Monday, September 21, 2020

Sounding good or Doing good? A Skeptical Look at ESG

In my time in corporate finance and valuation, I have seen many "new and revolutionary" ideas emerge, each one marketed as the solution to all of the problems that businesses face. Most of the time, these ideas start by repackaging an existing concept or measure and adding a couple of proprietary tweaks that are less improvement and more noise, then get acronyms, before being sold relentlessly. With each one, the magic fades once the limitations come to the surface, as they inevitably do, but not before consultants and bankers have been enriched. So, forgive me for being a cynic when it comes to the latest entrant in this game, where ESG (Environmental, Social and Governance), a measure of the environment and social impact of companies, has become one of the fastest growing movements in business and investing, and this time, the sales pitch is wider and deeper. Companies that improve their social goodness standing will not only become more profitable and valuable over time, we are told, but they will also advance society's best interests, thus resolving one of the fundamental conflicts of private enterprise, while also enriching investors. This week, the ESG debate has come back to take main stage, for three reasons. 

  • It is the fiftieth anniversary of one of the most influential opinion pieces in media history, where Milton Friedman argued that the focus of a company should be profitability, not social good. There have been many retrospectives published in the last week, with the primary intent of showing how far the business world has moved away from Friedman's views. 
  • There were multiple news stories about how "good" companies, with goodness measured on the social scale, have done better during the COVID crisis, and how much money was flowing into ESG funds, with some suggesting that the crisis could be a tipping point for companies and investors, who were on the fence about the added benefits of being socially conscious. 
  • In a more long standing story line, the establishment seems to have bought into ESG consciousness, with business leaders in the Conference Board signing on to a "stakeholder interest" statement last year and institutional investors shifting more money into ESG funds.
In the interests of openness, I took issue with the Conference Board last year on stakeholder interests, and I start from a position of skepticism, when presented with "new" ways of business thinking. If the debate about ESG had been about facts, data and common sense, and ESG had won, I would gladly incorporate that thinking into my views on corporate finance, investing and valuation. But that has not been the case, at least so far, simply because ESG has been posited by its advocates as good, and any dissent from the party line on ESG (that it is good for companies, investors and society) is viewed as a sign of moral deficiency. At the risk of being labeled a troglodyte (I kind of like that label), I will argue that many fundamental questions about ESG have remained unanswered or have been answered sloppily, and that it is in its proponents' best interests to stop overplaying the morality card, and to have an honest discussion about whether ESG is a net good for companies, investors and society.

Measures of Goodness
    We have spent decades measuring financial performance and output at companies, either at the operating level, as revenues, profits or capital invested, or at the investor level, as market cap and returns. Any attempts to measure environment and social goodness face two challenges. 
  • The first is that much of social impact is qualitative, and developing a numerical value for that impact is difficult to do. 
  • The second is even trickier, which is that there is little consensus on what social impacts to measure, and the weights to assign to them.  
If your counter is that there are multiple services now that measure ESG at companies, you are right, but the lack of clarity and consensus results in the companies being ranked very differently by different services. This shows up in low correlations across the ESG services on ESG scores, as indicated by this study:
Correlations across six ESG data providers

This low correlation often occurs even on high profile companies, as shown in a comprehensive analysis of ESG investing by Dimson, Marsh and Staunton, as part of their global investment returns update:
Source: CS Global Investment Returns Yearbook 2020, Dimson, Marsh and Staunton
Note the divergence in both the overall ratings and on the individual metrics (E, S and G) across the services, even for widely tracked companies like Facebook and Walmart. There are some who believe that this reflects  a measurement process that is still evolving, and that as companies provide more disclosure on ESG data and ESG measurement services mature, there will be consensus. I don't believe it! After all, what I find to be good or bad in a company will reflect my personal values and morality scales, and the choices I make will be different from your choices, and any notion that there will be consensus on these measures is a pipe dream.  

Even if you overlook disagreements on ESG as growing pains, there is one more component that adds noise to the mix and that is the direction of causality: Do companies perform better because they are socially conscious (good) companies, or do companies that are doing well find it easier to do good? Put simply, if ESG metrics are based upon actions/measures that companies that are doing better, either operationally and/or in markets, can perform/deliver more easily than companies that are doing badly, researchers will find that ESG and performance move together, but it is not ESG that is causing good performance, but good performance which is allowing companies to be socially good.

