Saturday 18 May 2019

Berkshire Hathaway succumbs to the tech bubble

We have currently reached the point in the cycle where investors are once again questioning whether traditional value investing is dead. The last time this occurred was in 1999, and much like in 1999, it has also resulted in many self-described value investors caving in to the pressure of years of disconfirmatory market outcomes (high growth, high quality businesses sharply outperforming - particularly hyper-growth tech names); abandoning traditional value discipline; and rationalising a move towards more growth-oriented investing, which feels much more comfortable (being with the crowd, and doing something that has worked very well in recent history).

However, one thing that is markedly different this time is that the bullish zeitgeist appears to have penetrated even the fortified walls of Berkshire Hathaway, which recently disclosed it had taken a stake in Amazon. Importantly, I said Berkshire Hathaway, not Warren Buffett. Buffett was quick to distance himself from the decision, noting that it was one of his lieutenants who made the move, and that (with respect to himself) "no personality changes are happening around here". That is a relief - when I first read the news I actually momentarily feared Buffett was descending into senility. It is instead his less experienced lieutenants that have been charmed by the boom and led astray (and I can't help but wonder if Buffett is now starting to question the wisdom of some of his anointed successors).

Now there is no denying that Amazon is an extraordinarily powerful company, nor that Bezos is a truly outstanding executive. It has been one of the greatest corporate success stories of the past 20 years. But that is the past not the future, and the point is that some very basic valuation math (below) illustrates just how extraordinarily difficult it is going to be for Amazon to yield even a 10% annual return from its current valuation level - a level of return that can quite easily be obtained elsewhere at present with much lower risk - because the numbers are just so impossibly large. Like many investors, Buffett's lieutenants appear to have been so captivated by the narrative that they have forgotten to undertake this basic math (or are so extraordinarily bullish on the company's long term growth prospects that they have abandoned any residue of a margin of safety).

In this blog, I've discussed on a number of occasions some of the core differences between 'growth' and 'value' investing, but perhaps the most fundamental distinction of all is attitudinal: real value investors expect to earn their returns from the cash flows generated by the asset over time relative to their purchase cost, and see themselves as (price permitting) permanent owners of companies, whereas 'growth' of 'faux value' investors are more interested in intermediate-term stock price outcomes. 

For instance, a growth investor might say 'I think growth can continue at 25% a year, and so if the stock continues to trade at 30x, I'll make 25% a year'. That is an intermediate term outcome. You might well make your 25%, but you are not making your return off the cash flows earned by the asset relative to your purchase price, but changes in the way the stock is priced during your shorter-term holding period. At 30x, your earnings yield is 3.3%, and even if earnings grow 25% the following year, your earnings yield is still only 4.2% (3.3% x 1.25).

You also see faux value investors say things like 'the stock is trading at 15x but comps are at 20x, and I think the stock can re-rate to 20x due to XYZ catalyst, yielding 33% upside'. That is also an investment case that is not based around the cash flows realised by being a long term owner, and so it is also an inherently speculative approach (at 15x, your cash flow return is 7%, not 33%). Essentially, the medium term outlook for earnings growth and changes in multiples ('re-ratings' and 'de-ratings') are given priority, and that is done for obvious reasons - those are indeed the variables that drive shorter term investment outcomes.

However, in the long term, outcomes are necessarily driven by the level of underlying cash flows relative to prices, and genuine value investors focus on this, because in the long run, it must work (by definition - financial assets are worth the present value of future cash flows). Value investors - on my definition at least - are interested in the cash flows generated relative to the price paid, and they view themselves as akin to private business owners.

To genuine value investors, share price volatility is irrelevant and concepts such as intended holding periods and catalysts also make little sense, because you're looking to own cash-generating assets into perpetuity, so long as they promise a decent return relative to the risks assumed. For instance, if I owned what was in reality an extremely good quality bond that yielded 15%, I wouldn't care if it lacked a catalyst to re-rate to a 5% yield, or for that matter be concerned if it repriced to a 20% yield, because I'm looking to make my return by owning the asset and earning (and reinvesting) the coupons, not by speculating on a short term re-pricing. Price and changes in fundamentals permitting, value investors buy to keep. That, incidentally, is why Buffett says his favourite holding period is forever. If you can keep making 15% into perpetuity, why would you ever want to sell?

