Towards the end of financial bubbles, asset prices behave in ways that can’t be explained with rational/historical metrics. So new ones are invented to make sense of things. In the 1990s tech stock bubble, earnings were “optional” and “eyeballs” – that is, the number of visitors to a dot-com’s website – were what determined value. In the 2000s housing bubble, home prices would always rise, which justified pretty much any selling price and asset backed security structure.
Now David Einhorn, a high-profile (and highly frustrated) hedge fund manager, has offered an explanation for today’s bubble:
“Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value,” Einhorn wrote in a letter to investors dated October 24. “What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss?”
Einhorn, who identifies as a value investor, said the market “remains very challenging” for folks like himself as growth stocks with speculative earnings prospects outperform value stocks.
“The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy,” he wrote. “The knee-jerk instinct is to respond that when a proven strategy is so exceedingly out of favor that its viability is questioned, the cycle must be about to turn around. Unfortunately, we lack such clarity. After years of running into the wind, we are left with no sense stronger than, ‘it will turn when it turns.’”
It’s tough being a value investor these days
Greenlight Capital returned 6.2% in the third quarter, bringing the fund’s year-to-date returns through September 30 to 3.3%. Meanwhile, the S&P 500 (^GSPC) rose 4.5% during the period, bringing its year-to-date return to 14.2%.
Value investors like Warren Buffett and finance academics would argue that a company’s true intrinsic value can be derived by discounting its projected future profits. Of course, it’s almost impossible to accurately forecast a company’s future profits. Furthermore, it’s widely accepted that a company’s market price in the short-run is affected by other factors including investor emotions.
One of the most widely-reported signs that the market as a whole is expensive is the cyclically-adjusted price-earnings ratio (CAPE), a measure of stock market value popularized by Nobel prize-winning economist Robert Shiller. CAPE is calculated by taking the S&P 500 (^GSPC) and dividing it by the average of 10 years worth of earnings. It has a long-term average of just over 16. Currently, CAPE is just above 31, which some view as trouble. The only other times CAPE climbed like this was before the market crash of 1929 and the bursting of the tech bubble in the early 2000s.
Einhorn explained that his investment strategy “relies on the assumption that the equity value of a company equals the market’s best assessment of the current and future profits discounted at the company’s cost of capital.” The fund should outperform when it finds opportunities where “the market has misestimated current or future profitability or miscalculated the cost of capital by over- or underestimating the risks.”
Unfortunately, that strategy hasn’t worked well as momentum stocks have continued to move higher.
“It’s clear that a number of companies provide products and services to customers that come with a subsidy from equity holders. And yet, on a mark-to-market basis, the equity holders are doing just fine,” he wrote.
Consider Amazon, Tesla and Netflix
Einhorn has placed bets against a handful of high-flying momentum stocks that he’s dubbed “The Bubble Basket.”
He pointed to Amazon (AMZN) as an example, writing that the company recently revealed “a much lower level of long-term structural profitability, causing consensus estimates for the next five years to drop by 40%, 22%, 18%, 14% and 8%, respectively.” Even still the company’s stock dipped less than 1% during the third quarter, he noted.
“Our view is that just because AMZN can disrupt somebody else’s profit stream, it doesn’t mean that AMZN earns that profit stream. For the moment, the market doesn’t agree. Perhaps, simply being disruptive is enough.”
Next, he brought up electric carmaker Tesla (TSLA), which he described as having an “awful quarter.” While shares dipped 6%, Einhorn felt it “deserved much worse.”
“So much went wrong for TSLA in the quarter that it is hard to only provide a brief summary,” Einhorn wrote. He went on to list numerous issues with the company including manufacturing challenges, reduced gross margins, markdowns on showroom vehicles, and intense competition.
Lastly, he brought up Netflix (NFLX), where he noted that competition has been heating up with Disney pulling their content for its own streaming service plans.
“NFLX continues to accelerate its cash burn as it desperately tries to compensate for its inability to rely longer-term on licensed content. On the second quarter conference call, the CEO stated, ‘In some senses the negative free cash flow will be an indicator of enormous success.’ To us, all it indicates is that NFLX is capable of dramatically changing the economics of stand-up comedy in favor of the comedians,” Einhorn wrote.
These companies have all raised red flags for Einhorn. Unfortunately, the market often doesn’t cooperate with what investors consider to be rational analysis.
“Perhaps, there really is a new paradigm for valuing equities and the joke is on us,” he said. “Time will tell.”
This has been an especially brutal bubble for hedge funds of every type except trend followers. As governments intervene in formerly free markets, historical relationships that drive black box trading models stop working, forcing the closure of a long list of big-name funds. As for value investors, peak bubble is always a time for questioning assumptions, as stocks that are the opposite of value seem to take over the world.
But not once has a new-age, this-time-it’s-different bubble rationale turned out to be valid. Fundamentals always win out — eventually. As Einhorn says, time will tell.