July 2017 Newsletter: Minding your Internal Clock

AAEAAQAAAAAAAAuUAAAAJDA1Y2QzZmY0LTU0MjAtNGJiMi05MTNhLWI4YThjNDA3NmI3YQ

Originally published on August 7th, 2017 by Tony DiGiovanni via LinkedIn.

The market continued its climb in the second quarter, ironically making investors a bit uneasy. It’s analogous to a quarterback’s internal clock when he drops back for a pass. After a few seconds, he knows he either has to throw the ball, run, or get creamed by a 300 pound defensive lineman. After enjoying eight years of nearly uninterrupted ascent, investors are looking over their shoulders for a blitzing linebacker. That’s understandable considering the last two bull markets ended in spectacular fashion – each declining more than 50%.

The prospects for a similar bear market are not that high, though 10-15% corrections could happen at any time. Bear markets (market declines greater than 20%) usually signal the economy is heading into a recession. Recessions usually follow a long period of excess that eventually gets exposed once growth slows. This recovery is anything but usual. Most of us are still waiting for growth to accelerate let alone slow down again. In many ways, the recovery feels like it is just starting. Unemployment continues to hit new lows and is at levels considered to be full employment for our economy (not something you see leading up to a recession). It’s a bit deceiving because underemployment is still relatively high. In other words, people are working, just not in their full capacity or in a job they want. This has kept a lid on wage inflation. Very slow wage and sales growth coupled with a small amount of productivity growth makes planning very easy and causes volatility in both the real economy and the stock market to plummet. For investors, this is ideal.

In a period where growth is at a premium, growth stocks have led the way, particularly the last three years. Growth stocks are the stocks in companies that tend to have higher earnings growth, but usually trade at premium valuation levels. This era of investing is starting to resemble a combination of the dot.com ‘90s rally and the Nifty Fifty craze of the late ‘60s/early ‘70s where growth stocks ruled the day.

I’ll admit, I don’t remember what it felt like during the Nifty Fifty era. The era ended when I was just starting kindergarten. Still, anyone in this industry has read about its history…lest we are doomed to repeat it. The Nifty Fifty represented the premier growth stocks of the day. These were can’t miss companies and one decision stocks (buy and hold forever). Investors were encouraged to buy these stocks at any price. If you didn’t, your portfolio was left behind. It didn’t matter that the price to earnings multiple (a measure of value) on these stocks were twice the market’s multiple.

This is the part where you’re expecting to hear how badly it ended for all of them. Well, for some, it certainly did end badly. During the bear market of ’73-’74, a few lost up to 90% of their value: Xerox, Avon, and Polaroid – how could instant photos ever not be a worthy investment? During the next 45 years, nine companies would either go out of business (Eastman Kodak), find themselves on life support (Sears), or sold off in pieces (ever hear of Heublein? – a spirits company which had US distribution rights to Jose Cuervo, Guinness Stout, and Bass Ale). Sixteen other companies disappeared through mergers with five of them in the pharmaceutical industry. Those that remain are (mostly) still considered respected companies in their industry. From 1980 until now, an equally weighted portfolio of the 30 remaining companies produced an annual return of 10.7% which is fairly close to the S&P 500’s return of 11.3%. Of course, this analysis suffers from what is called “survivor bias.” Had you included all nine failing stocks, things wouldn’t look so good for these “can’t miss” stocks. Because I’m sure you’re curious, the best performing Nifty Fifty stocks since that time are Philip Morris (now split into Altria and Philip Morris International), PepsiCo, and McDonalds.

This brings us to today. A handful of growth stocks have been the spark in this stock market rally. Because pundits like “nifty” names, they came up with one for this era – The FANG (Facebook, Amazon, Netflix, and Google) stocks. This sounds cool, but it is kind of forced. There are really five very important companies to this rally, and Google changed its name to Alphabet which ruined the acronym already: Facebook, Amazon, Apple, Microsoft, and Alphabet (the FAAMA stocks?). Growth stocks took the lead in this rally beginning in 2014. In this 3 ½ year period, the Russell 1000 (an index of the 1000 largest companies in the US) expanded by $5.2 trillion or 26.4%. The FAAMA stocks contributed $1.4T of that total, or 27% of the entire increase and averaged a total return of 91.5% during the period.

If we add in a few more well-known high fliers [Tesla, Netflix, and Nvidia (they make 3D graphic chips for virtual reality and gaming systems)], the total contribution rises to $1.5T with an average gain of 99.6%. Those extra companies allow us to get a new acronym: FATMANNA. The old guard growth names in the Nifty 50/now 30 climbed $0.4T for an average gain of 12.4%.

A couple of observations on this group are worth noting. As earnings have not grown 100% in the last 3 ½ years, it is a mathematical certainty that their stock returns going forward will be lower, and probably by a significant margin. Secondly, all of those companies are technology companies, or at least very technology dependent in the case of Amazon, Tesla, and Netflix. This makes it feel more like the ‘90s tech rally. There are, however, very important differences to that time period. These companies all make money (with the exception of Tesla). Tech companies that don’t, or seem faddish, haven’t done well; Twitter and Snapchat have fallen over 30%. The FATMANNAs resemble the Nifty Fifty growth names in that they are dominant in their industries and are growing much faster than the market. Anxious of the slow growth environment, investors are willing to pay up for these stocks.

As an aside, I’d like to highlight one company that participated in both this rally and the ‘90s tech rally for an important point. Microsoft was as dominant then as any company today or in the past. They sell a high margin product that most people need with very high barriers to entry and an entire ecosystem built around them. The company traded at a multiple of 80x earnings in 1999. It was thought that they would take over the world. During the next decade, earnings grew from $7.6B to $20.7B. However, the price was too high, and the stock price actually fell 36% during this very profitable period. The point is that while investors were correct to identify this company as a very important, high growth company, there just comes a point where the price paid for the expected earnings growth is no longer justified.

How high is too high? Microsoft and Alphabet are at 33 times earnings with Facebook at 40 today. Amazon and Netflix are in the 200x range, and Tesla doesn’t have earnings. Apple is at a downright reasonable multiple of 17, but the company is nearly $1.0T large. In fact, if the first five companies I mentioned (FAAMA) were combined as one, it would be worth $2.9T in market capitalization. In order for it to grow 10%, it would need to add $290MM. To put that number in perspective, Wells Fargo bank is the 10th largest company in America, and it is only $260MM. In other words, in order for these five companies to grow just 10%, it would need to add a company the size of a 165 year-old bank to their collective coffers. There are limits to growth at that size unless these five companies do indeed take over America.

So what does that mean for investors today? We are not at the extremes of either the Nifty Fifty or the dot.com eras. Thus, there is room for this trend to continue. Having said that, in the long run, I can’t imagine the FATMANNAs returning above average returns at this point. The most likely scenario, in my opinion, is the rest of the world starts to catch up. International stocks should do better than US stocks as their economies finally start to grow. Also, more stocks in the Russell 1000 will rise to narrow the valuation gap. This should last until we start to see strains in the global economy. If the market does take an unexpected turn for the worst, I’d imagine the FATMANNAs will lead the way if for no other reason than these stocks are the most liquid and largest companies in the indexes that more and more investors are utilizing in their portfolios. Regardless, enjoy the calmness of this summer. We’ll keep looking over your shoulders for that 300-pound lineman.