The ESG Sales Pitch - Promises and Contradictions
The power of the ESG sales pitch has always been that it offers something good to everyone involved, from companies adopting its practices, to investors in those companies, and more broadly, to all of society. 
  • For companies, the promise is that being "good" will generate higher profits for the company, at least in the long term, with lower risk, and thus make them more valuable businesses.
  • For investors in these companies, the promise is that investing in "good" companies will generate higher returns than investing in "bad" or middling companies. 
  • For society, the promise is that not only will good companies help fight problems directly related to ESG, like climate change and low wages, but also counter more general problems like income inequality and uneven healthcare.
Given that ESG has been marketed as all things good, to all people, it is no surprise that its usage has soared, with companies signing on in droves to social compacts, and investors pouring hundreds of billions of dollars into ESG funds and investments. In the process, though, its advocates have either glossed over, or mixed up, three separate questions that need to be answered, on ESG:

The reason it is useful to separate the three questions is that it opens up possibilities that are often missed in both debate and research. For instance, it is possible that ESG does nothing for value, but that it offers a sheen to companies that allows them to be priced more highly than their less socially conscious counterparts and enriches investors, who trade on its basis. Alternatively, it is also possible that ESG does increase value, but that markets adjust quickly to this and that investors do not benefit from investing in ESG stocks. It also illustrates the danger of overreach from ESG research. Much of the research on ESG is compartmentalized, where only one of these questions is addressed, but the researchers seem to use the results to draw conclusions about answers the other two. Thus, a research study that finds that investors make higher returns on companies that rank high on ESG often will go on to posit that this must mean that ESG increases value, a leap that is neither justified nor warranted. 

ESG and Value
The framework for answering the question of whether ESG affects value is no different from the framework for assessing whether acquisitions or financing or any other action affects value. It is both simple and universal, and I have captured the drivers of value for any business in the picture below:

Figure 1: The Drivers of Value
In fact, my favorite propositions in value is the "It Proposition", which posits that for "it" (investing, financing, dividends, ESG) to affect value, "it" has to affect either the cash flows (through revenue growth, operating margins and investment efficiency) or the risk in those cash flows (which plays out in the cost of equity and capital)

Goodness will be rewarded
Applying this proposition to ESG, the most direct way to induce companies to behave in a socially responsible manner is to make it in their financial best interests to do so. There is a plausible scenario, where being good creates a cycle of positive outcomes, which makes the company more valuable. Figure 2 describes this virtuous cycle:
In this story, being good benefits the company on multiple dimensions. Customers, attracted by the company's social mission, are more likely to buy its products and pay higher prices, increasing both growth and margins. The company is able to attract more loyal employees and suppliers, and build a model for investing that leads to more payoff from investments, i.e., more efficient growth. On the risk front, the company benefits from  investors who are willing to pay premium prices for their shares (thus lowering cost of equity), and lending that comes with lower rates and fewer covenants. Finally, by operating as a good corporate citizen, the company minimizes the chance of a scandal or a catastrophic event that could put its business model at risk. In the language of ESG, it creates a more “sustainable business”.  For proponents of corporate social responsibility, this is the best-case setting for their cause, because being good and doing well financially converge. This scenario holds, though, only because customers, employees, investors, and lenders all put their money where their convictions lie, and are willing to make sacrifices along the way, and it is more likely in some companies/businesses than others:
  1. Smaller, rather than larger: While it is not impossible for a large company to hit all the high notes in the virtuous cycle, it is far easier for a small company than a large one, because even a small subset of all investors (consumers) can provide the capital (revenues) at the favorable terms needed for this scenario to unfold. 
  2. Niche business, with a more socially conscious customer base: Adding to the smallness theme, it is easier for a company that serves a small customer base to attract customers with its ‘good company’ mantle than a company that seeks to reach a mass market. A company like Patagonia, with revenues of $750 million, can more easily make the compromises to stay socially responsible than a company like Nike, with revenues of $34 billion, which will be forced to make compromises that will undercut its goodness.
  3. A privately held company or a public company with an investor base that values corporate goodness and prices it in: Being a private company can help, especially if the payoff to corporate goodness is long term, another point working in Patagonia’s favor. A public company that is closely held or controlled by its founders can also make choices that may not be feasible for a widely held company with a vocal stockholder base. 
It is worth noting that the companies that tend to be most vociferous about their social consciences tend to meet these criteria, at least early in their corporate lives. However, they will face a challenge, if they are successful and want to grow, because growth will bring in customers and investors not so committed to ESG. The acid test of social consciousness occurs when a company scales up and must decide whether to continue to grow or accept a lower ceiling on growth, and perhaps lower value, in order to preserve it good company status.

