Nah…you just ain’t seein’ the ball

When I hear someone mope “the market doesn’t care about fundamentals” I change the channel.

Market prices are a collection of point spreads. I don’t really understand the logic of such an argument.

If the relationship between fundamentals and returns were easy to understand in advance, then price would adjust to make the trade hard. A “cheap” company that stays cheap is implying a low future ROIC. If you buy shares and the company is able to find better opportunities to re-invest its capital than what was implied, you’ll win.

But it’s going to take time to find out. You can’t make a statement like the “market doesn’t care about fundamentals today”.

Moaning that NVDA is unmoored to fundamentals, besides being underperforming-the-index cope, is comparing something you can see (a price) to what you can’t (what happens later). The price itself is mostly driven by the future. You can’t evaluate if the price did a good job until the later happens.

And even then you can be fooled.

In my early SIG days I remember Jeff gave a talk arguing that the dot com boom then bust wasn’t irrational. You only needed to look at the options market to see why.

A price is just an expected value — if the underlying distribution is highly uncertain, exactly as you might expect the distribution to be in 1999 when the internet and fiber promised to change the world. The price of dot coms are bounded by zero so they have no choice but to go through the roof based on such world-changing mathematical expectation. But option surfaces make higher resolution statements than the 2-D nature of a share price. [See the Market Innovation section]

AMZN used to be a 250 vol name. Stick 250 vol into a 1-year option price and look at the difference between the mean and median expected stock prices (median = geometric mean)

The options market said the stock was probably worth zero.

[Relevant reading: this post about the windowmaker is a lesson in what option butterflies mean]

And the options market was right for many of the dot-coms.

In fact the AMZN we are familiar with today is a delightful justification of the prevailing pricing back then — some company is going to reach breathtaking proportion if this tech is as important as we think. We just couldn’t predict which one. And in fact, owning the basket and following a index rebalance algorithm that sheds the losers (aka the Nasdaq index) worked out just fine because AMZN made up for Pets.com.

[Fun fact: iirc, AMZN did end up trading down to the implied mode, ie the most expensive butterfly, in the early 2000s washout.]

You can disagree with share prices. Your portfolio is how you disagree. And when the “later” happens you’ll find out if the future fundamentals were well anticipated by the today price.

I’ll be blunt. When I hear investors bitch about prices vs fundamentals I just hear a confession. “I can’t see the ball clearly anymore.”

Which is exactly what you should expect to happen in a competitive red queen domain unless your learning rate increases faster than the market’s lesson-internalization script runs.

Competing for provable alpha, the type that sits on many reps lending itself to statistical summary, means playing the trading game. Finding mispriced coins that will be flipped in the short term. Similar to arbitrage-inspired trading where futures and options expirations are a catalyst for convergence between prices and reality.

The competition for provable alpha is fierce. However the focus does open the door to alphas from having a long horizon. Long-term investors call this “time arbitrage”. That’s more of a clever marketing term than an investing phylum but it does hint at the reality of investing. (The fact that there is alpha in having a long-term horizon is also convenient cover to say “ignore our short term results”.)

You are unlikely to find the kind of provable alphas that are easy to raise money for. In fact, most investors who have such alphas don’t need or want your money. The “time arbitrage” people will happily take your money though. And you won’t be able to prove if they have alpha (otherwise you’d never hear from them), but this also means it’s the only chance you have of investing with someone who has an edge.

You just won’t know until later.

And even then you might still not know.

[Unless they boot you as an LP. Then you definitely know.

“Wait so if I pick the best horse my reward is being asked to redeem?”

Sorry, there’s no luxury more protected than a sure-fire compounding machine. You can buy your way into almost anything else from sex to a trip through space — but if you try to buy your way into a money copier the price adjusts until the ink runs out.

(Actually, as “strategic” investors know, you can buy your way in with other ways to add value. But nobody’s money is greener than another’s.)

A couple pieces I’ve read recently suggest market prices are doing their job. And also enlightened me on a significant (and not what I expected!) reason for “value” underperforming.

[Emphasis in the excerpts is mine]

• Total Shareholder Return Linking The Drivers of Total Returns to Fundamentals
  by Michael Mauboussin

A terrific paper by one of my favorite researchers.

