Through the close of trading on Wednesday, the Dow Jones Industrial Average was essentially flat for the year, an unremarkable start to 2018. The first two weeks of February, however, were filled with breathless headlines about volatility, market sell-offs, and investor panic. As a daily market observer, it seems investors have become overly accustomed to the idea that markets should rise inexorably. Anyone with a passing knowledge of financial history knows this reality cannot last. The downturn at the start of February should be viewed in the context of a January advance that represented the best start to the year for stocks in over 20 years. The fleeting bout of volatility of early February may be just beginning, with a bigger market correction likely in the next 12-18 months. Some of the stocks which are most vulnerable are those which have led the current advance, supported by a compelling narrative, but lacking a strong earnings foundation.
The markets unwavering calm has been one of the oddities of the past several years. In spite of geopolitical instability, tepid economic growth, and the ever-present risk of unpredictable events with severe consequences (so called Black Swans), stocks have consistently risen in value, shrugging off events such as Brexit, the Trump election, and threats to global trade, all of which “experts” warned could be severely destabilizing to markets. Until early February, the S&P500 had gone 449 days without a 3% pull-back, its longest streak since before 1928. Last year, the market gained nearly 20% (more when including dividends), well above its average annual advance. This was accomplished from a starting point that many investors already considered overvalued.
The market’s 20% gain last year was not accompanied by a 20% increase in earnings, suggesting we pulled forward some future gains. Investors would be wise to consider the possibility that the recent pull-back from all-time highs was not an aberration, but rather the market correcting a previous error of excessive optimism. Imagine a scenario where some positive development causes the intrinsic value of a company to increase by 5% but its share price rises by 20%. A subsequent pull-back would not only be likely, but should be expected. And yet, that first 20% move up is often seen by investors as appropriate. Mentally, they have already registered those gains. In contrast, the subsequent decline is likely to receive far more media attention and leave investors grasping for explanations. In this way, the current market calm coupled with the sizeable gains of the past several years may well be setting the stage for the next crash.
Look back to the equity markets of late-1999 or mid-2008. In retrospect, most analysts would agree that stock prices were unjustifiably high. In the moment, however, the sharp declines that followed caught many investors off-guard. Should they have? In fact, the market was correcting its previously unjustified advance. I’m persistently struck by how few investors have a well-developed concept of intrinsic value based on earnings or cash flow. This short-coming is not limited to retail investors. Many Wall Street professionals systematically develop complex-seeming but intellectually flawed rationalizations for why they like or dislike certain stocks. Need to justify a higher target share price? Just apply a higher target multiple or raise earnings estimates. Even when the logic is deeply flawed, having enough people believe something can cause share prices to rise. Such advances essentially reward bad behavior, giving support to a flawed investment approach, and becoming the grounds to justify further buying. As Benjamin Graham, the father of value investing observed in the 1930s, in the short term the market is a voting machine. At present, too many investors are thinking about what’s popular, not what earns money.
Amazon presents a useful example. The company has been massively disruptive over the past decade, impacting industries from retail and technology to transportation and healthcare. Its stock price advance has been equally astonishing, with its market capitalization increasing from under $22 billion at the end of 2008 to nearly $750 billion today. This 30-fold increase in equity value has been accompanied by a 9-fold increase in sales and a 3.5-times increase in profits. On the basis of its enterprise value (market value less cash plus debt), Amazon is now the most valuable company in the United States.
Size is often seen as an obstacle to growth, as the larger a company gets, the more difficult it becomes for it to realize significant further gains. Consider the challenge Apple would face in doubling its iPhone sales, or how difficult it would be for Facebook to double its user base. In the case of Amazon, however, this concern appears to be nowhere in its valuation. Additionally, the larger a company grows, the more likely it is to lose focus or misstep. Investors seem untroubled by Amazon the conglomerate. Admittedly, it has grown revenue at an astonishing rate for a company of its size. But can it continue to do so for many years into the future? How certain can we be that it can convert that revenue to profits? What is the durability of its lead in ecommerce? Is it also a near certainty that Amazon will be successful in any industry it chooses to enter? At present, the market certainly seems to think so.
The advance in Amazon’s market cap, far in excess of its sales or profit growth, means the company must realize significant earnings growth in the years ahead merely to justify its current valuation. How likely is this to happen? Below is a chat of Amazon’s pre-tax profit margins for the twelve years from 2005 through 2017.
