In last week’s “Interesting Articles” email, we linked a post entitled “Mr. Market Doesn’t Care What You Think.” That article focused on the link, or lack thereof in many cases, between market performance and consumer sentiment. As markets move deeper into earnings season, we couldn’t help but think of that title again when it comes to the stories and sentiment surrounding three particular companies: Apple, Amazon, and Research in Motion, soon to change its name to Blackberry. Each of them has either reported earnings or made a big product announcement over recent days and weeks. All three have made stock moves in recent months that have confounded a wide range of pundits, bloggers, and analysts. We can’t think of many other names in the marketplace of late that have inspired as much debate. All are prominent brands with relatively long histories and, in the case of Apple and Amazon at least, very large market caps. In that respect, one would expect an intense spotlight. However, the intensity of recent moves in the stocks has ignited debates about fundamental stock picking and the efficiency of markets. When it comes to picking individual stocks (and thinking about broader market moves), there are lessons we can all learn from recent action.
First, let’s quickly recap the stories and recent moves.
- Apple, of course, rallied relentlessly for the past three years, moving from a low of near $100 per share in early 2009 and hitting $700 per share in late 2012. This past fall, Apple became the most valuable company in the world measured by market cap. Astronomical increases in revenue, profit, and cash flow fueled those gains. The company started paying a dividend under Tim Cook’s leadership. Even with the massive appreciation in share price, the incredible growth in revenue and income has kept multiples at what many consider to be “value stock” levels. Currently, the trailing 12-mo P/E is 10x, and trailing EV/EBITDA is approximately 5x. Of late, the stock has been under pressure; it’s fallen 36% percent since late September. This downward move has inspired an enormous volume of debate, with many incredulous that a company with such a strong fundamental backdrop can act so poorly, especially relative to the broader market advance we’ve witnessed over the past four months. This “frustrated” side represents the majority with many of its representatives citing the continued top-line growth, additional opportunities to return cash to shareholders, strong brand awareness, and, of course, the compressed multiples (“It’s a growth stock with value stock characteristics. How can this stock not go back up!”). The skeptics point to declining margins, increased competition, and the fact that year over year earnings increases have shrunk considerable over recent quarters.
- Research in Motion, the maker of Blackberry smartphones occupies the other end of the spectrum. The stock and the company’s prospects have been in relentless decline since the introduction and proliferation of the iPhone and Android mobile ecosystems in 2007 and 2008. Blackberry at one time was the dominant force in the mobile smartphone space with market share levels solidly north of 50%. Market share over recent years has fallen to approximately 2%. The stock price followed the trajectory of the business, declining from a peak near $140 to a low of $6.22 in late September. While revenue is still above levels seen in late 2008, owing to the strong growth in overall smartphone sales in recent years, EBITDA has been halved and net income has actually crept into negative territory. Since September, however, the stock price has doubled, even taking into the account declines this week after the announcement of their new smartphone operating system. Like Apple above, this move over recent months has generated massive debates over the nature of the move, especially from those looking at the fundamentals and pulling their hair out strand by strand. The frustrated, representing a majority, tend to believe the company will remain in a death spiral. This group has been absolutely incredulous when it comes to the recent stock move (“This company is old news! They’ll never catch up to Apple and Android! Nothing else matters!”). Of course, judging by the short interest in the stock, this group probably represents a good number caught up in a short squeeze. To those on the other side, the company still appears cheap; these folks believe that if Blackberry can just hold the line with the new operating system and maintain a number three position in the cell phone pecking order, that the stock could continue to rebound dramatically due to the large cash position, debt-free balance sheet, and compressed multiples/expectations.
