A Changing Definition of Value

“When I look back on all these worries, I remember the story of the old man who said on his deathbed that he had had a lot of trouble in his life, most of which had never happened.”  – Winston Churchill

The year 2017 marks the 20th year that I have been charged with writing quarterly commentaries and related mutual fund shareholder annual and semiannual reports.  The total output is therefore a bit more than 100 of these kinds of pieces, though I lost the precise count a long while ago.  The range of market and financial press-driven topics has its cycles; not unlike the nightly news, some topics lead to deeper conversations, while others recede quickly from memory or voice for sheer superficiality and general unremarkableness.  The summer months of 2017 will likely fall into the latter category.  It has been a slow and volatility-free grind upwards for stocks (roughly 5% for each of the S&P 500 Index, the small cap Russell 2000 Index, and the  MSCI EAFE Index this quarter), while 10-year U.S. Treasury bond yields changed by a total of 2 basis points (falling from 2.35% to 2.33%).  Performance was broad, with pro-cyclical sectors advancing and defensive sectors generally lagging.  Markets were so devoid of specific news that it has precipitated the use of famous historical quotes to instigate a discussion.  Alas, poor reader, for the first time in 20 years we have resorted to the artifice of a Freshman term paper.  It is that dull out there.

For no obvious reason, a large number of economists and strategists wandered through our offices in the August-September time frame.  With near 100% consistency, all remarked that they cannot recall a better time in terms of the global economy since well before the 2008 Global Financial Crisis (GFC).  The U.S., Europe, Japan, and even the emerging world are exhibiting synchronized growth and modest (if non-existent) inflation.  Corporate earnings are generally strong, especially for the larger companies, and credit losses scant for the banks.  The technology gigaplexes have become their own unique self-contained multi-$hundred billion galaxies of unabated earnings growth and expanding addressable markets.  The laggard stocks for the most part find themselves on the perceived wrong side of history for the expansion of disruptive business models.

We examine what it means to be "value".

The consensus is cheerful, and the marketplace (not necessarily investors) has become comfortable, paying a full price in many cases.  Like Mr. Churchill’s old friend, I have begun to fret that the persistently low cost of capital and gigantic sums flowing into passive investing strategies have dulled the senses of relative risk and return, fluffing up valuations and business conditions in general.  The French even have a term for this force-feeding and consequent fattening as applied to the geese of the Bordeaux region: “la gavage”.  The unnatural fattening of the markets by index flows and a whole decade’s worth of ultra-low interest rates could prove to be just a vague worry or eventually wholly justified.  It’s less vague that markets no longer have the same structure.  The old price discovery mechanisms that link fast money traders, slow money investors, growth and value styles are crowded out by a novocaine drip of faceless flows pushing individual stocks gradually upwards.  If you take the time to tune into the daily nuances, you can see the algorithms and trading baskets at work, reacting to small changes in volume, the breaking or continuation of trend lines, or changes in analyst consensus numbers upwards.  Keywords on the newswire like “beat”, “miss”, “acceleration”, and “margins” trigger stock-specific moves, and trading patterns where whole market sectors reprice in near perfect synchrony.  Individual stock disappointments experience outsized wipeouts that often reverse in a matter of days, as there is little institutional capacity left to absorb motivated short term selling.  Popular sectors of late include industrials and semiconductors – which have blasted off to double-digit EBITDA multiples of current expectations that would have been laughed off just a couple years ago.  For the here and now, their earnings appear to still be rising, and the algorithms say “buy”.  More seasoned investors would caution against paying high multiples on cyclical elevated earnings; yet such caution has not been rewarding.  In smaller cap companies, we have seen a few names where institutional ownership structure has crossed over to become more than 50% owned by indexes and sector ETFs, begging the question of what exactly prevailing stock prices could mean.  Some old hands in the markets do here and there protest the prevailing winds by holding exceptional levels of cash, but a preponderance of these folks seem to have been negatively disposed for much of the last several years’ advances.  For the moment, the markets seem to be handling the daily blast of carbohydrates down the gullet about as well as the fat French geese, who waddle around the farm and still eat grains thrown to them, and do not look capable of taking flight if the urge ever struck.

