Image Source: Tesla Roadster
As we march forward in what Morgan Stanley has dubbed a bull market of “epic proportions,” euphoria appears to be at levels perhaps not seen since the dot-com bust of the early 2000s. Let’s take a look at some of the “hottest” names on the market.
By Kris Rosemann and Brian Nelson, CFA
Earlier this month, Ireland (IRL, EIRL) borrowed five-year paper at a -0.008% (negative 0.008%), meaning that the country is being paid to borrow. If you recall, we penned a piece in April 2016, that commented on an obscure article in the Journal where a Danish couple was being paid interest on their mortgage (that’s right – they are being paid interest, not paying interest), “Understanding the Market Melt Up.” With negative interest rates, the laws of finance are being bent, and an ongoing melt up in global stock markets has ensued as discount rates by some equity buyers (value estimators) approach zero, in some cases.
Despite ultra-low and/or negative interest rates being one of several glaring and obvious causes of the current stock market bubble, the US Federal Reserve somehow continues to find ways not to meaningful raise rates. Equity prices are now at nosebleed levels in the US, and unemployment rates are at 16-year lows (4.2% in September). The Dow Jones Industrial Average (DIA) closed Friday at 22,872, the NASDAQ (QQQ) at 6,606 and the S&P 500 (SPY) at 2,553, all three all-time highs. What’s more, the new highs are coming on the heels of practically negligible volatility. Pension Partners’ Charlie Bilello noted that the S&P 500 is holding onto the second-longest streak of trading days ever without a 3% drawdown (1928-2017) – second-longest ever. Optimism is reigning supreme! President Trump is loving it.
Stock Market hits an ALL-TIME high! Unemployment lowest in 16 years! Business and manufacturing enthusiasm at highest level in decades!
— Donald J. Trump (@realDonaldTrump) October 5, 2017
We’re mighty pleased the market is treating investors very well, too, but we think balance is always important. Glaringly low interest rates around the globe, the proliferation of indexing (“buying without care to price”), “Systematic Risk in These Frothy Times,” dividend growth reinvestment at any price, and corporate buybacks because well “every executive team thinks their stock is underpriced,” are several of the main drivers behind the market’s recent euphoric climb, in our view. The most recent Nobel laureate Mr. Richard Thaler, just was quoted as saying this could be “the riskiest moment of our lives.” I appreciate those thinkers that can accept what’s happening in the markets and finance, and still seek to explain the risks and uncertainties through honesty and clarity. Thaler is one of them. He said the “stock market seems to be napping,” and he’s right. Hardly anyone is paying attention to prices (i.e. the price versus value equation). Remember, according to JP Morgan, only 10% of trading on exchanges is estimated to be actual stock picking – the balance is indexing and quantitative investors.
Markets are a function of human behavior. If very few truly care about prices, “bubbles” can happen. To me, the markets are clearly showing that they don’t care about much. According to Factset, the forward 12-month P/E ratio for the S&P 500 is 17.9 times, significantly above the 5-year and 10-year averages. Whether it’s the market cap-to-GDP ratio or CAPE ratio or almost any other metric, US stocks are pricey, but most don’t seem to care. Doing so may fly in the face of their business model that may rely on index speculation. In some ways, the laws of finance appear to be breaking down due to Fed policy, and it’s only fitting that the latest Nobel prize winner is a behavioral pioneer. For as long as Valuentum has been in existence, we’ve been teaching investors about Keynes’ beauty contest in the ‘16 steps,’ a dynamic that Thaler himself has oft commented about. Those that are index speculators should not get a free pass when the tide goes out, in my opinion.
For every Howard Marks that has warned about the market’s euphoric nature, “The Wisdom of Howard Marks,” there may be dozens of wealth advisors that care little about 1) the common-sense risks of markets (despite they themselves being proponents of “random walk” theory, which itself may imply markets are unpredictable, thereby defeating their very own logic that “stocks always go up”), 2) the ties that bind stock prices to free cash flow generation as they proudly show long-term, upward sloping charts to the right as if the chart somehow is evidence enough for why equities may still go higher during these bubble-times (wouldn’t this be the same reasoning heading into the Crash of 1929, I ask), and 3) what a stock market is — it’s a market full of stocks, not a stock market. I believe the financial industry is starting to fall “off the tracks” with all its nonsensical commentary, if it hasn’t already, and even Uncle Warren can’t seem to resist as he says “Dow will hit 1 million in 100 years.”
I admire Uncle Warren, but even if the Dow reaches that level in 2117, the very idea that we don’t know if the US will be at war with North Korea this month or next year, or what we may be eating for breakfast or lunch or dinner on October 15, 2018 (next year), should provide enough common-sense backdrop to preclude anyone from making such outlandish predictions and for others to actually take them seriously. I always cringe when I see predictions like this and such as the ones from Jack Bogle that say “the stock market will return only 4% annually over the next decade,” for example. Have we lost our senses to understand how fragile these equity markets truly are–the S&P 500 collapsed to the March 2009 panic bottom during the Financial Crisis and has more than tripled to all-time highs at the time of this writing (in less than 10 years). That this happened shouldn’t embolden prognosticators to make ridiculous predictions of any sort, industry commentators, but if you have to make a prediction, please provide a range of probable outcomes. Annual returns can very well be negative during the next 10 years—stop the shenanigans.
