The purpose of this memorandum is to try to elucidate some of the key current capital market trends, what is driving them, and how we are (or are not) responding to them.
The growth versus value divide flipped yet again towards growth early this year, and gained pace in March as yields failed to break out above post-election highs. Indeed, it appears as yet another verse of a generally similar tune where declining risk-free yields embed a message of pessimism about returns on real book assets. Be they bank capital, industrials, commodities, or durable goods, lower yields give a green light to longer duration growth stocks and those companies whose organic growth shields them from the otherwise desultory economic conditions – in short, favoring growth over value. While this trend has been true this year, it is worth highlighting that value categories somewhat over-performed in 2016 – making a catch up/mean reversion environment in 2017 increasingly possible.
I somehow doubt that is the correct narrative, even if it correlates to the growth over value flip. Yields are lower, as the U.S. 10-Year has fallen from 2.40% in December to 2.15% at present; yet that is still far up from the 1.7% average for 2016 pre-election. It seems to me that once the value-upwelling of 2016 ended early this year, the markets’ yearning for all things tech and the future went into high gear, unbridled by the risk that rates continue to rise in a meaningful way. Beneficiares have included 1) supercap tech names, 2) certain hot sectors such as semiconductors, screen technologies, and other forms of automation/AI, and 3) software/tools that benefit future tech leaders. In a soundbite, if you can look at or engage with the product on a screen, or if it is a maker of screens or devices with screens, it is probably up a lot this year.
The elephant in the room has been the phenomenal performances of Supercap technology companies this year (Supercap = >$300 bn market cap). In Cambiar’s year-end 2016 letter, we went into some detail on the scope of American stock market outperformance this decade (all years 2009-2016 have seen the USA outperform EAFE or ACWI ex-USA). One result has been a circumstance whereby the top 10 companies globally (by market cap) are American; most of which are tech names. This outperformance continued through the end of the first quarter. Supercap tech has exploded thus far in the second quarter - such that the top 10 list is no longer all-American, but is even more heavily skewed to technology companies. Former Supercaps General Electric and Wells Fargo have fallen in value to less than $300 bn in 2017, overtaken by Chinese internet giants Alibaba and Tencent, which have both risen by over 40% to hit the $300+ bn club.
As of June 1st, the USA Supercap tech names have added $626 bn of market cap in 2017, while Alibaba and Tencent are up about $90 bn each, bringing the all-in addition to Supercap tech globally at over $820 bn (or just above Apple’s present market cap). Given the pervasive nature of indexing and quant strategies that amplify stock market trends, making a “money-flow” analysis of this asset-value expansion is a difficult exercise; however, I believe the $820 bn figure closely correlates to the sum of net flows into global stock markets this year – active flows are negative $60 bn roughly, and passive flows are + $200 bn, and within positive active flows, tech fund flows are over 25% of total which is easily the highest it has been since 1999 - early 2000. According to Zero Hedge (May 2017 BofA Warns of Tech Mania Risk), gains in the QNET internet index have annualized this year at a 75% rate, similar to the 80% gain in the Nasdaq in 1999.
Apple alone has added roughly $300 bn in market cap since late last summer, largely in anticipation of the pending iMoaph (mother of all phones) release. While I am interested in the iMoaph (along with most other phone owners), and they will sell a lot of iMoaphs at the expense of some of their other phones as well as other manufacturers, $300 bn is a staggering number if this is all about the iMoaph. How staggering? The $300 bn increase in market cap is more than all of the money Apple has ever earned cumulatively (true); and it has earned a lot in its time.
The Supercap tech names have exhibited a unique trait that tends to be found only in monopolistic businesses; namely, that measures of competitive strength and business returns have tended not to weaken as revenue and profits scale to truly global levels. In other words, these companies are successfully monetizing large populations, not just early adopters. Thus far, competitive efforts appear to be ineffectual (witness the takeover of Yahoo by Verizon; this is a waving the white flag decision). Absent a set of proof points that tech monopolies such as Google, Apple, Facebook, Amazon and Microsoft are actually having to field real competition, they are de-facto monopolies until proven otherwise, without much risk of profit/growth normalization as competition surfaces. So far they have also managed NOT to tread on each other’s territory too terribly much. For example, Facebook or Apple or Amazon could easily try to engage in search, though Microsoft has thrown a lot of money at this venture and not been successful. Similarly, Google could engage in eCommerce fulfillment as a component of search, but has not gone down this path. Given the gigantic size of these businesses, future scalability and the total addressable market opportunity are serious questions to ask. It is also not surprising that the market and growth investors are eagerly looking for the next potential monopolies that could erupt.
