Category Archives: Equity Market

Clearly wrong

Back at the end of July, in this post on artificial intelligence (AI), I highlighted a few technology stocks related to AI that may be worth looking at in a market downturn. I named Nvidia (NVDA), Google/Alphabet (GOOG) and Baidu (BIDU). Well, I followed through on two of these calls at the end of October and bought into GOOGL and NVDA. I am just still too nervous about investing in a Chinese firm like BIDU given the geopolitical and trade tensions. I am reasonably happy about the GOOGL trade but after their awful results last night I quickly got out of NVDA this morning, taking a 17% hit.

Last quarter CEO Jensen Huang said the following:

A lot of gamers at night, they could — while they’re sleeping, they could do some mining. And so, do they buy it for mining or did they buy it for gaming, it’s kind of hard to say. And some miners were unable to buy our OEM products, and so they jumped on to the market to buy it from retail, and that probably happened a great deal as well. And that all happened in the last — the previous several quarters, probably starting from late Q3, Q4, Q1, and very little last quarter, and we’re projecting no crypto-mining going forward.

Last night, they guided their Q4 gaming revenue down sequentially by a massive $600 million, about a third, to clear inventory of their mid-range Pascal GPU chips and warned that the crypto hangover could take a few quarters to clear. CEO Jensen Huang said “we were surprised, obviously. I mean, we’re surprised by it, as anybody else. The crypto hangover lasted longer than we expected.” That was some surprise!!

All the bull analyst calls on NVDA have been shown up badly here. Goldman Sachs, who only recently put the stock on their high conviction list, quickly withdrew them from the list with the comment that they were “clearly wrong”! My back of the envelop calculations suggest that the 2019 and 2020 consensus EPS estimates of $7.00 and $8.00 pre-last night’s Q3 results could be impacted down by 15% and 20% respectively. Many analysts are only taking their price targets down to the mid to low $200’s. With the stock now trading around the $160s, I could see it going lower, possibly into the $120’s if this horrible market continues. And that’s why I just admitted defeat and got out.

All bad trades, like this NVDA one, teach you something. For me, its don’t get catch up in the hype about a strong secular trend like AI, particularly as we are clearly in a late market cycle. NVDA is a remarkable firm and its positioning in non-gaming markets like data-centres and auto as well as the potential of its new Turing gaming chips mean that it could well be a star of the future. But I really don’t understand the semi-conductor market and investing in a market you really don’t understand means you have to be extremely careful. Risk management and sizing of positions is critical. So, don’t get caught up in hype (here is an outrageous example of AI hype on Micron).

Strangely, I find it a physiological relief to sell a losing position: it means I don’t have to be reminded of the mistake every time I look at my portfolio and I can be more unemotional about ever considering re-entering a stock. I don’t think I will have to consider NVDA again for several quarters!

Lesson learned. Be careful out there.

Peak iPhone

This will be a very interesting week on the stock market, not least the US mid-terms and the ongoing US/China trade saga, which will likely determine the short-term direction of the market. Apple (AAPL) reported last week and another stellar report was hoped for to calm technology weakness. Instead of a stellar report the market got weak Q1 guidance and the news that AAPL would drop detailed product reporting for their FY2019. Given that there is a massive industry dedicated to examining iPhone trends, the lack of specific numbers being disclosed has caused consternation amongst commentators.

It has been about a year since I last posted on AAPL (here) when it traded around $170. Of course, it has since traded up to a high of $230 before falling back to just above $200 currently. There is no doubt that the smartphone market is saturated with IDC estimating global smartphone shipments falling in Q3 by 6% to 355 million unit. In this environment, it makes sense to me for AAPL to focus on higher value smartphones and to extracting increased fees from services on their installed base. Extrapolating on the iPhone installed base analysis from my last post, I estimate that the iPhone installed base will peak around 650 units based upon iPhone unit sales fall to 200 million and 190 million in FY2019 and FY2020 respectively from 218/217 million in FY2018/2017. The active installed base, excluding non-core users, peaks around 570 million. My projections are shown below.