A strong intermediate term growth case can be made for AMZN today, just as it could for many years. Growth is likely to remain strong (albeit I believe it is at greater risk of slowing than many believe), and margins are likely to trend up, and if the stock doesn't 'de-rate' from a P/S or P/E perspective, medium term returns could well remain above 20% per annum. But instead of thinking about it like a growth investor would, let's instead put our cold and calculating value hats on, and do some simple math. Let's ask ourselves what sort of cash flows AMZN will need to generate to yield merely a 10% cash flow return (DCF return) to long term holders relative to its current price.

AMZN's current market capitalisation is US$920bn, so in order to yield a 10% return (pre-tax and pre-inflation), the company would need to distribute US$92bn in annual cash flows into perpetuity, starting from today. However, I'll give the company some credit for 'terminal growth', and assume that in the long term (after the company matures), it will be able to sustain a 3% terminal growth rate in annual distributable cash flow, which is likely roughly in line with global long term sustainable rates of nominal GDP growth. That means they would need to generate a 7% cash flow return (which coupled with 3% terminal growth rate would yield a 10% return). 7% of US$920bn is US$64.4bn.

But here is the kicker: that is the required distributable cash flow were it to start happening today. However, in reality, we are years away from AMZN being able to distribute meaningful cash flows, and for every year that goes by between now and the point where such distributions begin, the terminal amount they need to distribute will rise by a compounding 10% a year (in order to yield a 10% return from the date of purchase). Simple DCF math proves it. They can either start distributing US$64.4bn a year today, growing by 3%, or they can start distributing US$70.8bn with 3% pa growth from 2020, or US$77.9bn with 3% growth from 2021, and so forth. All of these outcomes yield an equivalent 10% cash flow return for today's buyer.

The problem for growth investors is that compounding even at 10% is a powerful force over extended periods. 10% compounded results in an approximate doubling in 7 years, and quadrupling in 14. So let's say it takes 15 years until Amazon's hyper growth starts to slow down, profit margins rise to long term normalised levels, and its starts distributing meaningful amounts of cash flow. By that stage, they will need to be distributing about 4 times as much cash flow, or US$269bn pa (64.4 x 1.1^15), with a 3% terminal growth rate in annual distributions thereafter. Assuming a 25% effective tax rate, that represents annual pre-tax profits of US$359bn - about 1x the current market consensus estimate for the company's sales in 2021 (i.e. already 2-3 years into the said 15 year growth window).

That's a herculean task to put it mildly. It will require Amazon to distribute cash flows annually in 2034 that are more than 5x as large as the largest sustainable annual distributions ever made by the most profitable corporation in the world (Apple - about US$50bn a year)! And this is also even before accounting for stock dilution (AMZN's share count is rising by about 1.5% pa).

Furthermore, if we were to push out the date to 2049 (30 years), they would need to start distributing US$1.124 trillion dollars (64.4 x 1.1^30), assuming all intermediate cash flows need to be reinvested to sustain hyper growth. That is more than 20x as much as Apple is currently earning/distributing, and assuming they were to make an 8% NPBT margin, or about 6% after tax, this would require annual sales of some US$19 trillion by 2049. By way of comparison, global GDP is currently US$85tr. And most importantly of all, this is what is needed merely to generate a modest 10% cash flow return - before taxes and inflation - not something spectacular like >20%.

