Hedging The High-Flyers For The Coming Downturn

by: Atlanta Capital Professional


No meaningful market drop of longer than a week has occurred in over a year.

The CAPE for the S&P 500 is over 28.5, a height greater than the 90th percentile of all market valuations since 1900.

Better than shorting the S&P as a hedge is a strategy of shorting a diverse basket of the high flyers across multiple industries and asset classes.

The market has enjoyed an unprecedented surge in the four months since Donald Trump's election. Speculation about favorable taxation and loose monetary policy has been everywhere. No substantive data has emerged about an improvement in American 4Q earnings reports. No meaningful market drop of longer than a week has occurred in over a year. The bull market is eight years old now, with no decline of 20% or more coming since early 2009. The CAPE for the S&P 500 is over 28.5, a height greater than the 90th percentile of all market valuations since 1900. The Market Capitalization/GDP ratio in the US is over 128%, a number classified as 'significantly overvalued' by GuruFocus. George Soros is making massive short bets against the market. Carl Icahn is net short because of his worries about blind buying, China, and valuations. Seth Klarman is warning his Baupost investors of 'perilously high valuations.'

The traditional way of hedging a portfolio after a long run-up is to short the S&P 500 (NYSEARCA:SPY), directly or via long-dated puts. But this method is too blunt. It shorts cheap and settled companies like American Airlines (NASDAQ:AAL) and Dow Chemical (DOW), whose EV/EBITDA ratios are below 10, alongside high-flyers like Netflix (NASDAQ:NFLX), Tesla (NASDAQ:TSLA), and even Facebook (NASDAQ:FB), with EV/EBITDA ratios from 24 to 380.

A better strategy is to short a diverse basket of the high flyers across multiple industries and asset classes. I mean the companies with the highest valuation ratios, the greatest multiple expansions during the run-up, and the frothiest animal spirits surrounding their products. Such companies will plummet more rapidly during a market downturn. This gives downside leverage to the 'high-flyer hedge.' So the hedge does not have to make up as large a percentage of your portfolio as a direct short of the S&P.

I am suggesting a basket of 10 different companies (and industries) in this high-flyer hedge. No single company should make up more than 10% of the hedge, so as to minimize single-company risk and focus the hedge against frothiness as a whole. I am not including on the list any company with high borrow fees, since no one knows how long the markets will remain elevated. Tesla's borrow fees are currently over 20%, and it is not on the list. The borrow rate for bubble stocks can defy gravity for years before eventually returning to earth, leaving massive fees in their wake. The hedge is a bet against high-flying valuations as a whole, and not against individual executives, management teams, or industries. In my portfolio, I am sizing this hedge at around 20%. No single stock in the high-flyer basket makes up more than 2% of my overall portfolio, protecting me through diversification from further run-ups.

Amazon (NASDAQ:AMZN): Its Prime subscribers have been increasing rapidly and its AWS segment has been turning a highly-publicized profit. Bezos and team are first-rate managers. Yet the stock is fully priced, with an EV/EBITDA of 30 and a P/S, the most important Amazon metric, of 3 (my numbers throughout the article are from Yahoo Finance). Amazon at bottom is still a low-margin online retailer, and a trailing P/E of 189 (forward of 64) suggests profits are far away in the future. Q4 2016 revenue was light at $43.7B, and Q1 2017 projected revenue came in lighter still at $33.25B-$35.75B. The company's retail segment is ferociously competitive, but a revenue growth slowdown to 47% in high-flying AWS suggests that investor optimism has become too great. At nearly $400B in market capitalization, Amazon dwarfs Wal-Mart's (NYSE:WMT) $209B market cap, although Wal-Mart still outstrips Amazon in yearly revenue at $485B to $136B. Amazon's online retail vision may still be the future, but a lot of missteps can happen at such nosebleed valuations. The stock has run up from $51 in late 2008 to about $830 today.