Badness will be punished
There is an alternate story that can be used to argue that companies should try to be socially responsible, but it is a more punitive one, where it is not good companies that get rewarded, but bad ones that get punished. This less upbeat scenario is described below:

Here, the punishment for bad companies is meted out from every direction, with customers refusing to buy their products, even if they are lower priced. These companies face higher operating expenses (and lower margins) in the long term, as they have trouble holding on to employees and finding suppliers. Equity investors avoid buying their shares, leading to higher costs of equity, and lenders are leery about lending money to these companies, leading to higher costs of debt. Finally, these companies risk exposure to grievous, or even catastrophic events, arising from operating with too little consideration of societal costs. It is often these events, such as the Union Carbide gas leak in Bhopal, Vale’s dam bursting in Brazil and BP’s oil spill in the Gulf of Mexico, that highlight shortcomings and create long term problems for the company. 

The Bad Guys win!
With regard to promoting social responsibility, the "bad behavior gets punished" scenario is not as good as the virtuous cycle, because it will tend to scare companies away from being “bad”, rather than induce them to be “good", but it is still better than a third and potentially devastating scenario for ESG advocates, where bad companies are rewarded for being bad, and become more valuable than good ones:
In this scenario, bad companies mouth platitudes about social responsibility and environmental consciousness without taking any real action, but customers buy their products and services, either because they are cheaper or because of convenience, employees continue to work for them because they can earn more at these companies or have no options, and investors buy their shares because they deliver higher profits. As a result, bad companies may score low on corporate responsibility scales, but they will score high on profitability and stock price performance. 

The Evidence
The question of which of these three scenarios is the right one is not one that can be settled by logic or with anecdotal evidence, but with data. For more than two decades now, researchers have examined the link, with the following conclusions:
  1. A Weak Link to Profitability: There are meta studies (summaries of all other studies) that  summarize hundreds of ESG research papers, and find a small positive link between ESG and profitability, but one that is very sensitive to how profits are measured and over what period, leading one of these studies to conclude that “citizens looking for solutions from any quarter to cure society’s pressing ills ought not appeal to financial returns alone to mobilize corporate involvement”. Breaking down ESG into its component parts, some studies find that environment (E) offered the strongest positive link to performance and social (S) the weakest, with governance (G) falling in the middle. 
  2. A Stronger Link to Funding Costs: Studies of “sin” stocks, i.e., companies involved in businesses such as producing alcohol, tobacco, and gaming, find that these stocks are less commonly held by institutions, and that they face higher costs for funding, from equity and debt). The evidence for this is strongest in sectors like tobacco (starting in the 1990s) and fossil fuels (especially in the last decade), but these findings come with a troubling catch. While these companies face higher costs, and have lower value, investors in these companies will generate higher returns from holding these stocks.
  3. And a link to Failure/Disaster Risk: An alternate reason why companies would want to be “good” is that “bad” companies are exposed to disaster risks, where a combination of missteps by the company, luck, and a failure to build in enough protective controls (because they cost too much) can cause a disaster, either in human or financial terms. That disaster can not only cause substantial losses for the company, but the collateral reputation damage created can have long term consequences. One study created a value-weighted portfolio of controversial firms that had a history of violating ESG rules, and reported negative excess returns of 3.5% on this portfolio, even after controlling for risk, industry, and company characteristics. The conclusion in this study was that these lower excess returns are evidence that being socially irresponsible is costly for firms, and that markets do not fully incorporate the consequences of bad corporate behavior. The push back from skeptics is that not all firms that behave badly get embroiled in controversy, and it is possible that looking at just firms that are controversial creates a selection bias that explains the negative returns.

In summary, based upon the studies so far, the strongest evidence in support of ESG seems to be that "bad" companies face higher funding costs (from debt and equity), whereas the evidence on ESG paying off as higher profits and growth is elusive. There is some evidence supporting the proposition that being socially responsible (or at least not being socially irresponsible) can protect companies from damaging disasters, but selection bias is a problem.

ESG and Returns
To begin with, the notion that adding an ESG constraint to investing increases expected returns is counter intuitive. After all, a constrained optimum can, at best, match an unconstrained one, and most of the time, the constraint will create a cost. In one of the few cases where honesty seems to have prevailed over platitudes, the TIAA-CREF Social Choice Equity Fund explicitly acknowledges this cost and uses it to explain its underperformance, stating that “The CREF Social Choice Account returned 13.88 percent for the year [2017] compared with the 14.34 percent return of its composite benchmark … Because of its ESG criteria, the Account did not invest in a number of stocks and bonds ... the net effect was that the Account underperformed its benchmark.”  In fact, there is an inherent contradiction, at least on the surface, between the argument that ESG leads to higher value and stock prices, made to CEOs and CFOs of companies, and a simultaneous argument that investors in ESG stocks will earn higher (positive excess) returns, by investing in these companies.