- Amazon straddles the line. Without a doubt, Amazon has become a phenomenal brand and success story. Over the past several years, the company has moved away from the core book and music categories to deliver a wide range of goods from food to household items. They’ve established digital video and music stores to provide serious competition to Apple iTunes, Netflix, and other entertainment companies. Amazon Prime, which allows users to pay a yearly fee for free shipping and access to digital video streaming, has been an enormous help in building brand loyalty. Even though Amazon faces increasing pressure to pay sales taxes in various locales, they’re working to significantly enhance their distribution network. In some areas, rumors suggest Amazon wants to move decisively into same-day delivery. Revenue has more than doubled since the end of 2009. The stock price has moved in lockstep, from just below $50 in late 2008 to $265 currently. There’s been one little problem, however. EBITDA and Net Income growth have been lagging to put it mildly. Amazon continues to trade at very high multiples. Estimated P/E for the coming year is 85x. P/B is nearly 15x. EV/EBITDA is a very high 40x. An earnings report over the past week has reignited the controversy over the future trajectory over the stock. Similar to RIMM, a solid number of observers are extremely frustrated that the stock has continued to march higher even though the company consistently fails to deliver solid bottom line growth. This group cites increased sales tax collection initiatives, potentially better online competition, and, of course, extremely high valuation ratios as reasons the stock should decline. Proponents of the stock point to the massive top-line growth and Amazon’s increasingly dominant market share position in online shopping, not to mention its increasing mindshare in the overall marketplace. Likewise they point out that Amazon is wisely investing in the future and that profits will come in spades once the management vision is completely executed. The earnings report generated one of the better lines this week from one of those incredulous about its new 52-week highs. Blogger Matt Yglesias stated, “…Amazon, as best I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers. The shareholders put up the equity, and instead of owning a claim on a steady stream of fat profits, they get a claim on a mighty engine of consumer surplus. Amazon sells things to people at prices that seem impossible because it actually is impossible to make money that way.”
Again, all three above have tended over recent months or years to confound a significant number of critics and analysts, many of them well-respected practitioners of fundamental stock analysis. We’re not here in this particular blog post to make a judgment about the future direction of the above companies or the direction of their market prices. Instead, we’re here to again point out the fundamental truth at hand: no matter how logical the argument, no matter how obvious over or undervaluation, no matter how obvious it seems that a particular business model is the greatest or worst of all time, the market at large could care less. In the cases above, and in many other cases in the current market, prices have made moves that upend the apple carts for a majority of investors. Several famous market clichés tend to capture this truth: “Don’t catch a falling knife;” John Maynard Keynes famous line, “The market can stay irrational longer than you can stay solvent;” and, “What Wall St. knows ain’t worth knowing.”
As campy as some of the statements are, there’s a lot of truth here. Watching the stocks above run against the consensus logic, which in many cases is sound, leads us to several conclusions that investors need to keep in the back pocket.
- Momentum is a powerful force in the marketplace.
- The above may sound obvious, but there are some interesting observations about market structure behind this statement. The overall market is heavily influenced by the activity of large institutional investors, from mutual funds to hedge funds. Most of the people managing funds are incredibly capable and logical analysts with many years of experience investing in public equities. Nonetheless, the professionals driving much of the market movement (and even a good number of the “machines” increasingly engaging in investment activity) are just as subject to the same biases and psychological errors witnessed across a wide range of human activity. There’s no need to talk about all the behavioral quirks here, but there are some that stand out. Prominently, managers are subject to herding behavior. As a stock moves higher, for instance, and generates positive performance, it’s easy for investors, individual and professional alike, to justify jumping on the bandwagon. Upside performance, such as that seen over recent years in Apple and Amazon, generates numerous positive articles in the mainstream press pointing out the performance and in many cases providing reasons why performance can only continue to improve. In the earlier phases, valuations are usually reasonable providing cover. Managers are cognizant of the public press and of the fact that their individual investors are attuned to the performance of these particular companies. It becomes important to have the high-flyers in the portfolio to show investors that one is clued into “what’s hot” in the marketplace and business community. Or, simply, the “missing out” component in the brain ignites pushing investors into the stock. Either way, massive flows of capital move in that direction. Confirmation bias creeps in. Managers and individuals begin to ignore any evidence that runs contrary to their position and focus entirely on evidence that confirms the thesis. As price continues to climb, and this became an issue with Apple, the stock becomes a bigger and bigger piece of a benchmark index leading other investors to add to the allocation simply to keep up with benchmark performance. Price/performance takes on a life of its own. In general, this is referred to as a stock under “accumulation.”
- Of course the same thing happens in reverse, leading to institutional “distribution.” The story changes, usually due to some sort of catalyst (unexpectedly bad earnings report, corporate action, etc.) leading institutions to begin selling the stock and taking profits. In Apple’s case, the Q3 earnings report and the maps debacle changed sentiment. As witnessed during the buy phase, the initial move is most likely justified by the fundamentals, but price movement takes on a life of its own. It doesn’t help that the stock is often trading at lofty multiples and resting on a weak market foundation. Managers only see the negative stories from this point forward. Unlimited prosperity becomes “death spiral.” News coverage becomes unrelentingly bad and managers don’t want investors to see any traces of the position in their portfolios. Stock performance becomes dreadful, in many cases exceeding anything logical relative to the true business prospects. Once again, it takes a catalyst to arrest the decline. For RIMM, this was a better than expected earnings report for Q3 followed by news that the new operating system would be unveiled on time.