The absence of volatility leaves little price action to react to, and we have for the most part stuck with our positions.  In fact, there was not a single new security purchased in the Cambiar Large Cap Value strategy during the quarter – a first in the last 20 years of operation.  Other strategies managed by Cambiar were a bit more active.  Ironically, given the absence of any notable volatility, stocks in the more traditionally defensive sectors such as consumer staples, food, and medical devices have de-rated in both price and valuation over the course of 2017, leading to relatively more comfortable entry points than cyclical growth businesses (source: Bloomberg).  The buying drought did end shortly after the fourth quarter commenced, mostly in these areas.  The actual decision process – just acting based on what the markets are giving us – seems correct enough.

A Changing Definition of Value

The old value investing textbooks preach that the best approach to long-term investing is to buy business assets well below the cost to replicate them, and then just wait around.  Eventually, the returns on assets should mean revert, pulling the stock prices along.  That playbook has been decidedly unproductive for many years now.  It’s not a question of asset value mean-reversion being slow and stodgy against faster growing and technology-driven alternatives.  Rather, it generates false positives.  Coupled with the ongoing upwelling in technology, internet marketplaces, new transportation paradigms, and other instances of “extreme futurism” as coined in letters from earlier this year, it has left some investors aghast at the impotence of a traditional framework of stock picking.

Value-oriented hedge fund investor David Einhorn, who runs a short book heavily populated by some of these names, best encapsulated the grievance as to whether there is some alternative intellectual premise behind the explosion in the value (and financial results) of these gigantic businesses.  To quote: “Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value… 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?” (source: Greenlight Capital – 3Q17 Letter)

Specifically, Einhorn was addressing the fact that his basket of “bubble shorts” — which includes market darlings like Amazon, Netflix, and Tesla — continues to rise, despite a lack of profitability or any clear articulation of when one should actually expect profitability.  So the question is, what is the narrative investors are assigning to these companies that somehow plugs the financial value equation given the lack of actual earnings?

I find this to be a profound question here in late 2017.  A successful investment discipline, whether value, growth, hedge fund-ish or just eclectic, does need to reach some clarity as to why this set of phenomena is happening all at once.  So restating the question of an alternative paradigm of value as a series of questions: 1) Why are there so many very large companies by capitalization that do not generate meaningful profitability? 2) Why are there so many gigantic companies in terms of capitalization period? 3) Are there structural reasons behind value investing’s ongoing lack of efficacy versus growth? 4a) Is there a certain formulaic definition of value that we should just rule out as being badly outdated (hint: yes)? 4b) What definition of value should we therefore favor?

I am going to table that set of questions for a minute and make some comments on Google/Alphabet, whose stock market value currently exceeds $700 bn.  Google still sustains a growth rate above 20% at massive scale, generating $28 bn of revenue for the most recent quarter at roughly a 60% gross margin, or about $6.5-7.5 bn of free cash flow per quarter (current) or about $107 bn of revenue and $52 bn of EBITDA for prevailing 2018 forecasts.   Five years ago, trailing revenue was about $40 bn (so up >2.5x) and EBITDA about $15 bn (up over 3x, as they are not spending as much money on dubious ideas like a rocket to Mars).  Nobody exactly thought Google was small then, and not unlike Apple, Amazon, etc…, it has become its own galaxy now.  Google crossed over $100 bn in on-balance sheet net cash, and has yet to acknowledge any real plan for it.  The company might occasionally want to buy things, such as a patent estate back in 2011, or more recently a $1.1 bn purchase of HTC’s engineering team to start designing better quality Android products. Might as well design some nicer stuff.