Value, Price and Returns: The Interplay
Whatever your beliefs may be on whether ESG increases or decreases value, you have to start with a fresh slate, and incorporate market behavior, to make judgments on whether investors will benefit from ESG investing, as can be seen in the table below:

Consider the first outcome, where ESG increases the value of a company, but markets overreact to the goodness of the company, pushing up the price too much: investors in good companies will earn lower returns (negative excess) returns over the long term. Flipped around, this table also yields the counter intuitive result that studies that conclude that ESG investing earns positive (or negative) returns tell us nothing or very little about the underlying benefits of ESG, since the market acts as the intervening variable. 

The Evidence on ESG and Returns
It should come as no surprise then, that the research on the link between ESG and investor returns comes to split results:
  • Invest in bad companies: There are the studies that we referenced earlier as backing for good firms having lower discount rates, including the ones that showed that sin stocks deliver higher returns than socially conscious companies. A comparison of two Vanguard Index funds, the Vice fund (invested in tobacco, gambling, and defense companies) and the FTSE Social Index fund (invested in companies screened for good corporate behavior on multiple dimensions) and note that a dollar invested in the former in August 2002 would have been worth almost 20% more by 2015 than a dollar invested in the latter.
  • Invest in good companies: At the other end of the spectrum, there are studies that seem to indicate that there are positive excess returns to investing in good companies. A study showed that stocks in the Anno Domini Index (of socially conscious companies) outperformed the market, but that the outperformance was more due to factor and industry tilts than to social responsiveness. In a different study,  researchers looked at the payoff to socially responsible investing by comparing the returns on two portfolios, created based upon eco-efficiency scores, and concluded that companies that are more eco-efficient generate higher returns. Some of the strongest links between returns and ESG come from the governance portion, which, as we noted earlier, is ironic, because the essence of governance, at least as measured in most of these studies, is fealty to shareholder rights, which is at odds with the current ESG framework that pushes for a stakeholder perspective. 
  • ESG has no effect: Splitting the difference, there are other studies that find little or no differences in returns between good and bad companies. A Morningstar Quantitative study of ESG stocks in 2020 found that companies that scored high on ESG generated mildly lower returns than companies that scored poorly, though the difference was statistically insignificant. In fact, studies that more broadly look at factors that have driven stock returns for the last few decades find that much of the positive payoff attributed to ESG comes from its correlation with momentum and growth.
In steady state, it is internally inconsistent to argue that good companies will benefit from lower funding  costs (lower costs of equity) and that investors can also earn higher returns at the same time. 

Glimmers of Hope for ESG Investing
There are two possible scenarios where being good may benefit both the company (by increasing its value) and investors in the company (by delivering higher returns).
  1. Transition Period Payoff: The first scenario requires an adjustment period, where being good increases value, but investors are slow to price in this reality. During the adjustment period the highly rated ESG stocks will outperform the low ESG stocks, as markets slowly incorporate ESG effects, but that is a one-time adjustment. Once prices reach equilibrium, highly rated ESG stocks will have greater values, but investors will have to be satisfied with lower expected returns. The presence of a transition period, where markets learn about ESG and price them in can also explain why there may be a payoff to more disclosure and transparency on social and environmental issues, by speeding the adjustment. It is perhaps this hope of transition period excess returns that that has driven some institutional investors to become more activist on ESG issues and can explain why some have been able to show excess returns from increasing (reducing) their holdings in good (bad) companies. It is not just the large players like Blackrock and Vanguard that have jumped on this bandwagon, but also pure return-focused investors like Elliott Management and Third Point which recently targeted utility companies about their excessive carbon footprints. Their activism goes well beyond jawboning management and includes efforts that range from stopping mergers to proxy fights to altering boards of directors. This study examined 613 public firms that were targeted by an activist institutional investor focused on improving ESG practices and found positive excess returns in the 18% of engagements where the activism succeeded. 
  2. Limit Downside: The other scenario where incorporating ESG into investing may yield a payoff is when investors are concerned about limiting downside risk. To the extent that socially responsible companies are less likely to be caught up in controversy and to court disaster, the argument is that they will also have less downside risk than their counterparts who are less careful. There is some evidence of this in this paper that finds that companies that adopt better ESG practices are less likely to see large drops in value. 
If there is an investing lesson embedded here, it is the unsurprising one that investors who hope to benefit from ESG cannot do so by investing mechanically in companies that already identified as good (or bad), but have to adopt a more dynamic strategy built around either aspects of corporate social responsibility that are not easily measured and captured in scores, or from getting ahead of the market in recognizing aspects of corporate behavior that will hurt the company in the long term.

