I wanted to put together a number of additional theories that are both new and old. Through some argument, those truths may come to be proven false, if they haven’t already. The previous memo, “Betting and Boredom” was originally part of this memo but started to become too long and could stand on its own.
Below are a few myths that I explored this week.
Myth: The Fed Can’t Keep Printing Money
It is naïve to think that there are limits to the Federal Reserve (Fed). They have proven that they can and will take out their bazooka (to paraphrase Ben Bernanke). They announced they were going to do quantitative easing, support corporate bonds, and provide financing to small-medium-sized businesses that needed it. Additionally, various current Federal Reserve Bank presidents confirmed their ammunition was unlimited. The stock market immediately turned around. This was the Fed affirming that they can use their powers. That alone was enough to stop the market from panicking. The Fed didn’t really have to do anything else outside of talking a big game.
But they went ahead and did purchase assets, to the tune of $3TT since March. They have quickly become the third-largest owner of corporate bonds since March from a stand-still (with Fisher Asset Management and Bank of America being the largest). They have also put together loan programs to medium firms and institutional-level companies, although the “success” of those programs may be limited (overwhelmingly, those companies eligible are unwilling to complete the laborious applications or take on the Fed’s restrictions for those loans. As procuring corporate loans becomes easier than ever, these firms don’t need the government’s money when they have other, less-prohibitive options).
The Fed does not necessarily want to own bonds or want to own corporate debt. But they spent the trillions of dollars anyways. Some think it was to show that they could do it, while others say it was necessary, given the state of the US economy, and that they needed to walk the walk. The amount the Fed has spent in a short period of time is staggering, but to assume we have seen the bottom of their barrel yet is simply foolhardy. If things get worse, they may opt to continue stimulating the economy.
Myth: Interest Rates Can’t Go Below Zero
Interest rates can and have gone below zero.
Negative interest rates are when you pay someone to take your money. Normally a bank gives you a savings rate in exchange for handling (using) your money. In a negative interest rate world, they get paid in exchange for handling your money. This penalization to save your money is designed to make you spend your money instead.
Interest rates have been dipping in negative territory in Japan since 2016. Currently there are seven countries with negative rates on their ten-year government bonds. They are:
- Switzerland (-0.4%)
- Germany (-0.4%)
- Netherlands (-0.3%)
- Denmark (-0.3%)
- Austria (-0.2%)
- Belgium (-0.1%)
- France (-0.1%)
Additionally, Japan and Sweden are at 0%. Negative interest rates are not only a reality today, but there is pressure on some governments to lower those rates further if their economies get worse. The only way to jumpstart these various global economies is for people to get out and spend money. Negative Interest rates are designed to do so.
Myth: Oil Prices Can’t Go Below Zero
On oil, we all saw what happened on April 20, 2020: oil prices (WTI Crude Oil for the last day of the May futures oil contracts) ended deep in the negative territory, at -$37 per barrel. What was not so widely known/reported was that, about a month prior, Western Canadian Select oil prices plunged to below $4 per barrel for April futures contracts. This offered a moment in time to question whether oil prices could go much lower. It was then that people who were paying attention realized “yes, oil could go lower, even negative.”
The Canadian oil issue was a warning; a precursor of what was to come. While Western Canadian Select never did go into the negatives for April future contracts, the next month the much bigger WTI Crude Oil market did go spectacularly negative. The oil pricing theory has emphatically been proven to be a myth as oil prices did go below zero.
Myth: The Economy Was Fine Before The Pandemic
Over the past few years, I have listened to countless economists forecast safe economic projections for the following years. In November, an industry conference forecaster said to expect 1.5% GDP Growth, 1.5MM new housing units, and inflation growth of 2%. By his own admission, his forecast was for an average year in all categories. While he could not see any structural problems with the economy, he was also making a prediction twelve years into a business cycle (which has a typical shelf life of seven years, on average). It’s like saying that your 13-year-old car with +300K miles on it will be fine this year, too. But chances are you may have problems, even if you can’t predict when or from where they will come. The time is due.
All of the rats in the economy went scurrying when Covid-19’s high-beams illuminated their dank, swampy lair. To put some perspective on that take, it is important to understand that not only were we twelve years into an economic expansion but that growth was partially fueled by cheap debt. Corporate debt went from a value of $6.1TT in Q4 2010 to $10.5TT in Q1 2020. Federal interest rates never got up to even 2.5%. March 2008 was the last time rates were above 3% and rates historically average around 4%.
Cheap debt also helped fuel stock buybacks for companies across the market.
Stock buybacks are when a company purchases its own public stocks. They do so with cash they have available (or have access to). In doing so, they take more public shares off the market, increasing their percentage of ownership in the company for shares that the remaining shareholders own. It also has the effect of increasing earnings per share (EPS). Stock buybacks tend to create the illusion that the company’s management is very good. In reality, they did nothing to make the business more profitable if they only reduced the number of shareholders. Company financial officers also know that rates of return for equity stakes are less than those for rates on loans, especially when lending rates are so low. Some corporate debt likely went to buybacks, trading equity for debt.
Stock buybacks are not bad, but when a company uses borrowed money to do it, the long-term implications can be treacherous. As an example, Sears borrowed and spent $6BB buying shares of its stock. They should have used that money to update stores, build out their e-commerce capabilities, do more marketing, etc. Their focus should have been on being more competitive in a tough retail market; instead, they artificially inflated their per-share earnings through stock buybacks. The end result was that Sears went bankrupt, after years of teetering on the edge of solvency.