Such euphoric predictions have in part offered false confidence to those holding equities, in our view, and many, namely Morgan Stanley of late, have dubbed the current environment a bull market of ”epic proportions.” We’re not bullish or bearish on stocks, but instead, we’re being reasonable (cautious and concerned), and hope through our writings to offer perspective that you’re just not going to find elsewhere–where conflicts of interest seem to be running rampant (has this always been the case?). Though as to not fall short of offering some perspective as to some of “hottest” names in this overheated market, let’s walk through a few examples in this piece. We continue to like the ideas in the Best Ideas Newsletter portfolio, but a look at what investors are willing to pay up for in today’s market is a healthy exploration.
Image Shown: Tesla’s stock price performance.
Model 3 Production Issues Dangerous for Tesla’s Competitive Position
There may not be a more exciting stock on the market than Elon Musk’s Tesla (TSLA). Not many CEOs are as tied to the share price performance of a company as Elon Musk, who is widely regarded as one of the most innovative thinkers of his generation. Tesla is certainly one of the most innovative companies in our coverage universe, but the completion of its quest to become a mass-production auto manufacturer is far from a certainty. The company continues to burn through tremendous amounts of cash, and its 52-week trading range of $178.19-$389.61 speaks to the speculative nature of the stock. Tesla may be one of the most exemplary stocks of this period in stock market history, as its valuation is based on what investors think it will be able to deliver decades from now as it continues to finance its operations via low-cost debt.
Supply chain and production hiccups have not been a new development for Tesla, but investors continue to have confidence in its ability to get such problems ironed out–eventually. The most recent example came in the third quarter of 2017 when production bottlenecks resulted in an 80%+ shortfall in Model 3 production. Management is adamant that no fundamental issues in the Model 3 production or supply chain exist, but it also notes a handful of manufacturing subsystems at its California car plant and Nevada Gigafactory are taking longer-than-expected to activate. The company may very well be correct in its assessment that this is nothing more than a short-term issue for production of its Model 3, but competition in the electric vehicle space can only be expected to intensify, especially considering the aggressive tone of recent strategy updates from General Motors (GM), Ford (F), and Honda (HMC). It appears Elon Musk is not the only one with big ideas for the future of consumer transportation.
The challenges in the production of Tesla’s Model 3 may be more noteworthy than similar problems in the past, as the vehicle’s launch has been tabbed by some observers as its “iPhone moment.” The vehicle is intended to be Tesla’s first foray in to the mass market due to its lower price target than previous models, and it could represent a material first-mover advantage if it is able to find its way into the mainstream before other automakers are able to catch up. It’s hard to see how Tesla can build a sustainable advantage around its technology, however, as GM, Ford, and Honda will be nipping at its heels at any moment, and jockeying for position in the electric vehicle space can only be expected over the long haul. The electric vehicle market may end up being large enough for a number of big players, however.
In any case, die-hard Tesla–and Elon Musk–fans have not had their confidence shook by production issues, or the resulting delay of its Tesla Semi reveal, and such loyalty may be eventually rewarded. However, a stock such as Tesla is fraught with tremendous risk and uncertainty, and doesn’t quite pass muster with our team. Tesla could continue to be a big winner, but at Valuentum, we tend to focus on entities with strong free cash flow generation and solid balance-sheet health, “What Are the Qualities of Highly-Rated Stocks on the Valuentum Buying Index?” Through the first six months of 2017, Tesla reported ~$270 million in cash used in operating activities, and it spent more than $1.5 billion in capex in the period. Net losses continue to pile up, and production speed bumps are not helping its road to profitability, which may not reach sustainable levels until 2020 or beyond. Tesla may very well come out on top in the electric vehicle race, but we’ve witnessed far too many pit stops early on to have any sort of reasonable confidence in its fundamentals to catch up to its current valuation, let alone drive it materially higher.
Image Shown: Take-Two’s stock price performance.
Take-Two Interactive Software: Digital Delivery Key to Growing Recurring Revenue, Free Cash Flow Generation
Take-Two Interactive Software is best known for video game development, and its strategy is focused on developing high-quality entertainment franchises across a variety of different platforms. During the past 10 years, Take-Two has added 9 new brands to its lineup of offerings, including successful franchises such as Red Dead Redemption, BioShock, and Borderlands. The company is also working hard to capitalize on the trend toward digital distribution, too, with Grand Theft Auto Online and NBA 2K, and its free-to-play WWE SuperCard has been a huge hit. WWE SuperCard has been “downloaded 14 million times and is (the company’s) highest-grossing free-to-play mobile offering.” Other favorite titles include Sid Meier’s Civilization and XCOM 2.