The COVID effect
The last few months have been a test of ESG investing, and while the consensus view seems to be that ESG has passed the test, it is worth separating the facts from what is debatable. 
  • Fund Flows (not debatable): It is not debatable that investors, whatever their reasons, have been investing more in ESG funds, both passively (through index funds) and actively (through ESG funds that contend that they can do better than the market). By early September 2020, impact investing index funds had risen to $250 billion in the US and more than a trillion dollars globally, with both numbers rising over the course of the COVID months. 

  • Performance (debatable): The question of whether ESG funds have outperformed during the COVID crisis is more debatable. Early in the crisis, Blackrock asserted that sustainable investing had shown its value added, pointing to the fact that ESG indices were outperforming their market counterparts during the crisis months. The problem, though, is that Blackrock is not a neutral commenter on this issue, partly because Larry Fink has been a vocal salesman for ESG and  partly because Blackrock has ESG products to sell. It is true that Morningstar seems to provide backing for this proposition, when they presented the results on ESG funds during the first half of 2020:

    Morningstar noted that ESG funds in all 26 categories that they track outperformed their conventional index fund counterparts. The consensus view that ESG investing outperformed the  market is now getting push back, with this paper arguing that once you control for the sector tilt of ESG funds (they tend to be more heavily invested in tech companies), ESG, by itself, provided no added payoff during the down period of the crisis (February and  March 2020) and pushed returns down during the recovery phase.
If success in active investing is defined as attracting investor money, ESG has had a successful run during COVID, but if it is defined as delivering returns, it is far too early to be doing victory dances in the end zone.

The Bottom Line
In many circles, ESG is being marketed as not only good for society, but good for companies and for investors. In my view,  the hype regarding ESG has vastly outrun the reality of both what it is, and what it can deliver, and the buzzwords are not helpful. That is the reason I have tried to under use words like sustainability and resilience, two standouts in the ESG advocates lexicon, in writing this post. I believe that the potential to make money on ESG for consultants, bankers and investment managers has made at least some of them cheerleaders for the concept, with claims of the payoffs based on research that is ambiguous and inconclusive, if not outright inconsistent. The evidence as I see it is nuanced, and can be summarized as follows:
  • There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good. In short, expensive gestures by publicly traded companies to make themselves look “good” are futile, both in terms of improving performance and delivering returns.
  • The evidence that investors can generate positive excess returns with ESG-focused investing is weak, and there is no evidence that active ESG investing does any better than passive ESG investing, echoing a finding in much of active investing literature. Even the most favorable evidence on ESG investing fails to solve the causation problem. Based on the evidence, it appears to me that just as likely that successful firms adopt the ESG mantle, as it is that adopting the ESG mantle makes firms successful.
  • If there is a hopeful note for ESG investing, it is in the payoff to being early to the ESG game. Investors who are ahead of markets in assessing how corporate behavior, good or bad, will play out in performance or priced, will be able to earn excess returns, and if they can affect the change, by being activist, can benefit even more.
Much of the ESG literature starts with an almost perfunctory dismissal of Milton Friedman’s thesis that companies should focus on delivering profits and value to their shareholders, rather than play the role of social policy makers. The more that I examine the arguments that advocates for ESG make for why companies should expand mission statements, and the evidence that they offer for the proposition, the more I am inclined to side with Friedman. After all, if ESG proponents are right, and being good makes companies more profitable and valuable, they are on the same page as Friedman. If, on the other hand, adopting ESG practices makes companies less valuable, the onus is on ESG’s proponents to show that societal benefits exceed that lost value.

The ESG bandwagon may be gathering speed and getting companies and investors on board, but when all is said and done, a lot of money will have been spent, a few people (consultants, ESG experts, ESG measurers) will have benefitted, but companies will not be any more socially responsible than they were before ESG entered the business lexicon. What is needed is an open, frank, and detailed dialogue concerning ESG-related corporate policies, with an acceptance that being good can add value at some companies and may destroy value at others, and that in the long term, investing in good companies can pay off during transition periods but will often translate into lower returns in the long term, rather than higher returns. 