This trendline shows a downward trajectory to Amazon’s margins. We might generously refer to it as range-bound between 1% and 5%. Amazon has grown its revenue significantly over this period, but notice that neither time nor size has helped its margins. Indeed, since 2010 its best performance was in 2016 when profit margins peaked just under 3%, well off pre-recession levels.
Now consider this same chart with the shaded region uncovered, showing average analyst estimates for Amazon’s future profit margins.
When I worked as an investment banker we used to refer to these as “hockey stick” projections. They warranted immediate skepticism, particularly for businesses that are not early stage start-ups. And yet, in this case, these are not projections which have been developed by a company trying to sell itself, but rather represent estimates from independent Wall Street analysts trying to advise investors.
Next, consider the impact of taking these margin forecasts and applying them to analysts’ revenue growth targets to arrive at Amazon’s profit. This has the compounding effect of taking revenue growth which is expected to average over 20% per year on top of the historically unprecedented increase in margins that analysts expect. First, here is Amazon’s historical pre-tax profit, presented as above, with Street forecasts shaded.
Now take a look at Street projections. Even the most doe-eyed optimist would likely agree that these forecasts appear aggressive.
Are these projections realistic? Will Amazon ever actually achieve these targets? Consider that in recent years, Amazon and other companies have faced an extremely benign operating environment with falling unemployment, rising consumer confidence, low borrowing costs, and stagnant wages which has kept a cap on labor costs. These conditions have led to profit margins that are near all-time highs for US corporations. Over the next several years, Amazon is likely to face rising labor costs, increased competition, higher shipping expenses as UPS, FedEx, and the US Postal Service push up prices, rising borrowing costs as the Federal Reserve moves to raise interest rates, increased regulatory scrutiny, and potentially higher costs in reaching new customers, particularly customers in more difficult to penetrate foreign markets. Additionally, Amazon operates in an industry – mass market retailing – that is notoriously difficult, characterized by thin margins and narrow profits. Walmart is famously cost conscious, yet they have struggled to lift operating margins beyond 5%, even in their best years.
Still, perhaps the analysts making these forecasts have some special insight given their experience covering Amazon. Maybe skeptics are overlooking some intangible consideration. If that were true we would expect analysts to have a solid track-record of forecasting Amazon’s results. In fact, their track record is abysmal. Below are consensus estimates for Amazon’s per-share earnings for 2015 to 2017 two years prior to its actual report.
Amazon has systematically missed analyst forecasts. The size of the forecasting error is even greater when looking at estimates more than 2 years out, as we have done for margins and profits above, with the bias always to the upside.
It would be reasonable to think that this track record of under-earning relative to expectations would cause analysts and investors to be skeptical of Amazon’s stock. One might also think that it would teach analysts to approach Amazon with humility, introducing more conservatism into their forecasts. As the hockey stick projections above show, no such thing has happened. In recent days I heard an analyst on a business news show speaking with a great deal of conviction on why he likes Amazon’s stock, supporting his Buy rating by pointing to a price target based on a multiple of his earnings forecast 5 years from now. This type of extreme optimism reflects the market we inhabit.
Amazon is a useful example because it is large and visible and one of the leaders of the current market upcycle. It is widely followed by analysts, and thus, one might think, a subject of thoughtful scrutiny. Of the 51 sell-side analysts tracked by Bloomberg who cover Amazon, 48 have Buy ratings, versus only 2 Neutrals, and a single, lonely Sell recommendation. That level of unanimity is stunning for a company with a rich valuation that needs to significantly ramp future earnings in a historically unprecedented manner simply to justify its current share price.
Given the charts above, it seems reasonable to be skeptical as to whether Amazon can actually reach these targets. Interestingly, however, an even more important question may be, does it even matter? The company may face a host of challenges ahead. It may face rising costs and increased competition. It may miss earnings estimates. Wall Street analysts may have dubious valuation approaches towards the stock. But for the moment, none of this seems to matter. Amazon’s share price has been a rocket ship. It is up over 30% in just the first two months of 2018. This comes on top of a 56% advance last year, nearly three-times the broader market’s gain. This while rival Walmart, with nearly 6-times the profit but barely one-third the market value, is down 11% year-to-date. So while analysts may have been dead wrong in their earnings estimates, Amazon’s share price advance has justified their Buy ratings, while making the lonely skeptic with a Sell rating appear a fool.
