The market for growth stocks has gotten choppy lately. We know this bubble in tech/growth stocks has been building for several months now. It is hard to know exactly when it will pop, but we looked at a half a dozen prior stock market bubbles (from dot-com to 3D printing to Bitcoin to marijuana stocks), and found that they tend to last between 9 months on the short end to 18 months at the longest.
Below is an interesting chart on the proliferation of option trading since 2000:
The above is call option volume on all exchanges going back to 2000. Call buying has more than doubled this summer, just compared to 2019.
Here is a one-year chart offering a bit more granularity:
Call buying by accounts big (SoftBank (OTCPK:SFTBY)) and small (Robinhood) drove bullish sentiment to extremes by early September. Apple’s (NASDAQ:AAPL) and Tesla’s (NASDAQ:TSLA) stock splits appeared to be the driver. I recall a tweet from Reddit in late August (probably at the peak), stating that Apple calls were “guaranteed” to make money.
Note that call option volume has recently plummeted. This could mean that the tech bubble has begun to deflate.
Bull markets tend to die when leverage is maxed out. The dot-com bubble and the housing bubble were driven by huge technical inflows, using leverage. Once everyone was fully long and leverage maxed out, there were no more buyers or borrowable capital in which to push these assets higher. As we know, tech stocks post 2000, and home prices collapsed during and even long after the Great Recession.
Last week on CNBC, Druckenmiller talked about the “raging mania” that is this stock market. Like any smart and humble person, he indicated that he had no idea if the market would rise or fall 10% in the coming weeks. But he did say that the 3-5 year timeframe looks quite tough.
Below is a chart going back to 1950, with the S&P 500 P/E ratio graphed.
At 26x 2020 earnings, we are closing in on dot-com highs.
Of course, this year is a depressed earnings year, so on forward numbers, the S&P is at 20x. That is still pretty high, but not quite dot-com bubble high. Note, in 2009, when earnings fell, stocks popped to roughly 23x earnings.
Eyeballing this chart, and pretty much the only time stocks traded above 20x, they dropped back to 15x. Of course, with very low inflation and interest rates, 20x may be arguably a fair value.
Looking back to late 1998, the last time the S&P traded at 26x earnings, we saw the market continue to trade higher for another year. The following 11 years (including before that last 20% pop) from January 1, 1999, until the end of 2009 proved to be a terrible one to own the S&P 500. Returns totaled 10% cumulatively for the S&P or annualized gains of under 1%.
If this is the right analogy, then the S&P may continue to rise for another 3-9 months, perhaps another 20%. But post that, the prognosis could be bleak especially if the Fed begins to taper its quantitative easing program. And really, at some point, the Fed has to taper. Another taper tantrum awaits us probably in 2021.
Of course, this is why we don’t simply buy the S&P index, but instead look for neglected, inexpensive names. Quality is our mantra, of course, at Cash Flow Compounders, and buying quality at inexpensive valuations (as we define them, a standard deviation to market or prior trading patterns) has proven to be a winning strategy.
Despite this backdrop, I am actually pretty excited about some of the bargains we are seeing outside of tech. There are lots of terrific, quality financials and healthcare stocks at record low valuations.
Legendary investor Joel Greenblatt said it pretty well when he was on CNBC about two weeks ago. The FAANG’s aren’t really at “bubble” valuations he said (although not convincingly regarding Apple or Microsoft (NASDAQ:MSFT)). It is the next 50 tech stocks that you have to worry about. Definitely true. I have been long Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook (NASDAQ:FB) for years (and written up in mid 2019). But entry points across the tech spectrum are challenged today.
Anyone not familiar with Joel Greenblatt, should watch this interview. He generated 34% net returns over a decade from 1985 to 1994, and pioneered spin-off investing and the magic formula (in the Little Book That Beats the Market). He’s a multi-billionaire for a reason, and a proponent of free cash flow and ROE factor investing.
Long-Term Successful Investing Factors
The classic definition of value stocks (by Morningstar anyway) include those trading at low price/book and low price/sales ratios. These metrics do not measure what we believe are most important: ROEs, cash flow, and EPS growth. Value stocks in the value ETF (ticker RPV for example) own plenty of crummy low ROE, low free cash flow generating businesses. Buying this means owning a lot of junk. Wholesale selling growth and buying a value fund is probably a bad idea.
Of course, growth funds own some pretty crummy, low ROE cash burners too. Lots of them are great companies, but too many today are not only at silly valuations but also just not great business models.