YouTube Video

Paper on ESG (with Brad Cornell)
My blog posts on stakeholder wealth maximization

Tuesday, September 1, 2020

Illusion, Perception and Reality: Stock Splits and Index Inclusions

After big market movements, we are eager to look for explanations, fundamental reasons why a stock or stocks collectively moved on that day, but the reality is that a great deal of the price movement on a day-to-day basis has nothing to do with earnings, cash flows or risk. On August 31, this reality was brought home by two events, neither with a strong connection to fundamentals, that represented the news of the day and contributed to price movements. The first was  that two of the highest profile stocks in the market, Apple and Tesla, had stock splits that day (August 31), though the market had been trading on the expectation of these stock splits, for weeks leading into the day. On the same day, the Dow 30, a hopelessly flawed, but still among the most followed indices in the market, also announced a major reshuffling, replacing Exxon Mobil, Pfizer and Raytheon, three of its components, with Honeywell, Amgen and Salesforce. That gave rise to a wave of speculation about whether these new entrants would be helped or hurt by their inclusion in the index. While it is easy to dismiss stock splits and index inclusions as non-events, that dismissal is contradicted by market behavior, which, rational or not, seems to view them as consequential. 

Value, Price and the Gap

I have long argued that value and price, while used interchangeably by many, are different concepts, driven by different forces, and lead to different numbers.

If you are an investor, no matter what your philosophy, this picture should not surprise you, since every philosophy is built around beliefs about the value and price processes. 

  • A value-based investor, for instance, believes that value and price can diverge, often by large amounts and for long periods, but that the price will eventually converge on value, delivering profits to those with the patience to hold on to the investment. 
  • A trader, in contrast, has little interest in value and plays the pricing game, gauging momentum and mood shifts to make money, and using liquidity or the lack of it to magnify these gains. 
  • An efficient marketer may agree that the price and value processes can diverge, creating gaps, but also believes that investors are incapable of finding and taking advantage of the gaps.

When an event occurs, whether precipitated by the company or an outside force, it can play out in one of three ways. A value event changes cash flows, alters expected growth and/or impacts the uncertainty/risk in these cash flows, and by doing so, change a company's value. A gap event does not change value, but is designed to get markets to notice mistakes that cause price to diverge from value, and to correct those mistakes, closing the gap. A pricing event is one designed to either alter mood and momentum or to change the liquidity characteristics of a company, causing price to change, even if that price change widens the gap with value. In the graph below, I have expanded the value and price distinction to include these events and the expected effects:

Without examples, these are abstractions, but before I cite examples for each, I want to emphasize that there are very few events that have only one effect, and that most have a dominant effect (on value, price or the gap) with secondary effects on the others.
  1. Mostly value events: When a manufacturing company adds to its production capacity or a retailer opens new stores, the effects will almost entirely be on value. Since these actions are generally in the normal course of operations for these firms, they are unlikely to attract new market attention (which you need for gap events) or change market mood and momentum. Higher profile actions, though, almost always have spillover effects, and here are two examples. When Walmart recently announced its intent to partner with Microsoft to buy TikTok, there is clearly a value impact that this action will have, costing tens of billions in current cash flows, while promising to deliver higher growth and cash flows in the future. At the same time, though, this action, by attracting tech investors  to buy Walmart, may alter momentum and have a secondary impact on pricing. When a California court ruled against ride sharing companies a few weeks ago, on the issue of drivers being employees rather than independent contractors, that decision had consequences for cost structure and value for Uber and Lyft, but it may have induced some investors to look at the gap between price and value at these companies.
  2. Mostly gap events: Gap events can be initiated either by the companies that are being mispriced (or at least perceive themselves to be mispriced) or by investors with the same perception. In academic finance, these events are termed signals, and while there is no guarantee that they will work, the motivation is to try to close the perceived gap between price and value. The cleanest example that I can offer for a gap event is a spin off or a split up, where a multi business company  spins off one or more of its businesses or splits itself up, with no consequential changes in how it is run as a company, but with two objectives. One is that the action will expose the disconnect between the underlying fundamentals and the pricing, by providing more transparency on cash flows, growth and risk of individual businesses. The other is that the action will draw investor attention to the company, and that the attention can lead to a repricing of the stock. Not all gap events originate with the company. When activist investors target a company either as a buy or a short sale, they are attempting to provide the catalysts for the pricing gap to close, though their end games may involve changing the way the company is run, thus affecting cash flows, risk and value.
  3. Mostly pricing events: With mostly pricing events, the end game is altering mood and momentum or changing the liquidity in the stock, and by doing so, affecting the pricing of a stock. An emerging market company that lists its shares on a more liquid, developed market exchange, for instance, has clearly not altered its fundamentals through that action, but may benefit from higher liquidity pushing up price. There can be spillover effects from increased information disclosure, perhaps helping to close gaps between price and value, and perhaps even greater access to capital, allowing for a value effect.
Finally, there are some events that can fall into any of the three buckets, depending upon who initiates the event and how the market views the initiator. Stock buybacks are perhaps the best example, since there are arguments you can make for buybacks to be value, gap or pricing events. 
  • If companies buy back stock, using borrowed money, the primary intent may be to change value by altering the financing mix and the overall cost of capital for the companies. 
  • In contrast, if companies buy back stock, but only if they perceive their shares to be under valued, the buyback becomes a gap event, focused on moving prices up to intrinsic value. 
  • Finally, if companies buy back stock to feed pricing momentum or to provide a floor to the price, buybacks are primarily pricing events. The question for today then becomes where stock splits and index inclusions fall in this spectrum of value, gap and pricing events.
There is one final point that needs to be made about all these events. With each event, there are two dates of note. The first is the announcement date, when the market learns about the event, albeit it with some leakage to insiders ahead of the date. The second is the action date, when the event actually happens. Almost every effect that I described in this section should happen on or around the announcement date, and action dates are largely ceremonial. Put simply, if you believe that an acquisition, a spin off or a developed market listing is going to have an effect on price, the time to take investment action is at the time that it is announced, not when it happens.

