Bubble Stocks Latest Update

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The group of ten is now done over 26% since our post.  Even Amazon is off 25%.  Roku is nearing the 50% level.  Tesla remains the sole outlier that is up.  If it is removed from the average, the other group of nine is down over 30%.  The value of growth options can evaporate quickly.

Tesla Competition in Germany

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Apparently the German Minister of Economic Affairs reads our blog.  In a recent meeting with the leading German automakers, he said (here is the link: https://electrek.co/2018/11/19/electric-car-half-sexy-tesla-german-automakers/)

“I really wonder when you, Mr. Zetsche (Mercedes), or you, Mr. Diess (Volkswagen), or Mr. Krüger of BMW will be able to get an electric car build, which is only half as sexy as one by Tesla. As far as the attractiveness of your e-cars is concerned, you could actually come up with some fresh ideas.”

At Cornell-Capital, we have been saying this for years.  The Model S came out in 2012 and we anticipated the arrival, not too far thereafter, of sexy well designed competitors.  We are still waiting.

Warren Buffett once told me, never fly on an airline that has coffee stains on the seats.  While coffee stains themselves are not a big deal, there existence says somehting about the quality of the airline’s management that could be critical.  The failure of German automakers to have introduced sexy competition to Tesla by now also may say something about management – that they lack the chutzhap to compete with the likes of Elon Musk.  At least that is what the market price of Tesla’s stock suggests.

Ranking on Growth Options

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Related to our recent posts on the role of growth options, we though it would be interesting to rank US equities based on the percentage of market value attributable to growth options as opposed to assets in place.  In the interest of simplicity (and access to necessary data) we use a simple “back of the envelope” method for computing the value of assets in place.  The value of the growth options is then the difference between the market capitalization and the value of the assets in place.

Specifically, we estimate the value of the assets in place as the forecast of earning for the next fiscal year divided by the cost of equity minus the inflation rate.  (We assume that everything grows at rate of inflation.)  Mathematically, we used the equation

Market Value per Share = Forecast earnings per share/(R – inflation) + Value of growth options.

Finally, using data for November 9, 2018, we calculated the percentage of the market value accounted for by growth options.  In doing the calculations, we limited the sample to companies with a market capitalization of at least $5b that are traded on US exchanges and for which EPS estimates were available from Sentieo.

The link below is to a spreadsheet of the results with companies ranked in order of the percentage of their market value due to growth option.

It is interesting to note that there are a number of companies whose portion of growth options exceeds 100% of their market value.  Conversely, there are even more whose growth options have negative value, indicating the market believes their future is bleak.

Not surprisingly, the top of list is heavily populated with bio-tech companies, where the outcome of future treatments or drugs can have a dramatic effect on value. Also, many of our “Top Ten Bubble Stocks” appear near the top as well.

As we wrote in our post on ROKU, companies with a high percentage of value in growth options are likely to be especially sensitive to news suggesting slowing growth. Consequently, investors who hold companies near the top of the list may want to be especially cautious.

Percentage of Value due to Growth Options Spreadsheet


Asset Sales and Corporate Restructuring

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You often hear that as part of a restructuring to improve its financial position, a company plans to sell assets.  GE is a focal point of such discussion currently and the company has sold off some divisions.  But before you accept the view that such actions are beneficial, you must ask yourself where the benefit comes from.  To answer that question, it is necessary to distinguish the operating value of the assets, which equals the present value of the expected future cash flows under current management, and the cash value, which equals the price at which the assets could be sold.

One possibility is that it makes sense to sell the assets because you have found a sucker who is not reasonably assessing the future cash flows.  This is just a version of the greater fool theory.  If a company can find a greater fool, then it is lucky.  However, such rare happenstances cannot serve as the basis for a systematic restructuring program, so let’s assume that all the potential buyers are rational and well informed so that there are no suckers.

In that circumstance, it makes sense to sell the asset only if the cash value exceeds the operating value.  But why would someone else pay more than the seller’s operating value?  It must be the case that the buyer believes he can operate the assets more efficiently.  This would be the case, for instance, if there were synergies or if the current owners lacked the skill to manage the assets effectively.

All this begs the question of why it makes sense for GE to sell assets.  True some of the assets like the power division may be struggling and losing money, but that just means they are not worth very much.  There is no reason to believe that they will be worth more to a potential buyer unless GE is mismanaging the assets, or the buyer can employ synergies that GE lacks.  Given the size and scope of GE’s businesses, the synergies explanation does not seem likely.  If GE is mismanaging the assets, the best solution presumably would be to solve the management problem, not to sell the assets.

