December 2018
Recent investment headlines remind us of when the internet bubble popped almost 20 years ago as today’s commentators shock their followers with statements like this one from Barron’s in late November: “Now the talk is about a trillion-dollar meltdown. The FAANGs—a basket of high-growth technology companies that includes Facebook, Amazon, Apple, Netflix and Alphabet (Google)—have lost $1.1 trillion since their peaks. This month alone, the loss comes to $400 billion.”1 Similar captions were prevalent in 2001, but this time around some tech companies actually make tons of money. With this Newsletter we reach into our historic Newsletter vault for a classic that Andrew Burns penned 17 years ago after the internet stock bubble crashed. We think you will find in the passage below that much of what was discussed then has relevance today.
From “Cash, Stock and 1965 Lincoln Continentals” (July 2001)
The investment public has been treated to quite a lesson over the last fifteen months. By most estimates, U.S. stocks are down some $3.0 trillion since March of 2000. Many previously highflying companies have witnessed billion dollar drops in their market value. With all these billions and trillions bandied about, it is time to draw an important distinction between “cash” and “stock.”
As a reminder, “cash” is the legal tender that teller machines spew and that children accept as weekly allowance. “Stock” on the other hand, is a printed piece of paper representing partial ownership in a company. As usual, we will use an analogy to contrast the two and their relevance to investing.
Suppose you were a collector of old cars or, like me, you inherited your grandfather’s 1965 Lincoln Continental. Curious as to its value, you flipped through a specialty car valuation magazine (Whitewall Street Journal) and learned that 500 Lincolns still existed and that recent sales occurred at around $10,000 each. Treating the old car market like the stock market, the “market value” of the Lincoln 500 (i.e., S&P 500) would be $5.0 million (500 cars x $10,000 each). For fun, let’s further assume that one could order old parts and assemble another 1965 Lincoln for $50,000 (can you see the “buy” versus “build” analysis coming?).
Indulge us further and pretend that Jack Nicholson stars in a new movie entitled “Honeywell Jack.” The Hollywood set crew buys one of the 1965 Lincolns as Jack’s cool car in the movie. The movie is a success and now everyone wants to own a Lincoln just like Jack’s. In fact, one Lincoln is sold to an exuberant investor during the movie’s first week for $20,000. Accordingly, the market value of the entire “Lincoln 500” doubles to $10 million (500 Lincolns x $20,000 each). Lincoln owners see the transaction reported in the Whitewall Street Journal and conclude that their investment is up 100% in one week.
Yes, that’s the way it works on Wall Street. The market value of the Lincoln 500 went up $5.0 million while only $20,000 in cash traded hands with the sale of one car! Similarly, when the stock market lost $3.0 trillion in “stock” value over the last 15 months, it is important to note that far less cash changed hands.
If the Lincoln scenario mirrored the Internet stock bubble last year, Lincolns would have eventually traded at $200,000, despite the fact that they could be built for $50,000. In fact, at $200,000 each, you would see people swapping their Lincolns for oceanfront lots. This is what happened when big companies acquired little ones for billions of dollars of “stock” during the heady days. No cash traded hands in most of those famous mergers and, likewise, no cash is lost due to recent “write-downs.”
The investment moral to the Lincoln 500 story is that cash is a different animal than stock. Our equity valuation methods compare the actual cash return from company earnings to the market value of stocks we are buying or selling. We also complete a “buy versus build” analysis when evaluating a company’s underlying worth. Finally, when learning that a company is acquired for “billions of dollars” we determine whether the offer was for “cash” or “stock” before giving the valuation any serious credence…
Back to 2018…
Yes, the combined market value of the aforementioned top five tech FAANG stocks dropped by $500 billion or more in recent months but we remind readers that only 1-2% of the shares of these companies actually change hands each day—that is to say, five or ten Lincolns are sold every day at prices that may or may not reflect a proximate value for them all.
There is, however, a big difference between values of tech stocks now and nearly twenty years ago—since some of today’s standard bearers actually make lots of money. Specifically, the three with solid historic profitability (Apple, Facebook and Google) currently trade at an average multiple of 18 times next year’s estimated earnings — a valuation that seems reasonable by most historic measures. The other two (Netflix and Amazon) are valued at a richer multiple of roughly 65x next year’s earnings estimates.2 Ironically, and perhaps why more correction is nigh in segments of the market, the latter two stocks have substantially outperformed the former group this year, despite being valued roughly 3.5 times more as a multiple of projected earnings. Put another way (and admittedly oversimplified, but still worth contemplating), holding other inputs constant, those two stocks could decline more than 40% and would still be valued twice as much on the basis of earnings.
As we face what may be the later stages of a nearly ten year bull market, Hamilton Point has made some tactical adjustments within portfolios to increase exposure to stocks that we believe may hold up relatively well should we face recession. As always our focus is on the underlying relative free cash flow produced by the companies we own rather than how markets might be pricing 1% slices of those enterprises trading on a daily basis.
Like the family’s durable 1965 Lincoln (showing 52,000 miles on the odometer now), this philosophy of “following the cash” on the stock side and managing risk with high-quality bond holdings, has been tested by economic cycles over the last 25 years, and we believe will help our clients get where they want to go over the next decade and beyond.
1) Kim, Tae. “The FAANG Stocks: A Case-by-Case Analysis.” Barron’s. 23 November 2018.
2) Source: FactSet earnings estimates and return data as of December 13, 2018.