Visa (NYSE:V): At a trailing P/E of 34, an EV/EBITDA ratio of 19, and a P/S ratio of 11, Visa is richly valued. While its Q4 2016 revenue, at $4.46B, represents strong 25% y/y growth, its margins have been contracting on a constant currency basis, and net income is up just 10% y/y. The company has been busy recently absorbing its big European acquisition. At a market cap of $180 billion, and with numerous payment competitors fighting for market share (MasterCard (NYSE:MA), American Express (NYSE:AXP), Discover (NYSE:DFS), Apple Pay (NASDAQ:AAPL), etc.) just how much growth lies ahead for Visa? Probably nowhere near what the valuation suggests. The dollar is strong, the business cycle is long in the tooth, and during the 2008-2009 recession, the payment companies were crushed. The stock has now run up to almost $86, from $13 in late 2008.

Caterpillar (NYSE:CAT): Caterpillar, sporting a trailing P/E of 92 and an EV/EBITDA of 16, is an established company with a low-growth future that is trading at incredibly lofty levels. True, its P/S is just 1.4. But its numerous industrial and equipment applications are almost all low-margin businesses, and the surge of optimism that has come with the infrastructure-based 'Trump trade' is waning. At a market cap of $56B, further multiple expansion is unlikely and buyout risk is non-existent. This is not an industry disrupter and it should not be trading like one. It is an established stalwart with operating margins below 6%, and in the next cyclical downturn, its price is certain to retrace to more reasonable multiples.

Domino's Pizza (NYSE:DPZ): The run-up in Domino's share price has occurred almost unchecked since October 2008, from $4 to $186 today. With a large TAM for pizza in America and operating margins close to 20%, it might appear at first as though there is further room for Domino's to run. But a whole lot is 'baked' into the stock at these levels. Its trailing P/E is 47, its EV/EBITDA is unprecedented at 24, and its TTM P/S is 3.8. This company is a player in the pizza sales and franchise licensing business, folks. It's not like it's the next Apple, Microsoft, or food industry disrupter. It's in a competitive industry facing Pizza Hut (NYSE:YUM), Papa John's (NASDAQ:PZZA), Little Caesar's and others - with a cutthroat fight for market share. And at a market cap of $9B on TTM revenue of just $2.39B, history suggests that there is going to be a large multiple contraction in this company's future.

Facebook (FB): Once a poster child for Yellen-era tech speculation, shares have cooled off now and are up 'just' 34% in the last year. This behemoth's market cap is nearly $400B, and although its margins from its advertising and data sales are still mere pipe dreams for most businesses, it's hard to see much upside from here. Costs are increasing, revenue growth is slowing, and advertising load is nearing saturation levels on the company's main platform. Oculus? A plaything of the wealthy. Instagram? Monetization is less certain. Expansion into the developing world? Far less monetizable as users. And just about everyone who's going to use these platforms is doing so already anyway. Acquisitions? Snap (NYSE:SNAP) has turned them down and anything else other than Twitter (NYSE:TWTR) might be outside of it wheelhouse. Zuckerberg and Sandberg are tech legends, to be sure. But at valuations like a 64 P/E and an EV/EBITDA of 24, the market has already priced in the whole future of this rapidly-maturing business. Especially prescient was the market's yawn at the company's surprisingly positive Q4 2016 report. The market is starting to move on from this one, and a general market downturn would cause its multiples to crash.

Adobe (NASDAQ:ADBE): At $117 per share and a $58B market cap, Adobe has climbed to lofty levels since it bottomed out at $17 per share in the Great Recession. The cloud pivot has been a smart move for this well-run business, whose operating margins are north of 25%. The public has an insatiable appetite for mobile, video, and digital in the cloud, and each of Adobe's segments in Creative, Marketing and Document appears to be healthy. But investor expectations have been greater still, and at a TTM P/E of 60, a P/S of 10, and an EV/EBITDA of 30, stockholders are incredibly sanguine about its prospects. Folks, I don't care if the cloud is going to fly us to Jupiter or Mars. This is a $58B market cap security that has returned over 300% in the last five years. It's not a penny stock and should not be producing penny-stock-like returns. A lot of that run-up has come from hot (and dumb) money that has flowed into countless index funds, each of which is buying up ADBE sight unseen.