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I have also assumed that the ASP for FY2019 and FY2020 increases to $819 and $847 respectively from $759 in FY2018. I further assumed that service revenue increases as a percentage of total revenue to 18% for FY2020 from 14% in FY2018. I suspect this may be too light given AAPL’s decision to move its reporting focus away from products to services. Although AAPL’s net cash pile is slowly dwindling (approx. $120 billion at end September from $170 billion at the end of December 2017), I think a more focused move by AAPL into the home and content to take on Netflix and Amazon will be a feature of the next few years (bring on the NFLX rumours, again!). My resulting quarterly revenue estimates into FY2020 are shown below.

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As you can see, these estimates do show overall revenue moderating with revenue for FY2019 and FY2020 at $270 billion and $273 billion respectively from $266 billion in FY2018. My diluted EPS estimates, assuming the same trend of share buy-backs, for FY2019 and FY2020 are $13.30 and $14.80, representing EPS growth of 12% and 11% respectively. These EPS estimates are consistent with current consensus. At a share price of $200, the forward PE would be 15 and 13.5 for FY2019 and FY2020 respectively.

My usual forward PE excluding cash graph, at an AAPL stock price of $200, is below. If AAPL were to return to its historical average multiple since 2009 of 9, then AAPL’s stock could fall back to $160 or below if the market gets really spooked about peak iPhone.

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The question therefore is how the market is going to react to AAPL’s attempt to move the focus from its hardware results and more towards its service business from its massive and loyal installed base. Changing the market’s obsession from iPhone sales will be no easy task. AAPL is an emotive stock, not only because of its products but for its incredible historical value creation. It is the one stock that I have always regretted selling any of. I do not think now is the time to sell AAPL but I will wait for the stock price to settle, particularly in the current volatility, to consider buying more. A fall towards $170 would be too tempting to ignore for this wonderful firm. Mr Buffet and the firm’s own buy-back programme make such a fall unlikely in my view but one can only hope!

Peak Earnings?

With the S&P500 down 9% off its high this month after last week, the question everybody is asking is whether this is a buying opportunity or the beginning of a new phase in the market. I have no idea. Nobody really does. I suspect this week will be bumpy but will rally off Fridays’ lows as there is some cheap names who have been hit hard. I have been modestly dipping my toe in on some names but am waiting before making any big moves. I hope to post on a few of the stocks regularly mentioned in this blog in the coming weeks.

The underlying concerns about the global economy and trade, the impact of US rate increases and quantitative tightening, Italy, to name but a few, have been and continue to be real issues to consider. The fact that the market has turned on a penny and is now all worried about the issues it shrugged off a few weeks ago is, well just how markets are!

What I do know is that this bull market has all been about earnings and margin growth, nothing else matters. So, I took the latest operating EPS and sales estimates for 2019 from S&P, extrapolated them into 2020, assuming a modest slowing of the EPS growth. These operating margin figures and assumed sales figures form the basis of Scenario 1. Stressed operating margin and sales formed the basis for Scenarios 2 and 3, with Scenario 2 falling back to the 2013-17 average operating margin of 9.5% and Scenario 3 falling more severely to the 2008-18 average of 8.75%. The graph below shows the operating margin assumptions in a historical context for each scenario.

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Assuming a price for the S&P500 as per Friday’s close of 2,659, the EPS figures with respective trailing and future 12-month PEs are as per the graphs below.

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So, if the current operating estimates for 2019 stand up and continue into 2020 as per Scenario 1, then I would say the current dip is a buying opportunity with a forward 2019 and 2020 PE of 15 and 14 respectively. If, however, you feel that we have reached peak earnings and a modest enough EPS retrenchment over 2019 and 2020 is likely as per Scenario 2, then the current S&P500 level looks vulnerable to further downside as the implied forward PEs of 17.5 and 18.7 for 2019 and 2020 look rich in a downward trending EPS environment. If, as per Scenario 3, the EPS retrenchment is more severe, then we are in for a very bumpy ride with another 15% to 25% downside possible.