Getting away from the technology sector Supercaps, valuation upside has been similarly spectacular in other tools of the future; this includes semiconductors and suppliers, screen manufacturers, electric cars and autonomous vehicle technologies (i.e., Tesla), next generation payments (Square, Paypal) next generation media (Netflix for the most part), and medical tools (Agilient is a Cambiar holding that fits this profile). There is an obvious pattern of “extreme futurism”, with strong bets on the perceived winners and attackers to win, and strong corollary bets on the perceived losers. Some of these bets appear well placed, such as Amazon to beat shopping malls or for internet advertising (Facebook and Google are most of it these days) to purloin ad spending from traditional media and ad agencies.
Other instances of extreme futurism seem very reminiscent of 1999 dreamscape thinking. Tesla, having yet to earn any economic or accounting profit, will blot out several major OEMs, dealer networks may become unprofitable or fail to earn anything resembling past through-the-cycle profits. Nvidia, maker of graphic processing chips (GPUs), exploded to nearly $100 bn market cap on the back of a view that all the screens in our cars, superphones, homes, etc… will need GPUs. GPUs have historically been a relatively fungible commodity, especially as screen density in pixels is reaching maturity; nonetheless, peak all-time profits for Nvidia are $1.7 bn in fiscal 2017. As a point of reference, the company has never gotten close to $1 bn in profits. It looks like one of those ‘buy the rising earnings stream’, with no eye towards a normal profit level…until that first earnings/growth miss happens.
I would make a parenthetical point about semiconductors and screen techs specifically – these companies face end markets that have low/mature longer-term unit demand. A recent management meeting with MPU champion Intel poured a heavy dose of cold water on PC demand ever going positive again (Intel of all companies thinks that’s implausible). Smart phone interest is heightened by Apple’s product cycle, but this too is mostly a replacement demand market. PCs and smartphones comprise over 60% of global semi demand (source: SIA 2017 Factbook). Historically, these dynamics have led to serial deflation and poor numbers from sector participants, making the current valuation-meltup look very speculative…
Companies perceived as being in sync with extreme futurism (such as Tesla) have traded at increasingly unbounded valuations, as the value associated with winning and dislocating older industrial iterations of various industries are considered vast. Companies on the wrong side of extreme futurism have tended to trade at despondent valuations versus historical profitability and are often heavily shorted. Traditional auto OEMs are viewed as serially at risk of not prospering or being viable in “auto 2.0” (the electrification/automation of cars and driving), with some risk of bankruptcy for companies not able to adjust rapidly to changing conditions. Old media forms of distribution and content monetization are also beginning to exhibit despondent valuations that similarly suggest little optimism that managements can navigate obvious changes in the way people view and engage with media. Even looking at our asset management industry, it is not hard to draw similar parallels – where the threat takes the form of ETFs, indexation, smart beta, and other forms of automated decision-making encased in a different wrapper.
In industries where there is not yet an obvious form of futurism that could supplant the existing order (think aerospace, hvac systems or restaurants), valuations have held up fine, and traded up in line with the general market. The future is indeed coming right at us, but not unlike the old economy/new economy divide of 1999-2000, it probably is not the correct conclusion that the entire set of old economy companies won’t adapt, or that the new economy leaders will have consistent success when their current businesses are tasked with scaling beyond early adopters. That’s more or less what happened in the early 2000s, by the way.
