Glamour Zooming Down

Summary

I review some recent research by Kenneth French on "Glamour Stocks" and their returns.

Next, I turn to today's Glamour stocks, such as Uber, Zoom, and Beyond Meat and look at some less hyped IPOs such as Adaptive Biotech.

Finally, I consider how Netflix's valuation might be affected as we transition beyond the glamour phase and consider the curious case of Tesla.Introduction

Kenneth French is the second half of the famous "Fama-French" pair (Fama recently won the Nobel price along with behavioral economist Shiller). The two have produced a number of widely read papers dealing with equity returns and factors and are largely responsible for today's factor-based approach to explaining the ascendancy of certain types of investments during particular phases of market cycles. The genesis for this article was a serious of charts I saw in an article on Bloomberg based sourced to Fama.

Fama uses the term "glamour" stock for firms that are highly popular, experience periods of wild success as measured by stock returns over particular short to intermediate time periods, but are nevertheless not profitable at all on a fundamental basis, or whose profitability is greatly at odds with their valuations. In today's market, we might be more familiar with the term "story stock" - those that have a great deal of optimism behind their world-conquering "story"; some of them might even have shown magnificent revenue growth for extended periods, but nevertheless their valuation requires not only a belief that such growth will continue for long periods of time, but that metrics such as return on equity, free cash flow, operating cash flow and net profit will all eventually catch up.

Our first chart looks at how value stocks have done relative to glamour stocks since 1969.

French looks at rolling 6-year total returns. Glamour stocks are in a glamorous blue and value stocks are in a boring white. The chart starts with a period where glamour stocks had done quite well, leading up to the great bear market of the early 70s. For the next 20+ years, value stocks outperformed, until the internet bubble of the late 1990s. There was a brief period in the late 90s where glamour stocks did well, but when the bubble popped, value stocks again rules until about 2014-5. Since then, glamour stocks have beaten value stocks by a large margin.

Our second chart uses one measure of value (Price to Book) to look at how fundamentals of the two groups varied over time.

To be fair, since the 1980s, traditional book value has picked up less and less of assets that indeed add value to modern companies: R&D, IP, brand value, network effects, etc. However, this is seen in the gradual ramp up between 1980 and 1990. The spike near 2000 is truly about the "glamour bubble", as can be seen by the return of the blue line to just above 5 after the 2000 bubble popped. We can see that around 2014-15, glamour again rose by this metric to levels last seen during the 2000 bubble, and have stayed above at that level for longer than they did back then.

Our final chart shows how fortunes were reversed in the 1970s.

While glamour outperformed for the first 6 years, the next 6 years saw a reversal in sign, and if you look closely at the magnitudes, value won in the second period by more than it had lost to glamour in the second period.

Relevance to Today

While few claim that there is a general stock market bubble today (apart from a few folks who have been saying it for many years), there is definitely a broad sense of unease among many long-term value investors. A number of story stocks have ruled the market since 2014-5, making value investors who did not choose to participate wonder if their rule book needed to be changed. More recently, with the VC-backed IPO boom that began earlier this year (see the next chart for how 2019 compares to earlier years), people began to question if perhaps we were beginning to see a much more localized region of froth in the markets.

It is natural to want to invest in IPOs. Indeed, if one were to be able to find companies destined to great, even at the rate of 1 in 5 or 1 in 10, the following chart shows the long-term returns that can ensure.

Many of today's "stodgy value companies" as well as some "blue-chip growth stocks" (Such as GOOG & AMZN) were once IPOs, and anyone buying even a small amount close to IPO compounded their money at ridiculous rates of return.

The problem is that the list above is not just 15 of 500 or 1000 stocks, but includes a whole lot of firms that were de-listed, absorbed by larger companies at cheap valuations, went bankrupt, etc. So success of the magnitude seen above requires having the ability to select the best 1 in 100 or 200 opportunities.

What are some indicators that predict the success of IPOs looking 3-5 years out?

According to Goldman: "Since 2010, IPOs with annualized sales growth above 40% from year 1 to year 3 and positive net income in year two have generated positive excess returns and the highest likelihood of out-performance." (full article here: IPO Success Metrics).