This bring me to my larger point about the current market. While Amazon may achieve those targets, the willingness of investors to put faith in and invest behind them reveals a great deal about investor psychology and the environment we inhabit. For more skeptical investors – or ones who prioritize earnings and cash flow – the current market (or at least pockets of it) may seem downright illogical. As with Amazon, many of the companies whose stocks have done best over the past several years are those which have made promises far into the future. Of course, it is difficult to hold these companies to account when the goal line continues to get pushed further into the future. In the meanwhile, investor faith is nearly unwavering. When such conditions exist, bubbles can be self-reinforcing. Share price advances become justification for further buying, regardless of fundamentals, this in turn drives ongoing gains, until the process unwinds and reverses.
The same leeway investors have been willing to extend to Amazon matches (and in many cases is exceed by) other stocks. This is where the collective psyche of Wall Street can be both fascinating and maddening. Consider an investor looking at Amazon in 2015 who believed that Street forecasts for 2017 EPS of $14 were far too optimistic. He might have decided to short the stock, betting against the company. His analysis would have been spot on, but his investment would have been a disaster. Similarly, imagine an investor looking at a company like Tesla in 2015 with a view that the company would lose money at an accelerating rate, that its production line would face challenges and severe delays, and that its unit sales growth would stagnate. As with Amazon, his analysis would have been correct, but his portfolio returns would have been terrible if he acted on that view and chose to short the stock.
The hedge fund manager David Einhorn recently lamented that value investing is dead. It occurs to me that many of the lessons taught in business school about how to value a company seem almost entirely useless in this market. In fact, worse than useless, their application can lead to some very poor investment returns (at least as measured thus far). Einhorn’s frustration is almost palpable. Investing is not supposed to be as easy as closing your eyes and buying Amazon, and yet that approach would have worked far better over the past several years versus a fundamental-driven analysis of companies and industries.
The Economist magazine recently noted that companies that lose billions of dollars a year have a poor track record of survival. The article specifically called out two of the best performing stocks of the past five years – Tesla and Netflix – which are not only losing billions, but doing so at an accelerating rate. Investors seem entirely untroubled by this cash burn. Those stocks are up 7% and 67%, respectively, in 2018 alone. As with Amazon, these advances in 2018 come on the heels of huge share price gains in 2017. The Federal Reserve’s extremely accommodative monetary policies coupled with enthusiasm for these companies’ products have kept these stocks afloat, even as their financial results have been atrocious. Could the market trembles of early February suggest we might be exiting this extremely forgiving environment? The sharp recovery from the February swoon seems to suggests it may be with us for some time longer.
Regardless of which market sentiment predominates over the next several years, it is a near certainty that the current exuberance cannot last forever. At some point, companies like Amazon, Netflix, Tesla, and others will have to generate massive profits to justify their valuations, or their share prices must fall sharply (at least in theory). Value investing may not be dead, it may just be resting for a while. These companies may be worth what they are currently trading for (or possibly much more), but the fact that Amazon receives almost unconditional support from the analyst community despite a price-earnings ratio in excess of 300 says a great deal about the market environment. It seems impossible that these companies will not be held to account one day.
So what should investors do? First, we should recognize that the higher the market goes, the more risky it becomes. Stock valuations are exceptionally high and the market has advanced rapidly. This means both that future returns are likely to be below historical levels, and the risk of a sharp and sizeable downturn is elevated. The only time the market has reached similar valuations based on economist Robert Shiller’s cyclically-adjusted price-to-earnings ratio were in 1929 and a stretch around the tech bubble in the late 1990s into early 2000, not exactly good times to be buying stocks. Second, investors who own shares of companies whose market values have risen far in excess of their earnings or cash flows should consider themselves fortunate, and then they should examine their assumptions. Finally, it is worth noting that we are living through the third longest economic expansion in history (soon to be the second longest). Good times don’t last forever. We should all be prepared for an eventual economic downturn, with an accompanying market correction. In my view, that downturn could be led by the high fliers of the past several years. As Howard Marks of Oaktree recently wrote, the easy money has likely already been made in this market cycle.
Disclosure: I am/we are short AMZN, NFLX, TSLA.