By definition, Cambiar’s relative value approach needs to be thrown out the window when dislocations occur in a specific industrial or competitive landscape. We find no shortage of the above tech victims trading at low capitalized multiples of past profits; yet with disruptive technological shifts in the air, it offers little, if any, predictive capacity for the future. Failing to see this phenomenon for what it is generates false positives. To be even a bit more self-critical, one could argue that trying to use some form of well-reasoned forward multiple projection (such as we do) in the face of so much technological dislocation is bound to be hopelessly difficult. Instead, “thinking like a growth manager” and buying only rising earnings streams while avoiding falling earnings streams would better protect capital from these broader concerns. [I am not saying that I believe that to be a correct approach fundamentally – it actually leads to some of the rather exaggerated circumstances of today - but it has obviously worked as of late.]
Cambiar’s positioning within our various portfolios has not exactly been heavy on the extreme futurism, and this has hurt in various ways. The most obvious detractors have been the omissions of Supercap techs – we own Google and on the fringes of the ecommerce/cloud mainstreams hold positions in Ebay and Oracle. Other monster runs in Supercaps have harmed relative performance. It is worth pointing out that in 1999, a similar modus operandi looked all wrong until it suddenly clicked – so I would not yield hope to participate in the Supercap tech parade more forcefully with our positions. Outside the USA, there is a similar case to be made that inadequate positions in fintech and Supercap techs have been detrimental, and that we harvested gains very prematurely in some semiconductor names. We recently added Baidu (basically the Chinese Google and Netflix) to our International Equity strategy after it lagged other Chinese Supercaps; we will see how this investment develops. But piling into additional tech positions at current levels would be outright irresponsible; per the above comments, I sense that semis are very overdone – perhaps in a bubble of their own right now.
Harder to evaluate are the positions that lie at the opposite (negative) end of futurism. These include two auto OEMs (Mazda and Tata), auto dealers such as Group 1 Automotive that trade close to recession-valuation levels, and energy stocks. On the latter, it is evident that given an absence of interest in production growth (there is evidently too much of it, leading to a poor oil price – in no small part because OPEC has not managed the global oil float effectively in 2017), the market is reasonably comfortable with sustainable yield stories (e.g., majors and mini-majors), but uncomfortable with smaller cap energy companies that pay no yield and need growth to represent a good investment proposition. It may be as simple as the above critique of relative value versus growth - unless numbers are rising, E&P or services stocks are not ownable. This still seems like an area of the market to us not to abandon completely, as contrarianism versus prevailing market sentiment tends to be rewarded (recall markets were pretty constructive on energy equities about 80 days ago). Curiously, energy stocks and tech are almost perfectly inversely correlated.
Elsewhere in the Cambiar portfolios, there is plenty of futurism – but you have had to hew to a subtle view of it. Panasonic has been a standout performer as Tesla’s chief battery supplier. Tata Motors is actually envisioned as a near-term competitor to Tesla, as they will have one of the first fully battery-powered SUVs on the market in 2018. Diebold, a small cap name we have struggled through for 2+ years now, is entering a massive global product cycle where current refrigerator-sized ATMs will be refitted as basically nice big screens take on even more of the functions of a traditional bank teller –including issuing cards and new accounts. Other tech positions such as Synaptics (whose chips power most touch interfaces) have just struggled for increasingly mysterious reasons. There are plenty of companies in our portfolios that lie well outside any of this futurism/reverse futurism schism; examples include utilities, miscellaneous industrial businesses, health insurance, and drug companies. It’s entirely unclear if banks and insurance companies will ever be technologically disintermediated, and these positions have performed adequately. Most of the pain points lie on the futurism fault line.
At the end of the day, in a growth-dominated market, a value mindset tends to be challenged; perhaps we have erred in being a little too value-y, and not expansive enough in the growth-dominated segments. Current action in the bond markets won’t help – although the monetary policy re-normalization we anticipated almost a year ago is clearly underway, the yield trade has gone south (based on today’s actions). I don’t think the yield renormalization story is over – the ECB has yet to move off NIRP (should begin this process in late 2017), and Fed balance sheet shrinkage is also a looming target, along with ever-expanding US deficits. Our research prescription for the above is mostly not to lose our heads in what has been an obviously potent – and potentially overdone – growth flip. That said, a huge part of the battle in asset management is to pick winnable fights. In this regard, I don’t think we are failing, and some of the recent gainers in both our USA and Intl strategies point in this direction. Note that nothing thematically links any of these stocks; they are up because of company-specific developments.
I hope our clients find these ruminations helpful.
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