While the above metric does not guarantee that the IPO will end up like one of the giants above, it does reduce the opportunity set one should search within. What else distinguishes the giants above, though? Every single one of them has some kind of moat. Disney, Nike, Walmart, Coke, McDonald's, Pfizer, Microsoft, Starbucks, FedEx, Google, etc. were all recognized as having a wide moat that allowed them to earn outsized returns on capital year after year, compounding their excess cash flow at well above S&P 500 rates. The source of the moat can be a network effect (MSFT, SBUX to some extent, FDX, GOOG), R&D and patent protection (PFE, MYL), brand uniqueness and loyalty (COKE, NKE, SBUX), or both (DIS).

Without such a moat, high revenue growth slows down and does not lead to high levels of profit as margins get competed away by competitors. With revenue growth that lacks profit growth and strong margins a few years later, a buy and hold strategy cannot hope to prevail. Instead, a trading mentality is needed, to buy early, hope the market goes bonkers, and sell out before the crowd also tries to get out. This is fine as a short-term money-making strategy, but not really part of a long-term value investor's buy and hold playbook.

The Current Crop

My interest in this topic started with a look at IPO lock-up expirations after the tremendous interest in earlier IPOs such as Uber and Beyond (I wrote an article about Beyond in which I predicted that it would drop over 50% but suggesting that options were expensive and shorting it was near impossible until lock-up expiration - so it was impossible to participate in safely either on the way up or the way down). Looking at the chart below, it was clear that BYND got exactly what I was expecting (and it may have another 50% again to go, perhaps shares will be available to short in a week or so).

The next table shows a list of IPO lock-up expirations happening in October 2019 (larger list available at: Lock Up Expirations).

My goal was two-fold: (1)find any hidden gems that had been ignored by the market. Ideally, they would have fallen below their IPO price, but fundamentally they would have a decent (say 10%) chance of being in an elite group of large, profitable firms in 10 years, with a moat and high profits. (2)Find good short opportunities (after all, as my screen name suggests, there are two ways to make money - you can buy what looks cheap, or you can sell what looks silly rich, and there is no reason to be limited to selling only after buying).

Generally, I found that the stocks that had tanked post-IPO deserved to have tanked. A couple didn't exactly tank but didn't soar like BYND or ZOOM either, and I think they are potential gems. Finally, I found some decent short opportunities. Before going on to tell you a little about each of them, a warning which I hope isn't news to anyone (but just in case): anyone who goes long or short a stock right after reading a single article on Seeking Alpha (no matter how good the article is) is doing something very, very silly. This should be a place to get some ideas to research further. And if you are not digging down into each potential opportunity yourself, you should use this site for entertainment, but not to invest your money.

Hidden Gems

1.Adaptive Biotech (ADPT): this company is combining modern data science and machine learning together with the fact that our immune system contains a record of every infectious agent we have ever come in contact with to potentially revolutionize the entire diagnostics market, and additionally to help other firms focused on harnessing the immune system and design customized treatments (such as for cancer, or to cure auto-immune diseases, which include types of arthritis, and indirectly the rise in food allergies). Their revenues have been doubling every 2 years, they have a partnership with MSFT on the data science/analytics front, and have one approved and paying product covered by insurance. The hard part of success is the science: if they are able to achieve their scientific goals, their lead in mapping known infectious agents and immune cell markers would create a very strong moat. I assign a very rough subjective probability of 10-20% to the achievement of this ambitious goal. However, if they succeed, I believe that becoming Amgen ($123 billion) or Genetech size ($44 billion when acquired by Roche) is quite likely. The stock price almost doubled post IPO but is now lower than on IPO day, so if one is interested, this is a good time to start investigating. I also love the story of how this company was started (two brothers collaborating) and the overall humility of the founders. IPO date: 6/26/2019

2.StoneCo (STNE): this company is disrupting the payment processing market in Brazil, taking business away from the oligarchy of banks which formerly controlled it. They have one significant competitor but appear to have a winning interface, leading technology and customer support, are profitable and have grown revenue over 100% a year in the last three years. Despite earnings more than tripling in the last year, the last 12-month P/E is 45x. I expect growth to slow to doubling every 2-3 years for the next 6 years and then more normal rates of growth, but they do have a couple of related markets they could enter to keep growth high for longer. Note that this is a true software company, so even a 5-10% growth rate P/E would normally be in the low 20s. What I like best about this company is how the founder/CEO explains their purpose and again, his humility and customer focus. I would not be surprised to see this company become the dominant one in this space in Brazil within 3-4 years and then begin to expand into adjacent countries in Latin America once they make the Portuguese to Spanish switch in their UI. I bought this company last year during the December downturn, but then sold it when it popped up in Q1, hoping to buy it back. Reading market tea leaves, I get the feeling I will have a chance. This time I do not plan to sell for a quick buck. IPO date: 10/14/2018My IPO Sell List

In this section I will omit the IPO date. I encourage readers to focus on the lock-up expiration dates, however.

