costly mistake. Lack of trust, closed trade borders and protectionist measures don’t encourage growth, they inhibit capital flows and stimmy value creation. China is the real competitor in the steel market; they control more than 50% of the steel production is the world. The US? An underwhelming 4%. Japan has a rich history of being in business in the US. The concessions they are making to allay concerns over american job security and anticompetitive practices are no joke. The US and Japan have had a military alliance going back to the 1960s. Perhaps, unlike the US, Nippon sees an opportunity to partner with an ally, scale a business and increase economic value.
Unfortunately, the business can’t survive in its current form. In fact, US Steel leadership has said they need to shutter plants and layoff workers unless something changes. At it’s current valuation you will have buy-out interest from Cleveland Cliffs, see below on put option. However, this tie up would concentrate automotive steel production to the point where the FTC would step in.
An ally is offering a life raft to US Steel, the union and the next president. And they all are willing to go down with the ship. Because of Pennsylvania's importance in the election we are taking a stance that will eventually lead to a demise of US Steel and american jobs, in the name of protecting american jobs? The irony. This deal could stablize an ailing industry and actually protect american jobs.
There is an argument to be made: back up the truck and buy the damn stock! US Steel is trading substantially below Nippons bid of $55. This sort of level might offer an asymmetric return. If a deal was to go through, you’re looking at a healthy gain. The downside is limited as I see a put beneath US Steel. The executives and board seem determined to find a solution for the business that is something other than what it is currently today. It was the board’s strategic review put the company up for sale in August of last year and led to this possible acquisition. The individual pieces of US Steel might be worth more than the sum of the existing company. It’s electric arc furnaces are the future of steel production. It provides a bolt on business for an acquirer that is not going to break the bank. It also appears the contention around US Steel landing in foreign hands has reminded everyone the value of the company. The government is essentially saying that US Steel is worth a lot more to them than what Nippon is willing to pay.
I recently drove past US Steel’s site just south of Detroit, Michigan. Steve Miller Band played on my speakers as I felt the heat coming off the apocalyptic complex. It looks underinvested, tired and anemic. Sadly, the community was a direct reflection. What we’ve been doing for the steel industry is clearly not working. If we dont act, we risk more US jobs and strengthen China’s dominance of a critical material. The facts line up for supporting the Nippon deal: It will be a value accretive outcome for everyone with our strongest ally. I think US Steel should take the money, and run.
Venmo Me Some PayPal Tendies, please.
August 2024
PayPal’s stock hasn’t picked itself off the floor since it’s massive run in the covid bubble. Which, thank’s to the interest hiking cycle in 2022 and 2023 took a lot of air out of almost every risk asset. While the rest of the tech market has rebounded, PayPal appears to be still trying to figure out how to shoot.
Is PayPal a Value Trap?
I like to find the wave and a trend or force that has more tailwinds than headwinds and get onboard. When a company is in a category that is the current wave and they are left behind it gets my attention. They are The Outliers. But it should make you ask why. Is this the market telling us something? PayPal is an outlier that is still on the wave but the market has forgot about it. In the past five years, the stock is down 20% while the rest of the tech market is up 125%. We have seen a repricing of the asset to something that resembles a slow-growth financial services business as opposed to a high-growth asset-light tech business that I think PayPal can be. With PayPal at a PE multiple of 17x today it is pricing similar to a bank. I see more of a payment provider than a bank in PayPal. Think Visa and Mastercard. They price for 32 and 38x earnings, respectively. These valuations, which PayPal should aspire to, are closer to the tech focused nasdaq 100 index at about 40x earnings. PayPal needs to shift the market’s narrative about itself to increase its multiple. The stock should become a vehicle for an investor to bet on small and medium sized e-commerce business platforms globally. If you want a piece of the internet shopping, you need to be in PayPal.
New players just joined the team.
The company is making serious moves on their executive leadership from the top down. In August last year, Alex Chriss joined on as President and CEO (prior head of small business at Intuit.) Subsequently, PayPal hired Jamie Miller as CFO (Cargill and General Electric) and Geoff Seeley as CMO (Cashapp, Afterpay.) In my view, possibly the most exciting hire was Marc Grether, an Uber VP of Advertising. PayPal should be data rich in insights about e-commerce consumer behavior that is valuable to brands. If they can monetize this data, they are sitting on a money geyser. PayPal also recently hired a new CTO from Walmart that specializes in e-commerce and retail. Outside hires with experience like this will bring a new energy to the business. They allow the narrative to change, hopefully to something I mentioned above. Chriss is building an army of hitters that know how to grow and scale a business.
The next step will be to execute.
The company needs to show strong numbers that say growth is back and our strategy is working. This comes down to the products and competitive advantage. As head of small business at Intuit, Chriss should know a thing or two about product development leading to growth. Recent strategic of strategic partnerships have been announced with Shopify, Adyen, and Fiserv. Fastlane, a new product announced in August, provides a frictionless online check out experience. And how about existing products? Venmo is a verb. There is a lot of untapped potential that PayPal can leverage to go deeper and build its network effect. Three metrics would get the market excited again about the companies stock: operating margin, total payment volume and active accounts. Currently these sit at about 23%, $1.6 trillion, and 450 million, respectively. The chocolate and peanut butter would be sales growth while also cutting expenses and excess spend. Meta used this strategy and it has paid off handsomely for The Zuck.
Long.
