Stock investors in the U.S., more than most, have a history of attaching a premium value to stocks of companies who are viewed as ‘visionaries’!  Some examples in the past have included Bill Gates of Microsoft, John Chamber at Cisco and Jack Welch at General Electric.  All those CEO’s took their companies to great heights, with each of them becoming the largest stock in the U.S. market at one point in their growth trajectory.  The problem with these ‘hero status premium valuations’ is that when the growth slows down, which it inevitably does, then the stock suffers a double whammy from both the slowdown (or decline) in earnings and the implosion of the earnings multiples.  We saw that in each of those.  Microsoft fell over 75% in value from the peak in 2000 to the 2009 low, despite the fact that earnings actually increased over that period.  Cisco suffered from even a sharper drop, falling by almost 90% from the tech bubble peak in 2000 to its low three years later.  Even GE, despite its more stable business of selling lightbulbs and power generators, fell over 90% from its peak in 2001 to its 2009 lows, driven in large part by a failed expansion into financial services.

Today we are seeing a repeat of this syndrome, with an even higher level of peak valuation, highlighted by a new round of ‘stock market heroes.’   Elon Musk (Tesla), Jeff Bezos (Amazon) and Reed Hastings (Netflix) have taken on the mantles of ‘visionaries’ in the eyes of investors as they grow business that are viewed as ‘disruptors’ in their respective industries.  This has created an additional level of risk for these stocks in our view since none of those three companies are generating cash flows in excess of cash usage, and all are using significantly more amounts of cash to build their businesses.   Stock investors are clearly giving them the ‘benefit of the doubt’ for now by attributing valuations to these stocks that are far greater than their current business would justify.  Tesla has a market capitalization of US$53 billion, slightly more than General Motors, despite the fact that GM currently produces more vehicles in one day than Tesla does in a year!  Amazon has a market cap of US$475 billion and trades at more than 100 times forward earnings.  Its value is more than 50% of the entire retail industry in the U.S. and is equal to 2.4 times annual sales, versus an average of 0.6 times sales for the rest of the industry.  Rounding out the group is Netflix, which now has a market cap of US$78 billion and trades at over 100 times earnings, over 50 times operating cash flow and 6 times sales.  While all these companies are clearly ‘disruptors’ in their respective industries and could end up delivering the kind of growth and change that their investors are counting on, there’s a lot that could also go wrong on these growth curves including changes in technology, new competition, regulation or continued pricing pressures.  The bigger problem for investors, in our view, is that these elevated stock prices and lack of demand for capital generation has allowed them to raise and retain capital for longer than most companies, and that could hide any underlying growth problems.  If these ‘hero CEOs’ prove unable to ultimately generate results equal to market expectations then the ‘fall from grace’ would be larger than we have seen in past cycles.

Another example of how this ‘hero syndrome’ in the stock market has distorted returns can be seen in the recent foray of ‘perennial’ hero Warren Buffett to rescue Home Capital Group (HCG).  Buffett announced in June that they were investing $400 million of new capital into the ailing higher-risk mortgage lender as well as providing a standby line of credit of up to $2 billion.   This allowed Home Capital to immediately pay back a high-cost line of credit from Ontario Pension and resulted in an immediate 50% gain in HCG’s stock, which had fallen 70% over the prior year.  While the arrival of Buffett as an investor seemed to take away the largest financial risks around HCG and perhaps guarantee its survival, it came at a high price to everyone except Buffett, who seemed to be able to ‘monetize’ this ‘hero status.’  The $400 million of equity capital came at an average discount to the existing market price of about 20%, a pretty good discount that the average investor would have no chance of obtaining.   Moreover, the line of credit came at an interest rate of 9.5% and a standby fee of 1.75%, only a slight discount from the 10% rate and 2.5% standby fee that was being charged by Ontario Pension.   While that capital injection should ensure HCG’s survival for now, it certainly makes it very difficult for HCG to generate any earnings since its cost of capital has now gone up significantly but it is unable to charge higher rates on its mortgages.  Of course Warren Buffett is already ‘in the money’ on his stock deal since he got his shares at an average cost of under $10 per share when the stock was trading at over $12.  While it did initially jump to over $20 per share, it has recently settled back to around $13.50.   So while Mr. Buffett is doing well on both his stock investment as well as the exorbitant rate of interest on his loan, any investor who bought stock on the deal news is now in a loss position.  He did the something similar with a preferred share deal with Bank of America after the financial crisis in 2009.   While that investment has worked out well, this ‘hero status’ valuation that investors such as Buffett receive guarantees that the benefits accrue to his account on a disproportionate basis while the risks are more protected.  The bottom line is to tread carefully when following behind well-known investors; their deal is probably going to be a lot better than yours!

While U.S. and global stocks have rallied in the first half of 2017 on optimism about economic growth, earnings and the Trump agenda, the U.S. economic data has been falling below expectations.  What we refer to as ‘soft data’ (confidence indicators, sentiment) and employment growth have done well, many of the other indicators have ‘missed the mark’ in terms of keeping up with expectations.  This is clearly shown in the Citi Economic Surprise Index (see chart below) which has been trending lower since the end of February.  But there has been a pattern developing in the past six years that the economic numbers have been sluggish in the first half of the year and then rebound in the back half.  Investors who keep buying stocks and pushing them to record valuation levels are definitely counting on this to occur again in the back half of 2017.Surprise Index looming

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