1. Beyond Meat (BYND):

BYND is the poster child that got me started on an IPO short strategy this year. While its descent from over $200 to around $100 has all occurred before the IPO lock-up expires, I have been sitting on my hands since my brokerage prohibited me from continuing to sell calls (occasionally calls get assigned, and shares to short are hard to find, so they only let longs sell calls for now). I am unwilling to short stock when borrowing rates are high, and puts have been so expensive that it's basically roulette wheel odds to make money in any given week on the put premium you lay out. Long date puts are exhorbitant. If shares become available to short at rates under 10%, I do plan to short it for a while because it is still a wildly overvalued no-moat hype company. Projected 2020 revenue is 415 million, competitors have all announced their products in this market, and market cap is $6.3 billion. Assuming one more revenue double is possible after 2020 before competition dramatically reduces their rate of growth (not to mention the ultimate victory of Impossible, which is pretty much assured based on nutrition AND taste), any market cap over $1 billion is pure glamour. Lots of insiders are waiting to sell come 10/29 and I am hoping some of the buyers of those shares are willing to lend to me soon thereafter.

2. Uber (UBER)/Lyft(LYFT):

I shorted Uber for a while but covered when it hit $30 in favor of better opportunities (see below). While I think UBER could simply become profitable by raising their rates and not investing so much in every ridiculous additional business line that could conceivably be linked to their name, I think a $56 billion market cap for a company that built an app Larry Ellison claims his cat could have written might be a bit too optimistic. While UBER does have something of a moat (how many apps are you willing to put on your phone to get a ride? wouldn't you rather just have one or two? and wouldn't anyone who drives want to drive for the company that everyone has the app for?) I believe that regulatory and legal risk is being wildly underestimated by the market. States are going to force Uber to treat drivers as employees (especially the most populous states where Uber gets most of its business), which means much lower forward margins need to be modeled to come up with a sustainable market valuation. The Uber valuation problem amounts to valuing what a taxi company that leases all its cars from the drivers, covering 30% of the US market, ought to be worth it. Also, in a couple of years, I expect a carbon tax or other form of global warming regulation to become a significant risk to this business in areas that have mass transit (buses, trains, even smaller shuttles that carry 20-30 are vastly more rider-mile efficient). Finally, the strong economy itself is a risk, as the more regular jobs people find, the harder it is to keep drivers while paying them peanuts. I expect to be short Uber again in the future, but it will definitely be some time after their lock-up expiration. Everything I have said about Uber (almost everything - their management does not seem as obsessed with putting their name on every conceivable affiliated business line) could be said for LYFT, except that they have a different share lock-up expiration date.

3. Zoom (ZM): this company competes with WebEx, Gotomeeting, etc. to provide teleconferencing services. 2020 Revenue is believed to grow to $589 million while the current market cap is almost $17 billion. The folks who own the stock whom I have read appear to believe that something is magical about their particular offering. However, when I go outside this site or read what different organizations recommend their employees use, or sample what companies in the financial services industry that I interact with (I have informally come to know what about 50 companies use), I see no discernible pattern in favor of one particular platform. It is pretty simple UI, video and sound and the quality of your internet connection seem to be much more important than any tweaks to the UI. In any case, UIs can easily be improved by tech companies. Therefore, this appears to me to be another moat-less business being valued as if there were one (glamour).

I initiated puts a bit before lock-up expiration as the puts were reasonably priced and my broker also let me sell calls on this one, so the put premiums were funded by call premiums. Since lock-up expiration on 10/15, shares borrowing rates have fallen rapidly and as of yesterday several hundred thousand were available at 5% rates, which makes this very much directly shortable (which makes me comfortable selling deep out of the money puts against my short to earn more in premium than I am paying to borrow the shares).