Carvana (NYSE:CVNA), Peloton (NASDAQ:PTON), Zoom (NASDAQ:ZM), Netflix (NASDAQ:NFLX), Spotify (NYSE:SPOT), and Moderna (NASDAQ:MRNA) do not impress me much. Great products, yes. But earning excess ROEs in these competitive spaces look extremely unlikely long term. And frankly, it is impossible to know if Zoom becomes the next Google, or Google becomes the next Zoom (remember what GOOG did to Yahoo and Microsoft did to Netscape).
As we know, growth today is at crazy levels. But owning value funds is problematic too.
So, we pulled up which investing strategies worked best over a 15-year period. The best strategies are at the top (data from Bloomberg):
At number one, Profitability (which we would link roughly to ROAs) has performed well not only long term but also this year and over the past seven years. Makes sense. The exact definition here is last 12-month sales divided by total assets. The companies that require little in the way of assets to generate each dollar of sales is typically a good business model (especially if those are profitable sales).
ROEs, another Profitability metric, show up in this table in three places.
So, why does Profitability matter? To state the obvious because high margin companies that require little in the way of capital expenditures can only generate tons of free cash flow. Cash is king, most of us know anyway, and means companies can maintain better balance sheets or use excess cash for buybacks or acquisitions. I like the technical term “free cash flow machine.”
When I see recommendations to purchase asset intensive companies like refiners or auto makers (yes, this includes Tesla) or E&P companies, then I would suggest that buyers do lots of homework. Chevron (NYSE:CVX) may be considered a “blue chip” name, but the reality is that it has woefully underperformed the market as it simply generates little in the way of free cash flow. In fact, we wrote it up negatively here in 2015 when it traded in the mid $90s per share.
Revisions in a variety of formats is number 2 broadly speaking. Unfortunately, predicting which companies can beat earnings estimates and, therefore, drive the largest percentage of sellside revisions upward is pretty tough. Occasionally, we can model a Bristol-Myers (BMY), as we articulated to subscribers last year, which was poorly modeled by the Street. But it is admittedly difficult to do.
We do have in our Compounders spreadsheet a column tracking earnings revisions. The problem, of course, is that Covid-19 pretty much destroyed every companies’ earnings pictures this year (that is almost every companies’ earnings were revised downward). But in this more stable world, going forward, we intend to pay close attention to revisions as well as look for one-off stories (often associated with mergers) whereby earnings accretion is typically underestimated.
3. Value/Free Cash Flow
Number three looks like a couple of value factors, which we noted in yellow above.
Value as defined by FCF/Enterprise Value and FCF Yield look like very successful, measurable strategies that outperform the market. And this appears true over both 7-year and 15-year timeframes. The S&P is up 12% over the past 7 years, so it has been only mildly outperforming lately. Given that, we think there is some “catching up” to longer term outperformance.
So, in building an investing process, we focus on high ROE/ROA stocks, high free cash flow names, and also look occasionally for those whereby Street estimates are too low.
It continues to amaze me that free cash flow is rarely a strategic focus among investors, either professional or otherwise. At private equity firms, I would bet that free cash flow is the primary metric they look at.
4. EPS Growth
The only growth metric that worked well over 15 years in the top 50 is in green in the table above. One year EPS growth as factor has performed very well long term, but oddly has not performed well this year. Over 7 years, it has ranked quite high. We focus intently on EPS growth, and borderline ignore revenue growth sometimes. Profitless revenue growth is worthless.
While size is a factor, this appears mostly due to the FAANMGs dominating. They are great businesses for the most part, but I generally don’t exclude smaller names for obvious reasons.
Year to Date Factors
Sorting this table on year to date returns, and it is clear that in 2020, the market only cares about revenue growth.
2-year forward sales growth has been the best strategy this year. Working capital, a measure of a good balance sheet, has also prevailed so far in 2020. Again, we have no Compounders without an investment-grade balance sheet (OK, I lied, HCA (NYSE:HCA) is high yield but has the metrics of an IG-rated company).
But picking stocks based on sales growth over the last 15 years has been a terrible strategy, ranking in the bottom 1/3 and underperforming the S&P by a wide margin.
The two value, free cash flow factors that have performed so well long term, are down 15% year to date vs. revenue growth up 51%.
That gets me pretty excited about the names I have been buying and recommending lately.
Which Value Factors Work?
Drilling down into value, we note which value factors have worked over the long term:
Again, free cash flow factors do seem to matter most within value. P/E measures, EBITDA/Price, book value to price all are perhaps “misleading” indicators as to value. Who cares if its cheap on an EV/EBITDA basis, if capex is so high that FCF turns out to be minimal?
EBITDA can be manipulated to the nth degree too. We pointed out last year that General Electric (GE) booked EBITDA to include gains on asset sales, yet excluded asset writedowns in their EBITDA math. What an insult to analysts like me. Again, determining cash EBITDA is critical in evaluating names. GE has been a disastrous stock for years.