By comparison, one can currently earn a compounding 10% annual return merely by buying something like Bank of America or Wells Fargo - incumbent businesses with solid moats that are trading at about 10x earnings. They don't need to grow those earnings at all - they can simply use them to pay reinvestable dividends, and buy back stock into perpetuity. Bank of America is currently distributing about US$25bn a year on a market cap of US$270bn, for instance. These companies don't need to move mountains, and change or conquer the world - they just have to keep doing what they are already doing, and distribute the profits (or alternatively, distribute say 70%, and use the remainder to fund about 3% compounding nominal growth at an incremental return on capital of 10%), and stockholders will make a compounding 10% pa with relative ease.

So ask yourself, what is more likely to happen? Which is riskier? For Bank of America or Wells Fargo to sustain constant levels of profits over the next 15 years, and simply use it to pay dividends and buy back stock, or for Amazon to grow to a point where it is able to annually distribute more than five times as much cash as the most profitable enterprise in the world ever has, and an annual amount that currently exceeds the level of its sales, despite it already being a very large business that will eventually succumb to the law of large numbers?

This sort of math is the fundamental reason why high multiple growth/quality stocks underperform in the aggregate over time throughout a full cycle. There is a fallacy of composition baked into growth approaches - they embed an implicit belief that realised returns from capturing multiple expansion and earnings growth can exceed the level of underlying cash flow based returns into perpetuity. I doubt, for instance, that there is a single investor in Amazon at present who expects to make a holding period return of well below 10% a year and sharply underperform a boring investment in BAC/WFC, but that's what the math suggests is by far the most likely outcome.

Value investing has always fundamentally been an embodiment of the parable of the tortoise and the hare. The is no 'free lunch' in economics, and what the value investors needs to give up in exchange for higher returns is any hope of making a lot of money fast (value investing is about getting rich slow). Value investors also need to settle for far more variable realised (as opposed to underlying) returns, including prolonged periods of underperformance during growth-infatuated bull markets, as the hare sprints ahead for sometimes extended periods - in markets sometimes for as much as a decade or more - essentially for as long as multiples continue to rise. But in the long run the tortoise tends to win, because as Buffett has noted repeatedly in the past, in the long run, investors in the aggregate cannot take more out of the market than what companies in the aggregate earn. It is a fallacy of composition to believe otherwise, but investors fall for it, again and again, because being a hare is so seductive, and even Berkshire Hathaway appears to have now been drawn into the fray.

I understand how it happens. I've been a long time admirer of Bezos and Amazon, and I almost bought stock at $280, and I remember telling a friend at the time that I thought it would probably become the world's first trillion dollar company. But when I ran the cash flow numbers, even then I thought there were easier and lower risk ways to make equivalent cash flow based returns, and my value discipline prevented me from acting. The stock is since up 7x, and I've watched it rise and rise, year after year, with great admiration for Bezos and what Amazon is doing. It takes a rare personality type to be able to do this with nonchalance and without regret, and not be drawn into the fold. Few investors seem to be able to do it.* Buffett's ability to resist doing so has been absolutely core to his success, but he does not seem to have picked successors with similar discipline.

It is interesting times to say the least. There is no way to predict how long this growth cycle continues, and indeed I have argued in past posts that there is at least a possibility that this cycle ends with the biggest equity bubble of all time, exceeding the bubble's excesses, and maybe even rivalling 1990 Japan. It would be foolhardy to try to call a top when we are in a world awash with unprecedented amounts of excess liquidity, where there is a good chance central banks cut rates back to/below zero and resort to more QE the second any economic/market speed bumps arise.

But there is going to be a 2000-02 type reckoning/reversal at some point in my view, with a analogous substantial de-rating in growth and resurgence in value. It's only a matter of time, because the numbers make it obvious that a reversal simply must happen at some point. Value stocks are simply generating too much cash vs. their share prices and growth stocks far too little, and for the leading 'horseman' of the current tech boom, the law of large numbers will also eventually be their undoing.


*The easiest way to do so is to assess your returns on the basis of the cash flows, earnings and dividends your portfolio is generating (and the growth in these metrics over time), rather than its change in market value. If you keep your eye on the ball like this, it's not particularly difficult to let expensive stocks with low cash flow returns go through to the keeper.