From the conclusion:

Total shareholder return (TSR) is the capital accumulation rate for investors who reinvest dividends at no cost. TSR is a popular return measure despite the fact that few investors earn it for the stocks of companies that pay a dividend. Investors fail to earn the TSR because they do not reinvest the dividend or cannot reinvest the full amount due to taxes or other costs. Price appreciation and the capital accumulation rate are the same for the stocks of companies that do not pay a dividend, which includes about 65 percent of U.S. public companies.

We can break down TSR into drivers, including net income growth, change in shares outstanding, P/E multiple change, and the benefit of reinvesting dividends. We examine each of these drivers and link them to underlying economic principles.

It is useful to think about the value of a business in two parts: a steady-state value and the prospects for future value creation. The steady-state value assumes that the company can sustain its current earnings forever. Future value creation reflects the ability to earn a return on invested capital in excess of the cost of capital, the amount of investment the company can make while maintaining a positive spread, and the length of time a company can create value with its investments. Historically, about two-thirds of the value of the S&P 500 has derived from the steady-state value.

The market determines the appropriate P/E to apply to current earnings through an estimate of the cost of equity capital. The cost of equity is the opportunity cost of equity investors and is commonly estimated by adding an equity risk premium to the risk-free rate. Over the past 60 years, the steady-state P/E has gone from a low of 5.1 in 1981 to a high of 17.7 in 2020.

The multiples of companies with high P/Es tend to regress toward the steady-state P/E over time because the relative contribution of future value creation shrinks. This reflects market saturation and competition. Some companies can defy this downward drift by either sustaining a high return or by investing in new businesses.

Investors often consider dividends to be part of total returns. But for investors using TSR, price appreciation is the only source of investment return that contributes to accumulated capital. Indeed, dividends and share buybacks have the same result in a TSR calculation because they both increase the percentage ownership in a company. In the case of dividends, the investor uses the proceeds to buy more shares at the ex-dividend price. In the case of buybacks, the investor does not sell and hence winds up with a higher percentage of the company. These are equivalent, save for the reality that dividend reinvestment generally has a cost (see appendix A).

Value traps exist when a company appears statistically inexpensive, often based on the P/E as compared to the stock’s past or to the market overall, but the future drivers of TSR perform poorly. The two main culprits in the bad results are growth below the average and P/E multiple contraction that captures fleeting or elusive prospects for value creation.

We explain TSR through drivers including EPS growth and changes in the P/E multiple. We have noted the severe limitations of EPS and multiples to explain value. To compensate, we seek to link these concepts to underlying fundamental drivers. Doing so gives investors and executives a framework to understand the past and to anticipate the future.

We decompose the returns for value and growth stocks in recent years.

Excerpts of note:

• Autocorrelation in net income growth is -0.10 for 1 year, -0.20 for 3 years, and -0.28 for 5 years. This is consistent with the academic literature that shows low persistence in net income growth. These results show that extrapolating past net income growth into the future is rarely a good idea.
• The presumption that buybacks always increase EPS is incorrect. The common portrayal is that net income is divided by fewer shares, which automatically leads to a boost in EPS. This simplistic analysis neglects the fact that the company has to fund the buyback, either with excess cash or additional debt. Excess cash generates interest income, and debt comes with interest expense. As a result, buybacks affect net income as well as shares outstanding.
• Appendix A: Dividend and Buyback Equivalence—Think Percentage Ownership
  • Dividends and buybacks have the same impact on corporate value. But executives think of them very differently. They consider dividends to be a commitment tantamount to capital expenditures and buybacks as a way to return excess cash after they have paid all of their bills and made of all of their investments.
  • In practice, dividends and buybacks are different because of tax consequences and the impact of gaps between stock price and value. But to understand TSR, the central distinction is between actively or passively increasing the percentage ownership in a company.
• Decomposing TSR for Value and Growth Over the past 15 years or so, “value” stocks have provided substantially lower Total Shareholder Returns (TSRs) than “growth” stocks. Value stocks are those with low multiples of price to sales, earnings, and book value. Growth stocks are characterized by above-average sales growth, high Price-to-Earnings (P/E) ratios, and positive stock price momentum.
  The S&P 500 Value Index tracks the investment return of large-capitalization value stocks in the S&P 500. The index includes about 400 stocks that have an average market capitalization of $60 billion as of September 29, 2023. The S&P 500 Growth Index draws about 235 stocks from the S&P 500 that qualify as large-capitalization growth. The average market capitalization was $110 billion at the end of the third quarter of 2023. The stocks of numerous companies are in both indexes.
  Exhibit 16 shows that the annualized TSR from 2007 to 2021 was 7.6 percent for the Value Index and 13.3 percent for the Growth Index. We end in 2021 in order to use forward P/Es, but the value index still underperforms the growth index by 330 basis points annualized if we include the returns from 2022.We can compare the drivers to see why the results varied. Companies in the value index grew their net income at a 5.2 percent rate during the period, a little slower than the 5.9 percent rate for the members of the growth index. But the translation from net income to Earnings Per Share (EPS) was impeded by net equity issuance among the value index constituents and aided by equity retirement for the companies in the growth index. As a result, EPS rose 3.3 percent per year for the value index and 8.0 percent for the growth index.
  Both indexes enjoyed P/E multiple expansion, although the contribution was 1.6 percentage points for the value index and a larger 3.6 percentage points for the growth index. Interest rates dropped over this period and growth companies have longer implied durations, a measure of the weighted average time investors have to wait before they receive cash flows. Assets with long durations are more sensitive to changes in real interest rates than those with short durations. The growth index likely benefited more than the value index when rates dropped during this time.
  The sum of EPS growth and P/E multiple expansion led to price appreciation of 4.8 percent for the value index and 11.6 percent for the growth index. Those drivers explain most of the TSR difference between the indexes.
• When governments tax dividends and capital gains at the same rate, as is the case in the U.S. in 2023, the decline in the stock price is roughly equivalent to the dividend. If taxes on dividends are higher than those on capital gains, the decline in stock price will be less than the dividend.

Pods, Passive Flows, and Punters
by Drew Dickson

Excerpt:

I am as convinced as ever that, eventually, it is the fundamentals that matter. Eventually, the market is a weighing machine. If you want some evidence – even from some of the most iconic, well-followed, index-heavy, retail-engaged, pod-owned, successful companies, it is still, eventually, about the fundies.

Let’s take some of the winners as an example. And by winners, I mean game-changing, world-dominating winners.

You’ve surely noticed what has happen to Nvidia lately. We used to just call these winners FANGs, and then FAANGs and then FAMANGs, but Nvidia has insisted on joining the league table. It now has a $1.7 trillion market cap. And in the last five years, the stock is up about 1,700%. Guess what else is up about 1,700%?

Nvidia’s earnings estimates.

How about Facebook, aka Meta, which goes through periods of hatred and love with equal vigor? Well, over the past seven years it has bounced around a lot but still has generated nearly 260% returns. And forward earnings projections? They’re up 280%.

We can stretch things further back, and look at Google over the past 14 years (earnings up 885%, stock up 980%); or Amazon during the same period (earnings up nearly 2,500%, stock up about 2,800%).

Or we can go waaay back and analyze Microsoft over the past 22 years. Forward earnings projections have increased from $0.93 in February of 2002 to $11.57 today. That’s nearly 1,150%. The stock is up just over 1,200%.

And finally, from one of my favorite former-CEOs Reed Hastings, we have good old Netflix. About 18 years ago, analysts were forecasting that Netflix would generate 11 cents of earnings in the coming 2006 year. Here in 2024, they are forecasting a whopping $17 of earnings in the coming year. That is a whopping EPS increase of 14,889%.

And how about the stock? We’ll it is up a whopping 14,882%.

Fundamentals matter, sports fans. Fundamentals matter.

Admittedly, some of these examples above are very long-term, but even when we self-select with some of the biggest, most exciting, long-term winners out there, and ignore the losers (of which there are many), it is still clearly apparent that it is the fundamentals that matter most.

So basically, it probably isn’t terrible advice to ignore the rest of it. Ignore the noise. Ignore the talking heads on CNBC. Ignore prognostications of meme-stock sith lords. Ignore the volatility. Embrace it, actually. And just focus on the fundamentals. Get those right, and you will likely win.

Can you take advantage of it? Can you take advantage of the noise?