Stock Splits

A stock split is a change in share count, without altering ownership shares. If you are an Apple stockholder, for instance, after Apple's four for one stock split on August 31, you would own four times as many shares as you did on August 30, but so would everyone else in the company. 

The Evidence: In one of the earliest empirical studies in academic finance, Fama, Fisher, Jensen and Roll looked at the effects on stock splits on stock prices in 1969 and found (not surprisingly) that, on average, they happened after big stock price run-ups and that the splits themselves create no additional run-up, at least in the aggregate. However, when the sample was broken down into companies that subsequently increased and decreased dividends, they found that stock prices rose after splits for the former and dropped for the latter. 

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In the decades since, there have been dozens of studies and while they generally find that split announcements are accompanied by small stock price increases, they disagree on the reasons. Some argue that it is because of post-split changes in liquidity, some posit that it is because splits operate as signals and some claim that they change value.

Value Effect: I pride myself on being creative in coming up with value effects for almost any corporate action, but I must confess that I am floored with stock splits. It is a purely cosmetic action, and the analogy that I would offer is that a pizza, sliced into six pieces, will not taste better and nor will there be more of it, if it is sliced into twelve pieces. Neither Tesla nor Apple become more valuable companies, because of their stock splits, because nothing fundamental has changed in either company, as a consequence of the split. In short, if you thought Apple was overvalued on August 30, trading at $500/share, you would still find it overvalued trading at $125/share, after a four for one stock split, since both price and value will be a fourth of what they were the prior day.

Gap Effect: There is an argument to be made that stock splits can operate as gap events, especially if a company is lightly followed and little attention is being paid to it, leading it to be under valued. The split, while just cosmetic, can bring the company (at least briefly) into the news and that attention may be sufficient to causing the gap to close, by pushing the price towards value (which remains unchanged). This argument does not hold for Apple, the most highly valued company in the world, and Tesla, a company that clearly has never had a problem with attention seeking, but it could be used by a company like Marten Transport, which announced a 3 for 2 split on July 17, 2020, after seeing its stock price stagnate for a three year period. 

Pricing: There are two components to a pricing argument for stock splits. The first is that stock splits, by altering price per share, can affect liquidity, which can change the price. Ironically, a stronger case can be made for this with reverse stock splits, where as a stock falls to low levels, say less than a dollar, folding in five or ten shares into a single share can reduce transactions costs. With high priced stocks, the argument that stock splits reduce transactions costs and increase liquidity had more resonance in the past when trading shares in less than round lots often cost substantially more than in odd numbers. In addition, an argument can be made that when share prices reach really high levels, some investors will be shut out of the stock, because they cannot afford to buy any shares in it, round lot or not. Here, a stock split, by bringing the price down to more affordable levels expands its investor base, and by doing so, its stock price. The second argument for stock splits being pricing events is that they feed momentum that is already prevalent in the stock, perhaps because of the perception that lower priced shares (even if there are more of them out there) just seem cheaper to investors. In effect, those investors (like me) who bought Apple at $75/share in 2017 and have seen it go up to $500, and are troubled by how much it has gone up in a short time period, will feel more comfortable when the stock price settles back in at around $125 after the stock split, because we compare this price (perhaps irrationally) to $75/share instead of $18.75/share. With Tesla and Apple, the fact that these splits are coming after a unprecedented run-up in both stocks suggests that the primary reason for the splits is pricing, and that it more momentum-feeding than liquidity-building. You will be able to test the latter, by tracking trading volume and bid-ask spreads on both stocks in the coming weeks, since a liquidity story should show up in higher trading volume and lower spreads (as a percent of the stock price).

