Instrument Flying
To say this has been an interesting year for the market would be an understatement. After the swoon in March due to the pandemic, we recovered the entirety of the downturn and then some. There have been only a few market declines of similar magnitude over such a short timeframe, and the abruptness of the snapback has surprised many, especially given what are likely to be longer-lasting effects on the economy from COVID-19. To be certain, fiscal and monetary stimulus have played a significant role in supporting the economy and aiding the market’s recovery. Interest rates have declined, helping make the case for higher P/E multiples. Lower interest rates reduce the rate at which future cash flows are discounted, raising asset prices in general. However, while a portion of the recent rebound in stock prices looks to be justified, it has been accompanied by some harder-to-explain moves in certain individual stocks, and for that matter certain other assets.
Though more traditionally discussed in relation to bonds, the concept of “duration” similarly applies to stocks. Duration is a measure of the weighted average of when investors receive their cash flows. Though the risk profiles generally differ, stocks and bonds are fundamentally similar. Each produces a stream of cash flows; however, unlike bonds, which have contracted payments over preset intervals, the “payment” on stocks is less certain. Assets that are longer duration are more sensitive to movements in interest rates, deriving greater benefit from lower rates and alternatively selling off more when rates rise. Stocks generally have a longer duration than bonds, and among stocks durations will differ as a result of the anticipated cash flows.
As interest rates have declined, fast-growing companies with large addressable markets have done disproportionately well. These companies are viewed as extremely long duration assets as each is relatively early in building its market share, with the bulk of cash flows coming many years down the road. Most of them operate at a loss, and some even have negative cash flow. Whether there is a path to profitability in the near term has become a secondary concern at best. The decline in interest rates this year means companies with the potential to become a significant player within a large addressable market are experiencing very favorable conditions. Furthermore, the market is ascribing a high probability of future success to seemingly any company meeting this description. P/E multiples do not even apply for many of these companies as they possess no current earnings.
To illustrate, I have chosen just a sampling of companies that fit this ultra-long duration classification. This is not to comment on what I believe is the ultimate chance of success or failure for any of these companies individually, and undoubtedly some will be successful.
This sample includes: Netflix (streaming entertainment +45%), Zillow (online home buying/selling +108%), Carvana (online car sales +79%), Wayfair (online furniture sales, +221%), Tesla (electric vehicles +428%), Zoom (video conferencing +545%), DraftKings (online gambling +417%), and Peloton (home fitness +216%). The list could continue, but the point is hopefully clear.
The blanket outperformance of companies meeting this categorization is suggestive of some excesses in the market. Each faces unique opportunities and challenges, but the category as a whole has been bid up significantly since the start of the year. This lack of differentiation is at least worthy of a raised eyebrow. There are other indications as well that investors have thrown caution to the wind. Individual stocks have responded very favorably to relative non-events such as stock splits. Seeing market capitalizations grow meaningfully in response to a split announcement—in some cases by billions of dollars—makes no sense given the minimal economic value added.
We have also seen a significant increase in Special-Purpose Acquisition Companies (SPACs). These are “blank check” shell companies that attract investor money by listing as a public company with the intention of acquiring another company within a defined period of time, typically a two-year period. The structure is particularly attractive for SPAC sponsors who raise the initial money and choose the acquisition target. More than 80 SPACs have gone public this year, raising a record $30 billion, and more are on the way. SPACs are viewed as an alternative way for companies to go public and avoid the scrutiny associated with IPOs. Historically, the average return on SPACs has been negative, but the significant flow of money into SPACs is suggestive of at least another area of the market that may be getting a bit overheated.
Signs of excess have also spread beyond traditional assets. The Wall Street Journal recently had an amusing article discussing inflation in rare plant prices. Interest in plants has increased during the pandemic, which has in turn led to an increase in plant “flippers.” One individual in the article said, “it’s better than the stock market. I got a bunch of these plants when they were in the double-digits, and now they are in the four-digit realm.” A grower who runs a plant store in Florida who recently sold a rare plant for $3,500 was quoted saying, “Nothing’s making sense anymore… it’s gotten out of control.” Google “tulip mania” for historical context.
Despite the quote from the grower and the other examples I highlighted, I don’t believe the overall environment is completely bonkers or that we are primed for an imminent selloff, although I can’t make sense of certain pockets of the market. My father was a pilot in the Air Force who would often give advice in the form of flying analogies. One that has stuck with me was the concept of instrument flying. If the conditions are such that flight by outside visual reference isn’t safe, the pilot is trained to navigate via reference to instruments in the cockpit. His example was more directed toward a teenager in terms of trusting your moral compass when your environment gets complex, but I believe it has broad application, including investing.
There is a lot currently going on outside the cockpit windows, enough to cause confusion. The pandemic has introduced uncertainty. We have experienced both fiscal and monetary support that has led to rapid appreciation in certain investments from public equities to plants, and we have a major election on the horizon. Areas that the market is currently rewarding are worthy of further investigation to determine investment merit. However, we will continue to do our best to determine investment worthiness using the tried-and-true instruments that have proven to be key ingredients to long term success. Our focus will remain on owning growing companies with strong balance sheets, solid competitive positions, and attractive valuations. This is what we expect will best serve our clients over time.
James M. Skubik, CFA