Stocks were essentially flat yesterday as there were few earnings reports of note. Economic data was also light and what there was confirmed a slow growing economy. Over the past several weeks, the yield curve has both steepened and risen, a sign the bond market predicts a slightly better economic environment moving forward.
Recent market weakness, tied to fears of an escalating trade war, had lowered the prices of some stocks to levels that discounted most of the bad news possibilities. Jim Cramer of CNBC likes to use the acronym NABAF, a short version of not as bad as forecasted. A perfect example yesterday was Honeywell# which reported slightly lower than expected revenues and reduced the high end of its forward guidance by a bit. But the stock rose 2% because its results were NABAF. That didn’t protect everyone, however. IBM# managed to once again disappoint on the top line, although financial engineering and lower taxes allowed it to meet earnings forecasts. IBM has played this tune so many times that investors are tired of listening to it. Despite the better than expected results from the recent acquisition of Red Hat, IBM’s legacy businesses continue to fall. When a corporation makes a decision to underinvest in its core operations, everyone, especially customers, can see what is happening.
Technology is forcing more rapid change. Good managements recognize the impact and are changing as rapidly as they can. A big company like Coca Cola# can’t change on a dime but management has exited the low growth and capital intensive bottling business while focusing on reenergizing existing brands and developing new products. It has had notable success in the process. Contrast that with Kraft-Heinz which tried to grow earnings by cutting costs (that sounds like the IBM tune) instead of reinvigorating its product line focusing on organic and/or plant-based protein that younger generations love. I’m probably still a sucker for Kraft Macaroni and Cheese, but I haven’t actually had it in years. Macaroni and cheese will never lose its popularity but the Kraft brand will.
As investors, we all see these changes. I will give you another personal example. My wife wanted to buy a new bedding set, sheets, pillowcases, shams, etc. The whole nine yards! Bloomingdale’s was having a big sale so she went on line Sunday night and placed an order choosing free 3-5 day shipping (yes, Amazon fans, I said 3-5 days). Last evening, she got two emails stating that the sham covers and the top sheet were unavailable. Any questions, she should call the 800 number. She did and got to someone fairly promptly. So far, so good. Why it took four days to determine it was out of stock wasn’t explained. The parts of the order that hadn’t shipped could be cancelled but they couldn’t cancel the pillowcases or the sham insides that had already shipped. She could take them back to a Bloomingdale’s store for a credit instead. OK, that isn’t totally bad, and it might have even been considered good service a few years ago. But in a world where Amazon will ship in 2 days, soon going to one, it becomes a non-competitive solution. It is a perfect example of a two-horse race where the leader just continued to gain ground even though the trailing horse might be running faster than it ever ran. It also explains why Macy’s stock is acting so badly.
But the story doesn’t end there. The so-called FANG stocks were the darlings of Wall Street in 2017 and 2018. Amazon is the A in Fang. It’s earnings this year are doing just fine. But its stock is a notable laggard. Its shares are essentially flat year-over-year. It is a simple story of valuation. Amazon’s shares simply rose too far too fast. One of yesterday’s winners in the market was Netflix which reported international revenues Wednesday night that were better than expected, but an 8% gain in late Wednesday after market trading, faded to a 2% gain by yesterday’s close and 24% lower than its 52-week high. In contrast, the overall market is up close to 20% this year and is only 1% from its all-time high.
Amazon and Netflix actually look rather healthy compared to some of the real high flyers that caught investor fancy earlier this year. We all know of the failed offerings by Lyft and Uber. But it is noteworthy as well to look at some of the winners. There probably has been nothing more exciting than Beyond Meat, a stock that rose over 6-fold from its IPO price despite no earnings. But by yesterday’s close, it was more than 50% off its high. Yet its valuation remains non-sensical. Slack first traded in mid-June at $42. This maker of collaborative software is growing fast and losing share to the market leader, Microsoft#, at the same time. Yesterday, it closed at $42. We (formally WeWork) wanted to go public with a $50 billion market cap. It didn’t happen. Today it is trying to stay alive and sell new equity at a quarter of that valuation.
Some might say the bubble has burst. I would argue, the balloon is only starting to deflate. Winning concepts are not necessarily winning stocks. If Uber wants me to pay half of what is needed to cover costs to get where I want to go, why shouldn’t I accept the ride. The company offers a great consumer value. And as long as investors are willing to fund the losses hoping for some holy grail years down the road, Uber will make a lot of consumers happy. But as we see with We, that picture can change very rapidly. Both We and Uber are now exiting new ventures that were money pits. Eventually, Uber will have to raise prices or run out of money. When it raises prices will it keep all its customers? Netflix has persistently raised prices to fund production costs. But now with Apple# and Disney# about to launch competitive services at half the price of Netflix, can it keep raising prices? If not, can it become cash flow positive any time soon?
It is very hard to marry great concepts with great execution with a viable economic model. Microsoft certainly did it with Windows, and later with applications software that ran on top of Windows. Apple did it with MP3 music players that soon morphed into phones. These companies found enormous addressable markets and could make great profit margins almost immediately. Facebook# and Google# are two other obvious examples. But there are precious few that actually can combine product or service consumers crave with an economic model that delivers extraordinary returns.
But every cycle, companies try. They seek the pot of gold at the end of the rainbow. But if I take you back to 2000, when the Internet bubble burst, I can only name you two companies that you might have owned then that would have done you proud 20 years later, Amazon and Microsoft. And your annualized return on Microsoft from the 2000 peak would only be about 3%. Everything else either died or is worth less today. Even Intel and Cisco#.
When the balloon deflates it doesn’t take long for all the air to come out. Many of the names now 25-50% off their 52-week highs have a lot further to go on the downside to get anywhere near something one could call fair value. Over the next several years, quite a few will disappear altogether. That doesn’t mean there can’t be intermittent rallies, even sharp ones. But I would suggest that most of these high flyers have seen highs they will never see again.
If investors start to flee these names, where will they go? In the short run, they could go to money market funds. Bonds don’t seem particularly attractive alternatives. In 2000 they went to Smokestack America stocks. Indeed, since the China-U.S. trade truce, the best acting group has been the industrials. The so-called safe stocks, including utilities, REITs, and consumer staples, have already had great runs as interest rates fell toward 1.5%. So, they can move higher as long as their earnings and dividends grow at or above average rates. But if the U.S. economy is going to improve and growth is going to get a nudge from lower rates, I suggest the cyclicals and financials will get more attention.
Today, Lindsey Vonn is 35.
James M. Meyer, CFA 610-260-2220