Putting GE aside, the situations in which asset sales would be beneficial are likely to be quite rare.  Asset sales should not be thought of as some sort of restructuring panacea, but as a tool to be used only in unique circumstances where the sale value exceeds the operating value.

ROKU : Growth Options and Bubble Stocks

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ROKU, a member or our “Top Ten Bubble Stocks (that could drop 50% or more)” list that we published in early October, reported earnings yesterday. Despite beating both top and bottom line earnings estimates, the stock was down a staggering 22% today.

We have talked extensively about “growth options” on this blog.  (High Expectations Can Bring Big Risks).  Recall that a firm’s equity value can be thought as being comprised of two components: 1) The value of current operations (which includes 5 years of future expected growth) and 2) everything else which is the “growth options”.  For tech companies like Roku, the growth options often include distant future opportunities that investors envision.

ROKU’s value is largely based on the 2nd components – the growth options. Companies whose value depends primarily on growth options can be highly sensitive to even a whiff of slowing growth.  That was the case with ROKU.  Despite the good top and bottom line performance, the earning release foreshadowed slowing user growth.  The related decline in the value of the growth options swamped any good news about current operations, sending the stock down 22%.  This underscores the need for caution among those considering investment in companies whose value is largely dependent on growth options.

Options and Market Declines

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            At Cornell-Capital we write a lot of options.  In some cases, it is part of a hedging strategy in which we own the underlying stock.  But it many cases, Tesla is an example, it is naked writing.  You would think that these short options positions would do well when the market drops like it did in October and they do, but less than you would expect.  The reason is that market declines, particularly recently, are associated with increases volatility.  For example, changes in the VIX index are negatively correlated with the return on the market.  The result is that when stock prices fall, volatility rises, so that there are two offsetting effects on the price of options.  The rising volatility pushes option prices up, muting the impact of declining prices.

Company Information Releases and Stock Prices

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            I don’t often disagree with Warren Buffet, but his position on companies providing guidance was one example.  In a previous post, I argued that the more information companies give investors, the more accurately they will price stocks, on average.  Perhaps there will be instances where investors might over- or under-react to certain information releases, particularly if it is vaguer information like guidance.  But that possibility should not make executives the paternalistic managers of investor sentiment.

            The problem is a good deal worse if companies decide to withhold value relevant historical information as Apple has now decided to do regarding the number of units it sells.  Withholding that information clearly makes it more difficult for investors to value Apple accurately.  Remember that the fundamental social role of the stock market is to move funds from savers to investors.  That task requires accurate pricing so that funds are allocated to the companies with the best opportunities.  If companies withhold information and pricing becomes noisier, the capital allocation process is impeded, and everyone loses.

Investment Risk and Stock Prices

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            Academics and practitioners alike recognize that increase in the perceived risk of equity investing, and the associated increase in the risk premium, can cause stock prices to fall.  Most of the measures of risk are abstract like the historical standard deviation of stock returns or the future implied volatility of returns as measured by the VIX.  There is one more basic measure that I believe has a more visceral impact, the frequency of large drops, defined as 1% or more, in widely reported stock indexes.  When sharp price drops occur not only do investors lose money, but the decline is big news in the financial press.  Pundits weigh in with explanations for the drop and worry about whether further declines are likely.  If several drops occur in close proximity, the impact is multiplied. 
            For the foregoing reasons, I like to track the frequency of 1% drops.  In the year from October 1, 2016 through September 30, 2017, for example, there were only 5 drops of 1% or more.  Furthermore, they were widely dispersed and typically followed by immediate recoveries.  Such a low rate of large drops was well below historical averages and, no doubt, conveyed an impression of quiescent times.  In October 2018, the situation was dramatically different.  There were 5 drops of 1% or more in that month alone – a rate 12 times that of the past year.  Not surprisingly, the financial press was filled with stories about the increased risk of stock investing along with a host of explanations for the drops.  From my perspective many of the explanations are speculative at best, but tracking the frequency of large drops is a recommended exercise nonetheless.

Bubble Stocks Update

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            With all the turmoil in the markets, I felt it was time to take a look back at the ten bubble stocks from my post after the close on October 3.  The table below shows the performance between the close on October 3 and the close today (October 29).  The table shows that the average return for all ten has hit bear market territory – down more than 20%.  If Tesla, the one exception to the rule is eliminated, the average for the other nine is down an astonishing 25.5%.  Turning to the individual stocks, there (AMD, Roku and Square) are down more than 30%.  Amazon has shed more than $250 billion in market value.  It is stunning how quickly sentiment can change on relatively scant economic news.