Friday February 5th was Freefall Friday for the Glamor Tech stocks that have been the apple of most market pundits’ eyes over the last few years. Many of these companies are not profitable on a GAAP basis; but use absurd accounting practices where a huge percentage of their expenses, such as stock based compensation, or amortization on overpriced acquisitions, are simply ignored in the “adjusted” figures. I’ve delineated between the top group, which trade at truly stratospheric multiples and need to operate perfectly to justify their stock prices, and the bottom 3 which are amazing companies that have justified valuations but of course still carry risks.
Now don’t get me wrong, many of the stocks in the top group are outstanding companies too, such as Amazon and Netflix. I use them both like crazy and think the business models are outstanding. The problem is that both are completely reliant on a high stock price to fund their acquisitions and capital expenditures. By issuing stock for a large percentage of employee compensation, it conserves cash but dilutes equity holders. This works when there is a rising share price, but when the stock drops and employee options become worthless, obviously a major problem develops.
Now just about all stocks are down, but this is the difference between value investing and momentum investing. Financial stocks are down too right, but they are down after reporting massive, multi-billion dollar profits in the case of the big banks’. Book values are growing and they are in stronger financial condition than they have ever been in. Even better, the valuations are as low as they’ve ever been excluding the lows of the Financial Crisis. We are not in any situation close to that. These glamor stocks however are still valued as though competition, technological changes, and challenging equity markets will never be a problem. Everybody knew in 2000 that Microsoft, Cisco, and Intel would lead the technology wave of the next decade, but that didn’t stop all 3 of the stocks from dropping by about 80% because the stocks were too expensive!
Lastly, I’ll touch on the bottom 3, which are obviously fantastic companies. All 3 have absolutely amazing franchises and are worth an incredible amount of money. Facebook’s price reflects a view that the company will operate virtually flawlessly for the next 5-7 years and follow the same trek as Google did. They are performing so well in the mobile revolution, I don’t doubt that they will succeed but the rewards don’t seem to outweigh the risks. Google is my favorite of the 3, but the stock’s strong performance has the shares pretty richly priced. If there weren’t so many no-brainer buys in this market I’d probably look to build a bigger position. Apple is a unique case.
It has the best balance sheet in the world and on a P/E multiple the company is dirt cheap. With that said, no consumer technology company has ever held up its margins for this long of a time and make no mistake, Apple is a mobile phone company as that is where all the profits come from. Now betting against Apple has made many look like fools but as the Law of Large Numbers dictates, the bigger the company gets, the harder it is to find the growth to keep the top line going in the right direction. We look for stocks that have the potential to double in 3-5 years and I don’t believe either 3 is a likely bet in that regard. For those of you that have Apple and have wanted to keep it we’ve made nice profits selling covered calls on the stock, and I believe that is still a sound strategy.
There are times when value investing seems like it will never come back in vogue and usually that is when it is poised to do the best moving forward. When pundits say that traditional financial metrics don’t matter anymore, warning flags should be raised. Value investing doesn’t keep you from taking painful short-term mark to market losses. That is obvious in a bear market like we are in and just about every stock is down big. But what it does do, is it gives you a compass to navigate through the stormy waters. There are the fundamentals of the business, which combined with valuations that make it extremely difficult to lose money over a full business cycle, that make the investment philosophy the most successful one over the long-term. Thank you very much and if you need anything, as always let me know!