And buying stocks cheap on a price to book basis, a metric considered important to hardcore value guys, has also been a pretty bad strategy long term. I have never even considered touching Citigroup (C), a dream stock on a price/book basis. I see hedge funds often take big positions in it, but have never been swayed. Given its poor ROE’s over time and probably going forward, it likely remains an underperformer.
In summary, we have developed our Compounder’s list to include only the highest quality companies, highest ROE names, with good balance sheets and also able to generate lots of free cash flow. Earnings revisions are a bonus, if we can find them.
We time our entry points into these great business models by comping them to cheapness on a P/E and EV/EBITDA basis. While this may seem contrary to certain poor performing value strategies, when we focus on companies that only generate lots of FCF, where cash earnings equal reported earnings, and cash EBITDA matches up with reported EBITDA, then it works well.
Most of our recent recommendations have been in these high margin, highly cash generative names. While I am not selling my Facebook or Amazon, I have trimmed these positions a bit. Selling Compounders generally has been a bad idea, so I remain long these for the long term.
Importantly, it is good to note that what works this year (e.g. revenue growth), hasn’t worked long term. Quants it seems do attempt to alter their trading strategies every year. But at the end of the day, the best investing strategy is to stick to your guns process-wise.
So What Stocks Appear Cheap?
Our spreadsheet shows an awful lot of healthcare stocks, with the top 5 all healthcare names. As one example, we have written up Cigna (CI), once in 2012, and again last year. Since our 2012 write up, it is up 271% cumulatively vs. the S&P up 201%.
Cigna is a high-quality company that fits the bill from many angles: low capital intensity, high ROE’s and profitability, free cash flow often exceeding net income, as well as growth in EPS.
The company has projected long term EPS growth between 10% and 13%. EPS guidance this year is $18.60, and $20.50 in 2021 at the midpoint. They have managed to grow earnings per share by an impressive 9% per year over the past 14 years, through Obamacare, and an astonishing 17% over the past five years.
Given that Apple has grown EPS by 9% over the past five years, it seems a no-brainer to sell AAPL at 35x earnings, and pick up a Cigna at 9x. I am betting significant dollars on this trade. Don’t get me wrong, Apple is a terrific business, which I have written up 3 times in the past, the first time in 2012 here, when I first purchased shares.
In fact, here is a quote from the 2012 piece, when Apple was considered a gadget company with slowing growth, and trading at a big discount to the market:
From what we know, Smartphone growth alone for Apple will still imply pretty solid EPS growth figures for 2012 and 2013. Growth will obviously continue to slow, but with the stock trading at 10x my conservative 2012 CY estimates, the market seems to be suggesting that growth will not only slow down, but stop entirely! The S&P currently trades at 13x 2012 CY estimates, 30% higher than Apple. But S&P EPS growth is forecasted at around 4-6%, compared to 27% for Apple this year.”
Sounds like Cigna today. Next year CI will grow EPS in the double digits, but it now trades at well over a 50% discount to the market’s multiple. (On 2021 guidance Cigna trades at an 8.3x forward earnings multiple vs. the S&P at 20x).
Obviously, election jitters have created fear among healthcare insurance investors. Biden ads over the past few weeks have talked generally about moving to universal coverage. We see little threat, however, and here is the latest from his website:
As president, Biden will protect the Affordable Care Act from these continued attacks. He opposes every effort to get rid of this historic law – including efforts by Republicans, and efforts by Democrats. Instead of starting from scratch and getting rid of private insurance, he has a plan to build on the Affordable Care Act by giving Americans more choice, reducing health care costs, and making our health care system less complex to navigate.” (emphasize theirs)
I have invested in and followed healthcare names since 2000 (when I covered a few insurers and nursing home names as a research analyst at Merrill). Back then, like today, healthcare was considered boring and over-regulated. Government cutbacks led to many nursing home companies filing for Chapter 11. Most nursing home providers were gaming the system too back then. Medicare rightly cracked down on them.
Insurers recovered, and performed well up until 2008, when Democrats took over both the House and Oval office. Campaign promises of healthcare reform were high on Obama’s list of change. Insurers dropped leading up to the election. In fact, when Obama took office, his first focus was in revamping healthcare and attempting to add a public option for those unable to afford insurance.
It worked. The Affordable Care Act (ACA, aka Obamacare) passed in 2010. The number of uninsured fell from 44mm to 27mm. As they had been beaten up heading into the election, healthcare stocks ripped.
Even better, Cigna outperfomed the market dramatically, up 113% in the 5 years from September 15, 2008 to 2013 vs. the S&P up 57%.
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Disclosure: I am/we are long CI, FB, AMZN, BMY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.