Broader Patterns on Hyped Stocks

It is possible that the rapid decline of these hyped glamour IPOs (as well as the popping of the cannabis bubble) has some implications for other, more covered and established stocks as well. The first one I want to address is Netflix (NFLX). While the dominance of this business and its success is without doubt, its valuation has continued to incorporate a great deal of optimism about non-US subscribers and margin growth. Emerging competition is likely to hurt both pricing power and the rate of overseas growth that can safely be assumed. Just as importantly, what was definitely a narrow moat is now under attack, so discount rates must be adjusted to take this into account. When I recommended a short back in July when I wrote Has Netflix Fallen Enough?

At the time, it had fallen from the high 300s when it was a prime short candidate to around $300. I was content holding that short, both by selling calls or outright short sales down to the mid-200s. However, since my analysis under an "everything goes right for Netflix" scenario was able to justify a $200 value, this short has entered the zone of uncertainty where it is neither a compelling value nor a favorable short. The response to the most recent earnings report, as well as to the news of Verizon giving a year of Disney+ away for free (the first a dramatic spike followed by selling, the second a significant drop) suggests that the best way to treat this situation is as an opportunistic short with high gamma but low delta. Buying puts after big rallies back to the $300 range or just prior to earnings releases (especially if this occurs after a substantial run-up) might be profitable, or at least a reasonable bet to take on overseas subs growth slowing faster than the more optimistic scenarios I outlined in my article.

The key point I want to make is that there is an underlying glamour or hype factor in both the IPO market and in what is being assumed about the hyper growth profitable companies that are cash flow negative, and generally being short this factor at the right times with a combination of high gamma (for when you turn out to be right) and low delta (for when you turn out to be wrong) can be quite profitable in the long run during the eventual deflation of the glamour factor.

The ultimate non-IPO glamour situation is the most overwritten-about stock on Seeking Alpha - Tesla (TSLA).

While its initial fall from the high $300 range can be attributed to the $420 tweet and its aftermath, the continuing lack of profitability and need for additional capital helped TSLA become a profitable short for many through early June. However, Tesla has shown that it has a rather unique set of believers, both on the retail investor side and in terms of institutional investors who were willing to add significant exposure even in June 2019 as other institutions who had been larger holders fled the scene. That this institutional support exists both in the bond and equity issuance market, together with the secondary trading market, is without a doubt.

Given that the Shanghai factory story is ascendant and will be for the next several months, I have my doubts about the utility of holding any kind of short on this name until things start to become clearer on what that means (or fails to mean) for demand growth in the largest EV market on the planet. Certainly the spike after another intermittent positive GAAP earnings number that primarily consists of regulatory credit income from the EU, combined with early recognition of an early FSD feature which could easily have negative intrinsic value (e.g. liabilities caused exceed convenience savings to lazy parkers) suggests that the glamour force is still strong and rather unusual with this one. While I expect that with more analysis of the release, it will become clear that (1)even this level of GAAP profit is not sustainable at this level of volume due to Capex being below depreciation for 9 months now (2)without a large boost in demand from China and the Y, sustainable profitability is still at least a year away (3)even with sustainable profitability, the comparisons with Amazon and Apple are absurd. Nevertheless, I expect that this is the Moby Dick of the glamour factor that will end the career of many professional shorts and be the one remembered in the nursing home by retail shorts.

One could believe that this situation is perhaps the ultimate test of when the glamour factor rotation value investors might expect some time in 2019-2021 based on the first several charts I shared can finally be said to have been completed - when TSLA is broadly agreed to have reached a rational valuation consistent with its demonstrated opportunity set rather than consistent with hypothetical potential future opportunity sets.

However, as a cautionary matter, I would not hold my breath or risk very much money on the glamour factor rotation occurring on the same time scale as it did in the 70s or 2000 (monetary policy is partly to blame, the other part is that the longer people are used to being stupid, the easier it is to stay stupid, until an actual recession hits) or on the correction necessarily reaching every corner of the glamour market at the same rate of diffusion (absent a recession). Investors continue to demonstrate that there are pockets of belief and imagination that mere numbers or data can take years to penetrate.

Disclosure:

I am/we are long ADPT.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure:

I may initiate a long position in STNE within the next 72 hours. I may initiate shorts on BYND and ZM in the next 72 hours. I am short ZM via puts currently.