We continue our blog series: Market Musings, Volume 2, Edition 8, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "The Question of Conservatism (in Investing)".
Back in the Stone Ages, or in January 1962 to be more precise, a manager of a small investment partnership sent his limited partners an update on the performance of their partnership for 1961 (for those curious, it was up 46% versus up 22% for the Dow Industrials). The manager had recently turned 31, yet professionally was wise far beyond his years. Indeed, those lucky enough to buy into his investment partnership early on became rich beyond their wildest dreams and, decades later, the manager would become one of the world's wealthiest people. Of course, we are talking about none other than the Oracle of Omaha, Warren E. Buffett (the above picture shows him teaching an investment class for adults at the University of Nebraska at Omaha around the referenced time period). In the 1961 partnership letter, Buffett included a section headed "The Question of Conservatism", which contains the following paragraphs:
Conscious, perhaps overly conscious, of inflation, many people now feel that they are behaving in a conservative manner by buying blue chip securities almost regardless of price-earnings ratios, dividend yields, etc. Without the benefit of hindsight, I feel this course of action is fraught with danger. There is nothing at all conservative, in my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.
You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism. You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.
I might add that in no way does the fact that our portfolio is not conventional prove that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results.
The more things change, the more they stay the same. Recently in markets we have again seen many investors bid securities up to absurd levels "regardless of price-earnings ratios, dividend yields, etc." Indeed, in many instances investors are attempting to justify higher stock prices based on the amount of money the company loses (not earns). Yes, that's correct, in this bizarro investment world the more losses a company generates and the more cash a company burns, the higher its stock price deserves to be, based on the dubious assumption that burning more cash means that management expects more "growth" ahead. "Growth" has been the market's mantra over the past few years: growth, growth, growth--not necessarily growth in earnings, mind you, but above all growth in revenues and, oftentimes, cash burn and losses (hey, it's still "growth").
Below we present recent earnings (using that term loosely) results for two companies that aptly exemplify this strange phenomenon (all amounts in $000):
Company A managed to lose $350MM in Q4 of 2017 and a grand total of $3.445 billion (yes, with a "b") for the year. Both amounts were far worse than the corresponding 2016 figures. Taking a look at the statement of cash flows, this was likewise atrocious:
Company A burned through $735MM in cash from operations in 2017, over $120MM worse than the prior year. It also spent far more on capex and acquisitions than in 2016.
Using any traditional investment measuring stick, the foregoing numbers would be considered truly horrific results. Yet when Company A reported these figures to the market several days ago, its shares skyrocketed nearly 50%. Was Company A's equity previously valued by the market at a de minimus amount, which perhaps might justify a brief, but minor, price spike upon reporting higher revenues year over year? Hardly. Before the 50% explosion in the share price, the fully-diluted market cap of Company A was over $17,000,000,000. For some strange reason, the market in its infinite wisdom upon receiving these amazingly dismal (to us) results, decided to mark Company A's already steep market cap up by over $8,000,000,000(!). Why, you ask? Well, Company A increased its number of product customers (aka "active users") more than expected, and thus "growth" (there's that word again) has supposedly been "reignited". (Note that the market does not appear to care at all about that the fact that expense growth has likewise been reignited.)
Company B managed to grow net losses by over $550 million in Q4 2017 versus the prior year's fourth quarter. For all of 2017, Company B managed to lose close to $2 billion for its shareholders, or nearly 400% the amount of 2016's annual losses. Below is the statement of cash flows for Company B:
While on the surface it appears that Company B's operating cashflow improved immensely in Q4 2017 versus prior quarters, almost all of the improvement was due to the "Changes in operating assets and liabilities" category, which is not indicative of underlying operating performance. For 2017 overall, despite working capital improvements generating nearly $500MM in cash, Company B still managed to burn cash on an operating basis and consumed an incremental $4 billion in cash from investing activities versus the prior year. Again, these results should hardly make a normal, sane investor rush out to buy shares. Yet, Company B inexplicably sports a fully-diluted market cap of over $55,000,000,000(!). Much as with Company A, the market has been relentlessly cheering Company B's "growth" (in revenues), while completely ignoring the massive recent growth in losses and negative cashflow (ex-working capital changes).
So, what is the identity of each of these market darlings? Company A is Snap Inc. (SNAP) and Company B is Tesla Inc. (TSLA). Interestingly, today both companies appear to be out of favor with the market, indicating that maybe, just maybe, our long national nightmare of bizarro market behavior--where up is down, black is white, night is day and terrible earnings and cashflow are bullish--may finally be nearing an end (and, if so, when it comes to investing Buffett will be proven right for about the 1,846th consecutive time):
DISCLOSURE: Short TSLA and SNAP.