- To close with the RIMM/AAPL example and show how quickly momentum can change, within a few short months in late 2012, the AAPL story changed from a company that could do no wrong to a company that couldn’t get anything right, even though nothing had fundamentally changed at the product level. Snafus like the maps issue became prominent whereas during the up phase snafus like “antenna-gate” were largely ignored by investors. RIMM, on the other hand, went from a company with a relatively small user base, poor technology and execution, and no prospects whatsoever in the press and analyst community, to one with a contender on its hands, “innovative” operating system, and a “solid base” of users to upgrade. Again, like Apple within weeks headlines that would have been framed in a negative context were written with positive overtones.
- Following from the above, markets are definitely not truly “efficient” in the short or even intermediate term. Market efficiency debates have been a prominent part of the discourse in finance disciplines for quite some time and there’s no way to even begin to hash out the research on this. Watching companies and markets trade on a daily basis, however, it’s quite apparent that asset prices can become quite unhinged from intrinsic value to the up and downside and (as the above bullet implies) emotional investing impulses can significantly override logic and good sense. In the late 1990s, many technology stocks traded at multiples that could never have been justified by any rational model, yet they continued rising for months and months. Moving away from stocks, we witnessed this disconnect in the housing market in the mid-2000s; there were many analysts screaming from the rooftops that the assumptions justifying high price ratios relative to historical mean were bunk and completely unrealistic. That didn’t stop people from lining up as far as the eye could see to buy unfinished condos. In any case, placing too much faith in market efficiency and logic can lead to very poor investment outcomes. Perhaps you though Amazon was extremely overvalued in 2010 (it was by many traditional conventions) and shorted the stock or sold a position. This would have cost the investor a pretty penny. Similarly, buying RIMM in early 2011 when it was near $50 may have seemed like a decent prospect trading with the stock trading at 12x earnings and an EV/EBITDA of 7x; this would have cost you 80% of your capital over two years. Over the intermediate to long-run, the fundamentals tend to work themselves out and markets seem to demonstrate efficiency. Many of the individual stocks trading at astronomical multiples during the tech boom fell dramatically in price, many never having reclaimed prior peaks. Looking at a broad market, the Nasdaq still trades approximately 40% below its early 2000 peak. Housing prices eventually collapsed, but are now much closer to median multiples witnessed over the historical record. The time it takes, however, for the market to come to its senses can be long indeed.
- If markets and stock prices can be inefficient momentum machines, chewing up logical analysis like a dog bone, what’s an investor to do? Knowing that momentum and price inefficiency can combine to create harrowing outcomes for investors, it’s important for investors to develop some semblance of a rules-based approach when investing. Some fundamentally-oriented investors still incorporate technical trading rules into the investment process to impose discipline, for instance. As we’ve seen a cheap stock can become demonstrably cheaper; perhaps a technical rules based approach can orient an investor to exit a position until more favorable momentum climes develop. Some investors incorporate rules such as stop-loss tactics. These types of rules aren’t guarantees that frustrating outcomes won’t occur, of course. There’s nothing more frustrating than getting stopped out of a position, only to watch prices reverse course and shoot to the moon. Rules can work in reverse as well. Technical trading rules can help investors maintain discipline, keep winners in a portfolio, and capture upside. For those investors not inclined to incorporate these tactics, simply observing certain portfolio management conventions can prevent poor outcomes. For instance, one could adjust position sizing to fit relative risk tolerances. For the more risk averse, smaller positions sizes and higher diversification levels lead to less anxiety if the forces above push heavily against the investor’s tip-top analysis in a particular stock. On the flip side, setting explicit price or multiple targets can help maintain discipline and define exit points for winners. Whatever the case, the ultimate idea is to suppress the behavioral biases and emotional responses that contribute to bad outcomes.
Platforms like the blogosphere and Twitter provide an interesting real-time observation deck to view the frustrations and emotional responses of investors in companies like Apple, RIMM, and Amazon when stock price movements aren’t following the consensus logic. As described throughout, price movements can cause a considerable amount of intense, emotional debate about “who’s right” and “who’s wrong” in particular situations. This shows up sometimes in raw emotional outbursts on the various social platforms. To borrow the phrase again, Mr. Market doesn’t care. As an investor, throwing up one’s hands in frustrating and shouting at the market-at-large only exacerbates negative outcomes. Investors need to enter every position with a clear plan as to the justifications for the position (valuation etc.), potential outcomes and targets, and plans for exit under various circumstances, positive or negative. This type of action plan helps cut through the considerable noise out there, impose discipline, and keep reasonable losses from becoming much larger losses.
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