PayPal’s stock has been in a consolidation phase. Now, It only has to do a few things right to turn it around. Leadership needs to shift its narrative; we are the company in e-commerce to own with sticky products and consumer data. We are more like a Shopify than a financial services business. They need to show growth has accelerated across sales, operating margins and account volumes. If they watch their burn rate while finding new ways to monetize the business the turnaround story will commence. Venmo me some PayPal tendies.
Is The Global Economy Headed for More Expansion?
3.4.19
While equity and credit markets are rebounding from December lows, one key index might be telling a more accurate, and speculative-free picture for the months ahead.
The Baltic Dry Index (BDI) measures the cost of transporting various raw materials, such as ore, grain, and coal, essential to industrial stability and growth. Prices are reported daily from a variety of shipbrokers representing Supramax, Panamax and Capesize vessels. These prices make up the index, which acts as a bellwether for the global economy.
After a muted 2018, global equity and credit markets are conveying more expansion is on the horizon. Take a look at high yield credit (often viewed as an index for determining risk appetite) up more than 5% YTD. The S&P 500 index has climbed more than 10% and the same goes for the Dow Jones Industrial index. Chinese markets have rallied even more aggressively with the Shanghai Composite surging about 20% (all figures 2019 YTD.)
But the BDI suggests otherwise, sitting on lows last seen in early 2016. In fact, YTD the BDI is down a staggering 50% (See chart below.) This is a stark difference from what we see in other markets.
Running with the simple logic that an exporter or trader wouldn’t nominate cargo without orders already booked, raw materials vital to growth may not be flowing. With that, how can the global economy expand?
This also leaves the BDI with little speculative influence, contrary to equity and credit markets.
A keen investor would be wise to keep an eye on the BDI to determine the real story behind future global expansion, free of noise seen in other speculative markets.
VIX Backwardation - Equities Run for Cover
10.10.18
The "fear gauge" is giving us some interesting clues into the current state of the equity market.
Deep in the woods of the derivatives market, a rare phenomenon is taking place: the inversion of the VIX futures curve.
The VIX is a derivative instrument based on the CBOE volatility index, a gauge of volatility over a 30 day period. The index is calculated through open put option interest in the market and is often used as a hedge against a negative move in stocks.
Usually, the VIX futures curve is in "contango", or upward sloping. This is illustrated by longer dated options receiving greater premium due to the greater level of uncertainty.
In the past week, the VIX curve has quietly inverted, or gone into "backwardation".
The front-month VIX contract has a greater premium than the second-month contract. This means traders are bracing for more volatility in the short-term; placing a greater premium to purchase the front-month contract.
On Friday, October 5th, the curve slightly inverted. In the following days, the VIX continued its strange behavior, closing even for the November and December contracts on October 9th.
VIX closing pricing 10/9
This was ultimately a warning shot. The following day, equities tumbled. All the major U.S. indexes were down, with the Dow closing on session lows, off 800+ points. In the heat of the sell-off, the spread on the inverted VIX curve was charging higher (see below).
VIX Thursday (10/11) shortly after market open
The good news for investors is the inversion of the VIX futures curve does not tend to last long. Markets will bounce and buyers will show up, even if it's short-lived. In the longer term, markets have greater headwinds. Rising interest rates, EM sell-off, dollar strength, trade war rhetoric, and overvaluations are all on investor's radar going into the final stretch of 2018.
Interest Rates - Started at the Bottom Now We're...Here?
3.28.18
In response to January’s labor data, which showed wage growth and job creation exceeding expectations, the U.S. underwent a healthy sell-off in the equity and fixed-income markets. Major U.S. indices dropped into correction territory while the 10-year treasury note saw yields jump.This sell-off then triggered a similar response in global markets. Seeing red for numerous days was a rare sight for investors. After a year of low volatility and strong returns from east to west, the cracks have started to show.
To give context, bond yields have been rising since the fall. The ten-year was hovering around 2% in September. By early February it had reached 2.84%. Since then, the ten-year has exceeded the 2.90% handle.
The labor data provided traders an opportunity looking to capitalize on a data event, and left investors considering the possibility that the fed could raise interest rates at a quicker pace than previously anticipated.
Quantitative easing, the purchase of bonds with freshly printed money, has created a mountain of debt for the U.S. Too add, recent tax cuts may put the deficit over $20 trillion by 2019. The federal reserve may have to raise yields to attract the demand for bonds.
What Does This Mean for Equity Markets?
In most cases, higher bond yields spell trouble for equity markets for a couple of reasons.
First, by increasing the cost of borrowing for companies and consumers, economic growth could be hindered. For consumers, costs would go up on interest payments, such as mortgages. In fact, a 30-year fixed rate mortgage is now at 4.38 percent, the highest it has been since 2014.
Second, American equity valuations are unusually high. The cyclically adjusted price-earnings ratio is 33.4. The historical average is 16.8. A convincing argument for high stock valuations has been the low returns on alternative assets, government bonds. An increase in yields would make this argument much less convincing.
One thing is for certain in the macroeconomic picture impacting equity markets. If the global economy continues to strengthen, interest rates will need to rise. This is more bearish news for equities. Why? Because all assets are priced as the present value of their future cash flows. Interest rates are the discount rate used to calculate present values.
The fed is in uncharted territory.
Late cycle monetary policy is difficult to navigate. Combine this will the unheard of low borrowing rates implemented post-financial crisis and the uncertainty is further illustrated. This is nothing new. The cards have also been on the table. But, as history has shown the equity markets were the last to get the message. Is it time markets start paying attention to the uncertainty or will the music keep playing?