To state the obvious, the current market focus is all about the earnings outlook for 2019 and 2020. The mid-terms over the next few weeks will be another factor to consider. It will be interesting to see if the market focus moves away from the economic prospects over the next few years and more towards 2018 bonuses and end of year window dressing as this quarter progresses!

Broken Record II

As the S&P500 hit an intraday all-time high yesterday, it’s been nearly 9 months since I posted on the valuation of the S&P500 (here). Since then, I have touched on factors like the reversal of global QE flows by Central Banks (here) and the lax credit terms that may be exposed by tightening monetary conditions (here). Although the traditional pull back after labor day in the US hasn’t been a big feature in recent years, the market feels frothy and a pullback seems plausible. The TINA (There Is No Alternative) trade is looking distinctly tired as the bull market approaches the 3,500-day mark. So now is an opportune time to review some of the arguments on valuations.

Fortune magazine recently had an interesting summary piece on the mounting headwinds in the US which indicate that “the current economic expansion is much nearer its end than its beginning”. Higher interest rates and the uncertainty from the ongoing Trump trade squabble are obvious headwinds that have caused nervous investors to moderate slightly valuation multiples from late last year. The Fortune article points to factors like low unemployment rates and restrictions on immigration pushing up wage costs, rising oil prices, the fleeting nature of Trump’s tax cuts against the long-term impact on federal debt, high corporate debt levels (with debt to EBITDA levels at 15 years high) and the over-optimistic earnings growth estimated by analysts.

That last point may seem harsh given the 24% and 10% growth in reported quarterly EPS and revenue respectively in Q2 2018 over Q2 2017, according to Factset as at 10/08/2018. The graph below shows the quarterly reported growth projections by analysts, as per S&P Dow Jones Indices, with a fall off in quarterly growth in 2019 from the mid-20’s down to a 10-15% range, as items like the tax cuts wash out. Clearly 10-15% earnings growth in 2019 is still assuming strong earnings and has some commentators questioning whether analysts are being too optimistic given the potential headwinds outlined above.

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According to Factset as at 10/08/2018, the 12-month forward PE of 16.6 is around the 5-year average level and 15% above the 10-year average, as below. As at the S&P500 high on 21/08/2018, the 12-month forward PE is 16.8.

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In terms of the Shiller PE or the cyclically adjusted PE (PE10), the graph below shows that the current PE10 ratio of 32.65 as at the S&P500 high on 21/08/2018, which is 63% higher than 50-year average of 20. For the purists, the current PE10 is 89% above the 100-year average.

click to enlargeCAPE Shiller PE PE10 as at 21082018 S&P500 high

According to this very interesting research paper called King of the Mountain, the PE10 metric varies across different macro-economic conditions, specifically the level of real interest rates and inflation. The authors further claim that PE10 becomes a statistically significant and economically meaningful predictor of shorter-term returns under the assumption that PE10 levels mean-revert toward the levels suggested by prevailing macroeconomic conditions rather than toward long-term averages. The graph below shows the results from the research for different real yield and inflation levels, the so-called valuation mountain.

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At a real yield around 1% and inflation around 2%, the research suggests a median PE around 20 is reasonable. Although I know that median is not the same as mean, the 20 figure is consistent with the 50-year PE10 average. The debates on CAPE/PE10 as a valuation metric have been extensively aired in this blog (here and here are examples) and range around the use of historically applicable earnings data, adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation).

One hotly debated issue around CAPE/PE10 is the impact of the changing profit margin levels. One conservative adjustment to PE10 for changes in profit margins is the John Hussman adjusted CAPE/PE10, as below, which attempts to normalise profit margins in the metric. This metric indicates that the current market is at an all time high, above the 1920s and internet bubbles (it sure doesn’t feel like that!!). In Hussman’s most recent market commentary, he states that “we project market losses over the completion of this cycle on the order of -64% for the S&P 500 Index”.