Costco (NASDAQ:COST): Costco has found a niche as a bulk seller in a weak retail environment, to the tune of a $76B market cap. Renewal rates are nearly 90%, and the customer base is nearly 90 million as well, as suburbanites seek ever-cheaper groceries, electronics, prescription drugs, gasoline, and tires. But operating margins in bulk seller land are way below 5%, and y/y sales comps are too. The company's TAM and brick-and-mortar expansion plans are limited. In no way will something this commodified ever be a lucrative business, and the second the company missteps a dozen other retailers which are selling the exact same products will all race by it. Yet at a forward P/E of 26, and an EV/EBITDA of over 14, the company's market cap feels more like index fund purchases than like investors who've been doing their fundamental analysis. A recession would torpedo the company's already razor-thin margins.

Priceline (NASDAQ:PCLN): With impressive comps growth and a much more profitable business model than Costco, one might at first think that Priceline would be a more resilient company during a market downturn. Its gross and operating margins are impressive, quarterly revenue growth is near 20%, and people clearly have now been habituated into the Priceline style of travel reservations. But when the business cycle turns, travel will be one of the first things to go, and at a TTM P/E of 42 and an EV/EBITDA of over 20, Priceline is 'pricing in' no such risks. Competition is increasing in the world of online reservations as well, and disrupters like AirBnB continue to gobble up share. At a P/S of nearly 8 in an increasingly competitive travel niche, the company is too richly valued to be an investable long.

Ulta (NASDAQ:ULTA): Ulta Salon, Cosmetics, and Fragrance has been a growth story par excellence. From humble roots around $6 in the depths of the recession, the stock trades at about $270 today. Revenue growth has been rapid, and revolutionary advanced planning techniques have created a loyal customer base. The strong dollar is not an issue, as Ulta is exclusively state-side. 90% of customers are loyalty program members who are fleeing department stores and turning to Ulta's disruptive social media presence for new offerings. Comps indicate double-digit sales growth, operating margins are near 15%, and ROE at 27% is notable. But shareholder expectations have ramped up even faster. The next four quarters will require Ulta to lap its toughest comps yet. At a trailing P/E of 47, a forward P/E of 34, and an EV/EBITDA of 21, Ulta is priced for maximal growth. Market expansion may continue for a few more quarters, but given the line of business, multiple contraction would be severe during an economic downturn.

Netflix (NFLX): With an EV/EBITDA over 140 and a P/S of 7, Netflix is facing increasing headwinds from competitors like Amazon, Hulu, Microsoft (NASDAQ:MSFT), and AOL (NYSE:AOL). At Q4 $2.47B (+35.7% y/y), its topline is still growing rapidly. But its bottom line profitability, with a Q4 adjusted EPS of $0.15, is still questionable, and its move into non-western streaming markets has greatly increased its cash burn rate. Reed Hastings has navigated troubled waters before, and the company's international streaming subscription additions surprised to the upside in Q4. But the company's DVD subscription business, its only profitable segment, is shrinking rapidly - down from 4.9M a year ago to just 4.03M in December 2016. Net neutrality will probably be revisited by the Trump administration. Where will the profits come from when every revenue increase at NFLX is accompanied by an even greater cash burn? Years of income and expansion are being assumed of NFLX at these sky-high valuations.


