Looking Back at Bitcoin

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Benjamin Graham once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”  That statement is a little hard to interpret.  The market is only open now, in the short run.  The way we interpret Graham is to say although investors may be swayed by emotion and folly in the short run, particularly if information is nebulous, as things become clear the market eventually gets it right.  The trick to being an intelligent investor, according to Graham, is to realize now what the market will only come to appreciate later.  That is to invest based on wise assessments of fundamental value.

That brings us to Bitcoin.  In our book, The Conceptual Foundations of Investing, we discussed bubbles.  We argued that bubble can arise when enough investors buy an asset because the price has risen in the past and, as a result, they believe the will be able to sell it for even more to someone else in the future.  If enough participants employ this strategy, it can become a self-fulfilling prophecy and prices can rise without a fundamental reason for the increase.

In our book, we offered Bitcoin as a modern-day example.  We warned that we could see little fundamental value for Bitcoin as either an investment or a medium of exchange.   We said, “The problem is that if the main source of demand is the general expectation of higher future prices, as soon as prices stop rising, demand evaporates.  With few, if any buyers willing to purchase on the basis of the security’s fundamental value, prices collapse. We suspect this will happen to Bitcoin” (page 123).

At the time of our writing, Bitcoin’s price had been skyrocketing and it was trading at over $15,000.  Not surprisingly, it was the focus of a vast amount of attention in the financial media.  Now Bitcoin is in the headlines again, but for the opposite reason.  As shown in the chart below, its price has fallen from nearly $20,000 to less than $4,000.  We suspect it will fall further still.  As Benjamin Graham stressed, in the long run the market will get it right and prices will converge to fundamental value.

Climate Change and the Stock Market

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No, I am not going to say how climate change impacts the stock market or even more far out how the stock market may impact climate change.  The point here is that the two phenomena share a statistical property that makes both controversial and difficult to interpret.

To get started, take a look at the chart below.  It plots the return on the market minus the return on 30-day Treasury bills over the 101-year period from 1927 to 2018.  The data are taken from Prof. Ken French’s website.  Basic analysis of risk and return predicts that the average return on the market would be significantly greater than the average return on Treasury bills – and it is.  But try to see that from the chart.  The problem is that the underlying relation, that the average return on the market exceeds that on 30-day Treasury bills by more than 8% per year, is dwarfed by the variability of the market returns.  It takes careful analysis and more than forty years of data to identify a statistically significant difference between the two returns.  Trying to draw conclusions from short-run variation in stock prices is a hopeless endeavor.

The same is true of climate change.  Serious long-run statistical analysis leads to the conclusion that human industrial activity has led to, and continues to lead to, a slow inexorable increase in average global temperatures.  This is analogous to the long-run difference between the return on the market and the return on Treasury bills.  But there is immense short-run and location dependent variation in weather.  The California drought, for example, may be due in some part to climate change, but most of it is probably due to random weather variation.  California had prolonged droughts well before the industrial revolution.  What makes interpreting the market or the climate so difficult and controversial is that we humans have short lives and shorter attention spans.  We want to understand things in terms of what is happening now, or at least in terms of what happened recently.  Unfortunately, in the case of the stock market and climate change that is not possible.  The only way to understand either is careful statistical analysis of long-run data.

Fuel Costs Comparison: Tesla vs ICEs

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Hidden within a previous post on “How Green is Your Tesla” was a discussion of fuel costs.  But with gas pricing falling, I thought fuel costs deserved another look.  Attached is a handy spreadsheet that calculates how many miles per gallon your gas powered car has to get for fuel costs to be less than for a Tesla Model S 85.  The calculation is done assuming that electricity costs either 25 cents or 35 cents per kilowatt hour.  Those are the second and third tier rates charged by Southern California Edison in the Los Angeles area.  You can plug in your own rate, but remember you want a marginal rate after taking account of your normal home usage.  The marginal rate is more likely priced at a higher tier.  The spreadsheet also takes account of the fact that the actual Tesla range is on the order of 67% of the stated range as documented in the previous post.

As the spreadsheet shows, given a cost for gas of $4.15 per gallon (the currrent mid-grade rate in Los Angeles) , the breakeven mileage is 34.0 mpg at the 25 cent electric rate and 24.3 mpg at the 35 cent rate.  The bottom line is there may be a lot of reason for choosing an electric car but saving on fuel costs is not likely to be one of them, at least at current prices.

Explaining Stock Market Moves After the Fact

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Whenever the market moves sharply, the media feel compelled to offer an explanation.  Sometimes this is reasonable.  For instance, a sudden increase in reported inflation is likely to be bad news for the market.  But much of the time, there is no logical explanation for why prices have moved.  Steve Ross, the seminal financial theorist, said it best before his untimely death in 2017.  Professor Ross put it this way,

It is one thing not to be able to predict what asset returns will be since they will depend on news, and news, by definition, is information that has yet to be revealed.  It is another, though, to observe the movement of prices and not know why they moved after the fact.  I am particularly troubled that contemporaneous news seems to explain so little of the contemporaneous prices.

By contemporaneous news, Professor Ross had in mind the revelation of actual value relevant information such as announcement of last month’s inflation rate, not ex-post speculation or what biologist Stephen Jay Gould called “just so stories.”  Examples of such just so stories include things like rising fear of inflation and panic selling.

When most of a company’s value is attributable to growth options the problem is compounded.  Market values rest not on what a company is doing today, but what it could do in the future.  As we have noted repeatedly in this blog, dreams of the future can evaporate for no apparent reason.  The last six weeks have been a good reminder of that.  Why they evaporated at this particular juncture is anybody’s guess.

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.