Though Take-Two (TTWO) remains tied to the physical video gaming industry to a large degree, its success represents the first technology shift in gaming away from physically-delivered video games. The company’s digital online distribution revenue continues to grow at a breakneck pace, rushing ahead more than 55% in the first quarter of fiscal 2018. (In fact, the massive shift to digital distribution is one big reasons why we are very cautious on GameStop’s (GME) long-term financial health). Take-Two’s Grand Theft Auto Online has been a key driver for the company, and it and its digitally-delivered portfolio-mates are driving serious levels of recurring revenue for Take-Two. Management expects recurring revenue, which has hovered at ~50% of net revenue from digital online channels in recent years, to grow at least 30% in fiscal 2018. Recurring revenue was ~26% of total revenue in fiscal 2017.
Take-Two’s business has always been capital-light (meaning, as a software developer, it doesn’t have to spend a lot on property and equipment), and its accelerating shift to digital distribution should only augment such a characteristic. Free cash flow grew to $310 million from $163 million in fiscal 2017 from fiscal 2015, driven by expanding margins and reduced capital spending. For further context into the firm’s free cash flow generating capacity, consider free cash flow was more than 4.5 times net income in fiscal 2017, and capital spending came in at just over 1% of revenue in the year. However, capital spending is expected to jump to $60 million in fiscal 2018, or roughly 3.5% of management’s net sales guidance for the year. This, combined with a projected step back in cash flow from operating activities, is expected to result in free cash flow of only $140 million for the year. We expect this to be a more normalized level of free cash flow generation, as it is 100%-125% of expected GAAP net income for the year.
Though its fundamentals look attractive, shares of Take-Two are currently trading at more than 92x the midpoint of fiscal 2018 GAAP diluted net income per share guidance, which has been issued in a range of $1.00-$1.25. While a degree of this massive earnings multiple can be attributed to the high-growth prospects and tremendous free cash flow generating capacity–more free cash flow is generated by a lower level of GAAP profits than a typical company, thus garnering a higher P/E ratio–we aren’t convinced such a multiple is fully warranted, especially considering the boom-or-bust nature of the video game business. Such a notion may be even more justified after considering the significant step back in free cash flow the company is expecting in fiscal 2018. Take-Two does hold an impressive net cash position of nearly $1.5 billion as of the end of fiscal 2017, however.
Take-Two Interactive Software has an attractive business model with impressive growth prospects, but as you can probably gather from our tone, the company’s valuation is far too rich for us at this point in time. We love its balance sheet and free cash flow generating capacity, of course, but a return to more normalized levels of free cash flow, which are still relatively robust, in fiscal 2018 may bring some of its “stock price hype” back down to earth. When it comes to Take-Two, we would like to see more stabilized and sustained free cash flow generation and margin performance before building a strong case for such an idea. We think a far more attractive entry point may be in the future, though Take-Two’s hit-or-miss gaming business model is not for everyone.
Software – Graphics: ATVI, AVID, EA, GLUU, RST, TTWO, ZNGA
Image Shown: Starbucks’ stock price performance.
Starbucks Leading in Technology and Teenagers
The strength of the Starbucks (SBUX) brand has been a key competitive advantage for some time now, helping support its annual price increases on its coffees and products to become widely-accepted by consumers of all ages. Starbucks has been able to continuously attract a younger demographic to its stores, too, and in a recent Piper Jaffray survey, for example, the company was listed as the top restaurant chain by teens in both average income and higher income brackets. We think Starbucks is doing a great job becoming a “destination” for coffee-drinkers, and it continues to boast a “feel-good” ambiance.
The company also prides itself on being a leader in technology in the coffee and quick-service space, and its mobile order platform continues to improve and has become an increasingly important part of its investment thesis. Mobile payments, for example, increased to 30% of all transactions in US company-operated stores in the third quarter of fiscal 2017, and mobile order and pay rose to 9% of all transactions. Such developments go hand-in-hand with Starbucks’ ability to attract younger customers who generally have an increasing bent toward the convenience of mobile order and payment capabilities.
In what could be considered a first-mover advantage in its own right, we think customer loyalty to the Starbucks brand can be expected to continue with younger consumers thanks to its improving technological capabilities. The same can be said about the success that mobile technology has brought to the likes of Dominos (DPZ), too, for example. Even if Starbucks is unable to continue to meaningfully differentiate its core products (food and coffee) or the perception of them in the eye of the consumer from competitors, it appears to be carving out an advantage in its mobile ordering and payment platform that could further bolster its brand strength and awareness among younger consumers.
While Starbucks trades at far more reasonable earnings multiples than Tesla and Take-Two, for example, shares are currently changing hands at nearly 24x fiscal 2018 (ends September 30) consensus earnings estimates. Starbucks was materially free cash flow positive in fiscal 2015 and 2016 and should produce similar results in fiscal 2017 if performance t