Market Talk, May 8th 2022
Market Talk is a bi-weekly Sunday issue, where I curate the best things I have consumed during the last two weeks.
Every second Sunday I will share:
• The greatest articles I have read during the last two weeks
• A few stellar podcasts or interviews
Comments from Me
As earnings season is once again here, I am working my way through those, expecting to write up a handful of companies. Elsewhere, I am in the middle of writing up a sub $250M market cap UK restaurant business.
Side note: The month of April saw a strong number of readers subscribe to Investment Talk. After taking a ~1month break earlier this year, it’s great to see that trickle upwards once more as the cadence of my writing is now back.
I know 95% of readers don’t care about things like this, but it’s great to celebrate the small wins.
Recent Publications: Memos I have shared since the last Market Talk.
Here is a shortlist of a few interesting pieces that I have read over the course of the last two weeks, to feed your mind.
Note, that these articles are not listed in order of perceived value.
To access the suggested article, click the purple link after the source subheading.
1) The Art and Science of Downside Protection
Length: Light Read
Not an incredibly long read and 4 of the 7 pages discuss Aikya’s fund performance and positioning, but the first three pages, which feature a discussion of the principal-agent conflicts amongst retail investors, institutions, and managers, as well as their prediction to “constantly obsess over various ways we could lose money”, were insightful enough to be included in this edition of Market Talk. Aikya then walks through their method of downside protection, which is a pertinent topic right now.
“When times are good, and share prices are rising, most companies appear to be high quality. Both managers and investors tend to overlook the sources of downside risk, and instead get seduced by ever rosier expectations of the future. It is only when bad times arrive that the true resilience and quality of a company is tested. Many risks seen as low probability before, become real, while sources of future upside disappear. The human brain is not designed to correctly weigh probabilities and assess future downside risks.”
2) All Revenue is Not Created Equal
Length: Moderate Read
Source: (Above the Crowd)
An old (2011) piece from Bill Gurley with an opening dialogue that feels familiar to the 2021/22 market; “Calculating or qualifying potential valuation using the simplistic and crude tool of a revenue multiple was quite trendy back during the Internet bubble of the late 1990s”. Offering up an opposing view, one which outlines the 10 characteristics of a potential “10x Club” stock, Gurley discusses; competitive advantage, network effects, predictability, switching costs, gross margin, marginal profitability, customer concentration, dependencies, organic and inorganic spend, and growth.
“If high price/revenue multiple companies have wide moats or strong barriers to entry, then the opposite is also true. Companies with little to no competitive advantage, or companies with relatively low barriers to entry, will struggle to maintain above-average price/revenue multiples. If an investor fears that a company’s competitive position (which allows them to create excess cash flow) is tenuous and will deteriorate, then the value of the enterprise may be worth the cash flows only from the next several years.”
3) Why Does the Stock Market Go Up Over the Long-Term?
Length: Light Read
Source: (A Wealth of Common Sense)
A very succinct memo from Ben Carlson, but an important reminder that the S&P is not an escalator that pumps out 9% returns annually. In this piece, Ben walks through the history of S&P drawdowns, and the importance of getting your face ripped off, every once in a while.
I won’t lie, I find reminders like this useful. Spending a great deal of time on Fintwit, the daily proliferation of noise, of fear, of excess greed, of bias, is pungent enough that one can almost smell it. As the “world’s megaphone” or the investor population’s “town square”, much emphasis is placed on the now, and not the later. Which, being a source of news, makes sense, but is equally contradictory to what long-term investing is supposed to be about.
“Since 1928, the U.S. stock market is up 9.8% per year. The market is up roughly 3 out of every 4 years. There have been no 20-year periods where the U.S. stock market has been down on a nominal basis. I’ve gone over these kinds of stats ad nauseam over the years. But why is this the case? Why does the stock market go up over the long-term?”
4) Retro Article: How Inflation Swindles the Equity Investor, Warren Buffet, 1977
Length: Dense Read
Source: (New York Times)
Another oldie for you, this time from 1977, authored by Warren Buffett as a segment in the New York Times. Written during a decade-long bout of inflation, Buffett outlines the misconceptions about the relationship between stocks and inflation, oft-cited to be a “hedge” against the latter.
This particular edition of the article has a follow up from things Buffett has said about inflation since the original rendition, which I found to be quite useful. It’s pretty dense but well worth your time. For those looking to learn more about the ‘Great Inflation,’ this article by the Federal Reserve History department will serve you well.
“It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms; let the politicians print money as they might. And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon?) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate that have been earned by companies during the postwar years will discover something extraordinary: The returns on equity have in fact not varied much at all.”
5) Intangibles and Earnings
Length: Dense Read
Source: (Counterpoint Global)
A piece from Mauboussin and Callahan that, again, dives into the topic of intangibles and the clarity of financial reporting. With intangible and tangible assets each existing on different statements and expensed in differing ways, the duo ponder what would happen in the event we treat intangibles as though they were tangible? I.e, capitalising those investments that exist on the income statement and amortising them over their useful lives, much like one would do for a tangible asset, living on the balance sheet.
The discussion of the foibles of using valuation multiples was particularly interesting.