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Given the technological changes in business models and structures across economic systems, I believe that assuming current profit margins “normalise” to the average is too conservative, particularly given the potential for AI and digital transformation to cut costs across a range of business models over the medium term. Based upon my crude adjustment to the PE10 for 2010 and prior, as outlined in the previous Broken Record post (i.e. adjusted to 8.5%), using US corporate profits as a % of US GDP as a proxy for profit margins, the current PE10 of 32.65 is 21% above my profit margin adjusted 50-year average of 27, as shown below.

click to enlargeCAPE Shiller PE PE10 adjusted as at 21082018 S&P500 high

So, in summary, the different ranges of overvaluation for the S&P500 at its current high are from 15% to 60%. If the 2019 estimates of 10-15% quarterly EPS growth start to look optimistic, whether through deepening trade tensions or tighter monetary policy, I could see a 10% to 15% pullback. If economic headwinds, as above, start to get serious and the prospect of a recession gets real (although these things normally come quickly as a surprise), then something more serious could be possible.

On the flipside, I struggle to see where significant upside can come from in terms of getting earnings growth in 2019 past the 10-15% range. A breakthrough in trade tensions may be possible although unlikely before the mid-term elections. All in all, the best it looks like to me in the short term is the S&P500 going sideways from here, absent a post-labor day spurt of profit taking.

But hey, my record on calling the end to this bull market has been consistently broken….

Value Matters

I recently saw an interview with Damian Lewis, the actor who plays hedge fund billionaire Bobby “Axe” Axelrod in the TV show Billions, where he commented on the differences in reaction to the character in the US and the UK. Lewis said that in the US, the character is treated like an inspirational hero, whereas in the UK he’s seen as a villain. We all like to see a big shot hedgie fall flat on their face so us mere mortals can feel less stupid.

The case of David Einhorn is not so clear cut. A somewhat geekie character, the recent run of bad results of his hedge fund, Greenlight Capital, is raising some interesting questions amongst the talking heads of the merits of value stocks over the run away success of growth stocks in recent years. Einhorn’s recent results can be seen in a historical context, based upon published figures, in the graph below.

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Einhorn recently commented that “the reality is that the market is cyclical and given the extreme anomaly, reversion to the mean should happen sooner rather than later” whilst adding that “we just can’t say when“. The under-performance of value stocks is also highlighted by Alliance Bernstein in this article, as per the graph below.

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As an aside, Alliance Bernstein also have another interesting article which shows the percentage of debt to capital of S&P500 firms, as below.

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Einhorn not only invests in value stocks, like BrightHouse Financial (BHF) and General Motors (GM), but he also shorts highly valued so-called growth stocks like Tesla (TSLA), Amazon (AMZN) and Netflix (NFLX), his bubble basket. In fact, Einhorn’s bubble basket has been one of the reasons behind his recent poor performance. He queries AMZN on the basis that just because they “can disrupt somebody else’s profit stream, it doesn’t mean that AMZN earns that profit stream“. He trashes TSLA and its ability to deliver safe mass produced electric cars and points to the growing competition from “old media” firms for NFLX.

A quick look at the 2019 projected forward PE ratios, based off today’s valuations against average analysts estimates for 2018 and 2019 EPS numbers from Yahoo Finance of some of today’s most hyped growth stocks plus their Chinese counterparts plus some more “normal” firms like T and VZ as a counter weight, provides considerable justification to Einhorn’s arguments.

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[As an another aside, I am keeping an eye on Chinese valuations, hit by trade war concerns, for opportunities in case Trump’s trade war turns out to be another “huge” deal where he folds like the penny hustler he is.]

And the graph above shows only the firms with positive earnings to have a PE ratio in 2019 (eh, hello TSLA)!! In fact, the graph makes Einhorn’s rationale seem downright sensible to me.

Now, that’s not something you could say about Axe!