The high-flyer hedge strategy faces two upside risks. One is single-company risk. No one wants to bet against an Apple- or Microsoft-style disrupter early during their run-up. But the high-flyer strategy minimizes this risk by shorting a diverse basket of companies, across multiple different industries and asset classes. It is not a hedge against any one company or asset class, but against the market's frothiest valuations as a whole. All of its members have been surging for at least 3 years, and in some cases 8 years (or more). All are at (or near) their all-time highs. Little short-squeeze risk exists because the hedge is so diversified. Disrupter risk is minimized via diversification. Buyout risk is minimal because of these companies' large capitalizations and frothy valuations. Share buybacks and the manipulation efforts of analysts are unlikely to make a big price difference.

Suppose the worst. Suppose a massive upside squeeze occurred in a single name. Recall how Morgan Stanley's Adam Jonas, who a couple of years ago 'raised' his price target to over $400, cynically initiating a massive short squeeze just prior to Tesla's announced equity raise (in which Morgan Stanley was a participant and Jonas a beneficiary). Or think of Andrew Left at Citron, who is able to publish bombshell research reports that can change the market capitalizations of $40B+ companies in a matter of days (i.e. Valeant, Mobileye). If any one of the companies in the basket were to surge by 25%, the high-flyer hedge strategy would only be down by about 2.5%, and at 20% of one's overall portfolio, the portfolio as a whole would only be down by about 0.5%.

The second risk is whole-market risk. This is the only large risk to which the high-flyer hedge is exposed. If the timing of the hedge is off, then it will lose some short-term money and demand opportunity costs from your portfolio. Are we about to enter an unprecedented run-up? Almost certainly we are not. The bull market is 8 years old. Valuations are stretched already. Does anyone really believe that at this point in the business cycle we are about to launch off into another 5, 4, or even 3 years of substantial market upside? Most asset class real return forecasts for both large-cap and small-cap American equities are around -3% over the next 7 years. Inflated asset prices suggest prospective future returns that are lower than were suggested in both 2000 and 2007. The high-flyer hedge strategy is a way of being prudent about position sizing and risk management. An investor who follows this strategy for at least two years and at 20% of his portfolio will be handsomely rewarded.

Finally, although I prefer to stay away from most macro-analysis, I feel that when a lot of the macro-data are suggesting nosebleed valuations then one is compelled to find a hedge. Bloomberg and others have reported that shorts have been fleeing the market in droves since the election. That's bearish. According to the CBOE, the ratio of puts to calls has hit unprecedented lows. That's potentially bearish too. Home sales, durable goods, and other 'real' economic indicators have not been supporting these speculative valuations. In December 1999, during the only extensive run-up of the last century in which the CAPE was higher than our own 28.5, large-cap high-flyers included Yahoo (YHOO), Microsoft, and Cisco (NASDAQ:CSCO). Yahoo fell from $108 to $6 in about a year. Microsoft fell from $58 to $22. Cisco fell from $77 to $12. All of these companies are still in business today, but they are just more reasonably valued. The high-flyer hedge is not intended to be a bet that any of its members will fail. It is only a bet that their valuations are over-extended.

Do not wait to short until after there is a newsworthy catalyst. Short sellers who sold high-flyer fast casual chain Chipotle (NYSE:CMG) after the E. coli. scare made little profit. And random things happen in the market. A couple of years ago, Tesla underwent a sudden 25% drop in its equity valuation. The catalyst was its 3Q earnings report. Yet the earnings report itself was quite normal. Guidance about Tesla's future battery supply was weak, to be sure, but the company appeared to have been executing according to plan - at least, the plan that management was telling shareholders in its conference calls. What caused the market to react in the way that it did was its disappointment in a normal earnings report that undermined its irrational belief in Tesla's revolutionary trajectory. Things happen all the time in the market and the talking heads don't know why until afterwards.

No, it's not different this time. Yes, history does rhyme with itself. Don't wait for a negative catalyst. The time to hedge is now, while you still can.

Disclosure: I am/we are short AMZN, NFLX, FB, ADBE, COST, PCLN, ULTA, CAT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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