Was the economy in good shape? It is not a stretch to say that the US economy was due for a recession; had the pandemic not occurred, a likely place to look for blame for that recession would have been shopping, working, and/or housing trends. A pandemic did occur and magnified corporate troubles. Any lowering of revenues puts more pressure on companies to meet their mounting debt obligations, which leads to an incline in corporate bankruptcies.
In conclusion, I am skeptical when an expert says the economy was fine before coronavirus. Large companies going bankrupt right now are using the pandemic as an excuse, when it was only the straw that broke the camel’s back.
Myth: Value Investing Is Dead
According to Investopedia, value investing is “an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the market is underestimating.” The most famous value investor is Warren Buffett. There are plenty of smaller (some very successful) investors that use similar value investing methods, but Buffett’s face is the one you see in the mental encyclopedia when that term is thrown around.
This theory’s genesis comes from value investors currently reaping lesser returns than those earned on S&P 500 buys. Those value-investors’ profits have underperformed while the stock market has gone crazy this past decade, and stock market trends have passed them by. Barstool Sports founder Dave Portnoy claims he is a better investor than Warren Buffett. At the same time, Buffett is selling airlines at their lows, while others are picking them up with their stock prices soaring.
Let me add a bit of color to this. In mid-late March, I scoured public company financials. Given that the stock market was temporarily pricing companies so low, I surmised there had to be some companies that were trading at bargain prices, and were not exposed to coronavirus-related closures (now or in the future). Every company was impacted in some way by the pandemic, but stocks trading at steep discounts from their highs, like hotels, airlines, cruise ships, casinos, restaurants, and retailers had the very murkiest few years ahead of them. To be specific, I was looking for companies with regular earnings growth, low-ish debt, and prices low enough to reasonably assure a decent return. I was using value investing principles.
My research found that no companies were trading at prices low enough to warrant investing in them. Not one company fits the criteria. The market needed to drop another 10-20% for some companies to become potential targets. I can understand why value investors were quiet during that time; there was simply nothing worth buying with scale.
The stock market then went up rapidly, and others laughed that value investors (Warren Buffett) missed out. It is very likely that the Fed’s unprecedented actions helped to prevent an additional 10-20% market drop. Still, value investors believe there will still be turmoil going forward; and they prefer to stay cash-rich by not participating. That prediction does not necessarily mean stock prices will plunge, just that chaos will continue to reign in the markets. Those investors would rather wait for things to calm down, especially if nothing is on sale low enough to justify the risk.
One to two years from now, when the dust has settled on the coronavirus impact, it will be easier to pass judgment on value investors and their activity during this time. It will be interesting to see if Warren Buffett makes any investments during this period; very likely given that the cash position at Berkshire Hathaway is huge ($128BB in cash and equivalents). Buffett has already recently unloaded about $10BB on Dominion Energy, a natural gas bet.
This “myth” is one that could come true if the historical record does not look kindly on value inventors during this crisis. I am not biased to think value investing is dead. It would be like betting against Bill Belichick reaching the super bowl. The track record for value investors is too long and they have been too successful to let one decade muddy the waters on the benefit of their methods. After twenty years though it might be time to question the approach.
Myth: Companies Without A Profit Are Good Growth Bets
It has become fairly common for companies who show no profit to list publicly, then watch their stock prices soar. Companies like Amazon and Facebook are the poster-children for the “massive-growth-and-subsequent-profitability” story. For years these companies showed zero profit, but rather used their free cash (and debt/equity raised) to pour fuel on the fire that is “market share”. Once those companies achieved a scale that ensured their dominance was hard to compete against, only then did they begin to show respectable profits.
The problem is that many companies, particularly those branded as “tech companies”, have no proof that they would, in fact, be profitable were it not for current, supercharged growth. WeWork is a good example, where knowledgeable investors analyzed the firm’s initial public offering (IPO) documents and could see that the company would not be profitable. WeWork was a rare case where the company was so bad that the investment community actually shielded it from ever going public.
For those companies that pundits do think can someday be profitable, investors have been known to bid the price up if there is a “tech” component. Tesla is the most valuable car company on earth, next to Toyota ($298BB vs $208BB). Yet Tesla only makes about 3% of the cars Toyota manufactures and has never been profitable in a year. Nikola is a semi-truck and truck manufacturer that just went public and had a market cap of $28.7BB (now at $17.6BB). As a comparison, Ford’s stock puts its value at less than $27BB. Have you ever seen a Nikola truck? Neither have their customers. They will only begin to produce inventory next year! The company posted a $32 million loss on $58,000 of revenue last quarter. It is worth almost $18BB. It’s like little Johnny making $58 at his lemonade stand which cost him $32,000 to run but his lemonade business is worth $18,000,000 simply because it is branded Citron 3000: The Lemonade of the Future! Oh, and the $58 is advanced payment on lemonade that he is going to make…in the future.
In my humble opinion, companies that have never made a product or seen a profit should not be allowed to have crazy valuations.
The coronavirus pandemic is challenging some old universal truths and spearheading new theories as well. It is important to look at those rules with a skeptical eye, particularly during these weird times. Writing down these theories and then doing some research on them has been helpful for me. Of course, I come into the conversation with a bias on many topics but fleshing out those opinions through actual stats often helps a) bolster that bent or b) cast more skepticism on it.
July 20, 2020