Here’s what is interesting: in 2012, Google traded cheap-ish because it had yet to migrate its paid-click advertising business to mobile, creating some less favorable comps at the time amid some uncertainty as to what a mobile-first future would look like.  It has now thoroughly completed this task, with no visible dent in its ~70% search market share, benefitting from both the vastly larger mobile audience of roughly 3 bn non-Chinese smartphone users, and increasingly, web-site design and Internet content are configured for a mobile-first experience that Google basically pioneered (That is market power!).  Looking into the very near future, YouTube TV awaits, with over 2 bn global users ready to pay for content directly (through subscriptions), partially (a la carte), or entirely indirectly (by being blasted with ads in exchange for their viewing).  How hard will it be to begin attracting traditional linear television subscribers en masse?  The expensive cost of traditional paid-linear TV provides a deep pricing umbrella, along with the shifting viewing habits of the coveted younger demographics, and the lack of entrenched profitability to risk.  All Google has to do is pick away at these opportunities.  Can it be as big and profitable as paid-click search?  Given how much information they will be able to gather about viewers and their interests, one can envision many possibilities.  That… is how modest the barriers to disruptive entry are in traditional media programming and distribution.  Meanwhile in the other corner, traditional giants such as Comcast, Disney, Fox, and their ilk are supposed to do what exactly to offset customer leakage?

Let’s get back to the valuation paradigm question: is the salient feature of today’s stock market an outsized capacity for disruptiveness over profitability?  Here we need to have some appreciation for the marketplace-disruption paradigm.  Once a disruptive technology or market/customer relationship emerges, the growth-oriented crowd will identify a clear winner and begin valuing the company on the basis of a theoretical TAM (Total Addressable Market) that it has some probability of winning in totality.  This seems to be true in two very distinct categories: marketplaces and network-effect platforms.  Winners have taken all (or very close to all) in stock exchanges (a marketplace) and credit cards (networked payment platforms) for most of our lifetimes, and in traditional forms of software for many years (think iOS versus Android versus everything else).  This dynamic has the appearance of taking hold elsewhere in distribution networks, internet retailing, social networks, and possibly media subscriptions.  Networks increase in value as connections grow, and marketplaces gain value with liquidity.  Upon reaching critical mass, economic value engines so-constructed tend to pull in activity with a gravitational-like effect.

Value investors are not altogether accustomed to this process just suddenly erupting, living in a seemingly dated realm bounded by traditional scale economics and limits on how well large businesses can navigate new fields.  With common electronic customer connection points that number in the hundreds of millions or billions, as category giants like Google lean into established markets, the disruptor does not require nearly the scale of the disrupted to quickly upend established customer-to-business relationships and kick-start the network effect cyclone.  It’s tough to stop.  Put differently, if the primordial value equation is to buy business assets cheaply, or below their replacement cost, would someone who possessed the $ billions needed to physically replicate traditional media or retailing businesses choose to do so in the manner they are currently constructed?  Or would a completely different approach make sense?  All that said, it’s far from clear why companies who do not seem to show much propensity to generate profits when these dynamics are working in their favor should be valued as though their margins can suddenly approximate the older business order.  Re-channeling Mr. Churchill: “However beautiful the strategy, you should occasionally look at the results.”

This set of examples hopefully provides fodder to answer these questions.  1) Why are there so many very large companies by capitalization that do not generate meaningful profitability? – The markets are anticipating marketplace/network effects to eventually predominate.  2) Why are there so many gigantic companies in terms of capitalization period? – When the network effect happens the scope can be massive.  3) Are there structural reasons behind value investing’s ongoing lack of efficacy versus growth? – Less clear but a lot of business/customer relationships that were strong in the 20th century appear dated in the 21st.  4a) Is there a certain formulaic definition of value that we should just rule out as being badly outdated?  Yes, replacement cost of assets.  4b) What definition of value should we therefore favor?  – Still working on this.  Network effects and high switching costs seem critical.  But we still like cash flow, and tend to recoil from businesses that do not appear to have a profit motive.

The internet and technology supergiants all possess aspects of the platform/network/marketplace business-value structure.  Which brings the discussion oddly back to another older network-effects marketplace called the stock market.  The value of publicly traded stocks has never been greater.  The global economy has seldom looked better.  Yet the number of stocks is shrinking, down over 50% since peaking in the mid-1990s.  Liquidity is shrinking.  The number of market participants is shrinking.  IPOs are few and far between (source: University of Chicago).  Exactly what becomes of the marketplace/network effect of this most classic of marketplaces as this process continues?  What happens when market prices are not based on the decisions of economically engaged parties?  Perhaps this past summer is a prelude to a future devoid of the traditional pricing and feedback loop?  Or perhaps it is as unnatural a creature as an overfed farm animal.

Thank you for your continued confidence in Cambiar Investors.