Sometimes it is easy to look at what is working in the stock market and assume that it is the “safe and prudent” way to invest, because it is working. Remember that investing is about buying securities at a discount to intrinsic value based on a fundamental analysis that suggests the securities should appreciate over time. It isn’t the same thing as trying to time the market over 3 months, or even a year for that matter. Let’s take a look at what has worked in this bizarre year’s market and what these valuations suggest.
The two most obvious areas that have worked are Technology and Treasury Bonds. The reasons seem pretty sensible given that the global economy has been shut down for much of the year, causing unprecedented disruptions. Interest rates precipitously dropped, which causes bond prices to go up. Meanwhile, with those that could work from home forced with no other alternative, the use of various technologies saw accelerated growth, favoring certain dominant companies. All of that is what it is, but we’ve seen over the history of markets that often trends get taken to excess, as market participants chase what is hot. If you pay too much for a stock, it can cause huge losses and never get back to where it is. If you buy undervalued companies, you might take short-term mark to market losses, but the prices should recover over time as the fundamentals play out. The example I often give because it is so relevant to today’s environment is the Tech Bubble, which burst in 2000, causing a 80% decline in Nasdaq peak-to-trough. It took over 10 years to get back to even and obviously many were devastated.
Tesla currently trades at 977x earnings. This implies an earnings yield of 1/10th of a penny if they were to pay out 100% of their earnings as a cash dividend to you. Perhaps you are thinking, revenue must be growing like a wildfire. It is up about 3% on the year. I love Tesla cars personally, but the common stock at current levels is almost certainly a massive bubble.
Amazon and Netflix are two amazing platforms but they trade at 126x and 82x earnings, respectively. These aren’t small companies that are growing at triple-digit rates anymore. They both likely have bright futures, but to live up to those levels, nearly everything has to go perfectly. Amazon has been arguably the biggest winner of lock-down, but it is so large and I’d be surprised if it didn’t face anti-trust actions sooner than later, as the retail industry is now shattered, aside from the largest companies. Netflix faces massive streaming competition.
Even Microsoft and Apple trade at 37x and 35x earnings. Those levels are more than double their historical rates. Earnings are not growing at anything close to those levels. Google and Facebook trade at 34x and 32x, which seem more reasonable comparatively, but are no surefire bargains. Remember that the same momentum that has pushed these stocks, will likely push them down when people sell. We’ve seen it after every bubble. Most people think they can time it can will get out, but discerning between a small pullback, and a collapse is no easy task. Things can happen quick and in a lumpy fashion.
We all know these are great companies, but we can’t underestimate the risk of paying too much for them. That has historically been a terrible way to make money and a great way to lose it. Predicting the timing is very challenging. These companies are such large parts of the respective indices, that it could have a considerable effect on things, which is why long-term we want to be underweight them.
Another big winner has been Treasury bonds. The 10-year is currently yielding 0.664%. That is equivalent to a price to earnings multiple of 150x, with zero growth. As we’ve discussed before, inflation and higher rates are a huge risk, which can lead to very substantial losses on these bonds.
The value stocks we own have not held up as well this year, after doing great last year, as we all entered the year with our accounts at all-time highs, but I’m confident we’ll get there again sooner than later. It is frustrating short-term without a doubt, especially when you combine it with all the other stresses and challenges we all have going on during this pandemic/lock-down madness. It causes many market participants to just say forget it, load me up on Tech, and I get the sentiment. However, these are just the times when we have the best opportunities to really build wealth with far less risk and higher potential. Take a 2-5 year perspective, and the returns should be phenomenal as the stocks we own have 10-20% earnings yields, plus the ability to grow those earnings. Those are fantastic odds. Almost all of them are profitable, despite this adversity, as they are just out of favor.
As we wrote about in the last newsletter, the news on the virus is getting much better. Hospitalizations and CLI (covid-like illnesses) are plunging. Many still haven’t caught on to this, as the media narrative has been mostly doom and gloom throughout. As the tragic fatality numbers start dropping, along with cases, we should start seeing things opening up again. We are close to football season and school is starting. People will start thinking more about the future and less about the nightmare of these last 6 months. Obviously the election is a big deal, as is the stimulus deal, which I still think will pass in some form when Congress reconvenes. A lot will be changing by the end of this year and we have the tailwind of time-decay on our sold options. Things have improved but the future is much brighter. We will push through and I hope this letter puts into context how we look at the opportunity-set a bit. Taking too short of term of a focus is toxic to good long-term investment returns.