“A survey of nearly 2,000 professional fundamental investors revealed that nearly 93 percent use multiples to value businesses.6 The most popular multiples are P/E and EV/EBITDA. Earnings can be misrepresented for businesses that invest heavily via the income statement. In a moment, we will show that the consequence of this adjustment varies widely. But it should be clear that a simplistic comparison of multiples from one company to the next is fraught with the danger of false conclusions.9 Research shows that earnings are less relevant and informative today than they were in the past.10 That means that multiples, which seek to serve as a shorthand for the proper valuation process, are often not up to the task of discerning value and value creation.”
6) Beating a Bear Market
Length: Moderate Read
Source: (Asian Century Stocks)
More bear market commentary here, but this memo from Michael Fritz, author of Asian Century Stocks, highlights 5 methods that an investor can use to ensure they survive a bear market. Suggestions include; increasing the cash position, contrarian investing, avoiding cyclical and fast-growers, shorting institutional favourites, and special situations.
“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favourable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.
Other Items I Read
Note: ($) indicates there is a paywall on this content.
• The KCP Group: The Attention Span, Three Steps to Freedom
• Steve Clapham: Are Investors Kicking their own Ass?
• 1Main Capital: Q1 Shareholder Letter
• Farnam Street: Q1 Shareholder Letter
• Credit Suisse: Was Buffett Right? Do Wonderful Companies Remain Wonderful?
🕵️ Company Related 🕵️
• The WSJ (SBUX): Starbucks Is Having an Identity Crisis. Can Howard Schultz Fix It?
• Young Money Capital (ZBRA): Zebra Write-up
• Stratechery (AMZN): Beyond Aggregation: Amazon as a Service
• TSOH Research (NFLX): This is When it All Matters ($)
• The Long Game (GPRO): GoPro Write-Up
• Value Situations (PANR): Pantheon Resources Write-up
• The Verge (AAPL): EU Preliminary Ruling Calls Apple Pay Anti-Competitive
• Stock Opine (ADSK): Autodesk Write-up
• Special Situation Report (DOUG): Spin-Off Write-up for Douglas Elliman
• Ensemble Capital (CMG): Chipotle Write-up
• Ensemble Capital (GOOGL): Alphabet Making it’s Users’ Lives Easier and Better
• Antonio (SPOT): Q1 Earnings Write-up for Spotify
• AGB (ALGN): Align Technology Write-up
Here, I will share some podcasts I listened to during the last two weeks, that I feel are worth your time.
(1) Is this a Bear Market?
I only listened to one podcast these last two weeks, but it was a fun one. I have listened to Ben and Michael for years, and find them to be a fun ‘get away’ from the seriousness of the market, whilst also conducting an informed discussion. In the wake of current events, with the S&P 500 being down double digits for the year, the duo had some interesting, lighthearted, discussions pertaining to whether or not this is a bear market.
As remarked in the episode, the average drawdown from ATHs from 1950 in the S&P 500 is ~13%, roughly where we are now. From 1928 to 2021, in 59 of those 94 years, there was a double-digit drawdown during the year. 58% of the time, when a double-digit drawdown occurred in a year, investors ended the year with a gain. 40% of the time, the gain was double digits by the year’s end. This time might be different. The Fed is taking the punch bowl away, and interest rates are rising, but all of these past drawdowns had things going on too. So, some food for thought.
(2) Peter Lynch Lecture from 1994
Like the Buffett article I shared from 1977, this is another retro snippet. Perhaps, as the market tumbles, I am subconsciously looking to the past, to see how the greats handled these bouts of pessimism. Nonetheless, this presentation from Peter Lynch (starts ~9 minutes in), in which he outlines how the ‘small investor’ can invest successfully, is a timeless classic. A favourite quote from the lecture; "If you spend 14 minutes of economics a year, you've wasted 12 minutes".
Guest: Peter Lynch
On Wednesday, 4th May, after the Fed announced a 0.50% hike in interest rates, the S&P 500 climbed ~2.98% from the prior day’s close. This has only happened ONCE in the past 40-years, with one exception, March 21st, 2000. The S&P 500 would later fall ~45%, before retracing those losses a cool 7-years later.
As much as I find these snippets of history fascinating, the 7-year retracement would be considerably less painful if investors were buying in 2003. Then again, the same investor could have been tempted to buy in 2001, only to watch stocks sink further. Or perhaps 2002, to the same outcome. Investing is hard.
Meanwhile, the PE multiple of the S&P 500 currently sits at a cool ~36x or so.
BUT, ladies and gentlemen, the perfect contra-indicator, that is CNBC “Markets in Turmoil” segment was enacted on Thursday, 5th May. The results following this “special” segment on CNBC speak for themselves.
However, as Charlie Bilello notes, there is an important caveat; “the data set of “Markets in Turmoil” specials starts in 2010, and is therefore limited to a buy-the-dip bull run where corrections have been short-lived”. Another omission, in none of these cases, was the fed tightening whilst inflation was running this hot…
But doom and gloom aside, here is a hilarious 2003 SNL skit circa 2003 post-bubble-bust.
Have an awesome weekend everyone!
Author of Investment Talk