Index Inclusion/Exclusion

We use stock market indices to track market movements, but we also attribute qualities to companies, based upon the indices that they are part off. Thus, a company that is part of the S&P 500 is considered to be safer and more secure, and with good reason, since market capitalization is one of the key factors that determine whether a company is part of the index. It is not the only reason, though, since based upon its market cap, Tesla should clearly be in the index, but it is not, because its cumulated profits over four consecutive quarters have never been positive, a requirement for index listing. In recent decades, another phenomenon has fed into the index game, and that is the growth in index funds and ETFS, tailored to mirror indices, often by buying shares in companies that are part of the index. When a company is added to an index, these passive investors will then buy its shares, altering both its stockholder base and the demand for its shares.

The Evidence: Not surprisingly, the evidence on index inclusion has been focused on the S&P 500, with studies examining how stock prices are impacted by a company's inclusion in or exclusion from the index. While there are dozens of papers, the findings can be broadly summarized as follows:

  • Positive or negative: The consensus view across studies is that a company that is added to the S&P 500 sees its stock price increase modestly, and that the increase is permanent, and that companies that are removed from the index see small drops in stock prices that persist. There are two caveats. The first is that this increase may be more a consequence of the circumstances that led to the the company being added on to the index than the index addition. This paper, for instance, looked at a matched sample, where companies added to the index were paired with companies with similar characteristics (high momentum, rising earnings etc.) that were not added to the index and concluded that there was no index addition effect. The second is that there seems to be some evidence that the index effect has become smaller over time, rather than larger, even as passive investing has become a larger part of the index.
  • Volatility and variance: There is some evidence that a stocks that get added to the index see increased volatility, as institutions become bigger players, and move more with the index, for the obvious reason that they are now part of it. 

Value Effect: As with stock splits, it is difficult to make an argument that index inclusion or exclusion changes value, but there is a possible, albeit unlikely, path. When a company becomes part of a widely followed and tracked index like the S&P 500, its investor base will change to become more institutional and more passive. You can argue that these investors bring very different views on risk and preferences  investing, capital structure and cash return than investors in the rest of the market. For instance, this study documents that companies that become part of the S&P 500 tend to behave more like their peer group on dividends and buybacks and become less profitable, after the index inclusion than before the inclusion, and these changes can affect value adversely.

Gap Effect: As far as I know, there is no index that looks at how much a company is under or over valued in making a judgment on whether to include it. That said, though, companies that get added on to the index tend to be companies whose stock prices have done better in the period prior to that add on,  than the companies removed from it were doing prior to their removal. For some contrarians, the act of being included in an index may therefore be a signal that the stock price has outrun value.

Pricing Effect: The pricing argument for index inclusion is that it can increase the investor base for a company, by drawing in investors who invest only in that index (like index funds) or primarily in the index (like many large active institutional investors), and that increase should play out in a jump in stock prices on the stock. The effect, though, will vary depending upon the company in question and the index on which it is listed. The Dow 30 may be widely followed index, but it is not an index fund favorite or even one that institutional investors use to track their returns. Consequently, I don't think that Honeywell, Salesforce and Amgen are going to be helped by being added to that index or that Exxon Mobil, Pfizer and Raytheon will be hurt by their exclusion from it. In contrast, when ServiceNow was added to the S&P 500, its stock price climbed 4%, reflecting both the company's status (low profile, not widely followed) and the S&P 500's standing as an index. I know that many Tesla bulls are awaiting its inclusion in the S&P 500, and with the full recognition that I will be wrong in hindsight, there is nothing that leads me to be believe that it will be a game changer for the company. In fact, you could argue that this company's rise in market capitalization has come from individual investors with strong views on the company, and that the investors that may be drawn to the company post-index-inclusion may not be in sync with the company's business practices.

Why should you care?
At this stage, you may be wondering what all of this means for you, especially if your focus is on whether to buy, sell or hold Apple or Tesla, and the answer is that it depends on your philosophy. 
  • If you are an investor, nothing that happened on August 31 should alter your views on the company. In other words, if you believed that Tesla and Apple were (under) over valued on August 30, 2020, you will continue to do so on August 31, notwithstanding the stock splits and the chatter of Tesla becoming part of the S&P 500. 
  • If you believe that one or both of these stocks is under or over valued, and you are hoping that the stock splits will close the gap, I am afraid that you are disappointed. These are among the most widely followed stocks in the world and stock splits are not going to draw new attention or cause neglected details to come to the surface.
  • However, if you are a trader and you play the momentum game, this is your moment of maximum pain and gain. It is conceivable, and perhaps even likely, that the split will keep the momentum going for the near term, and that you can take advantage by buying today and holding for a period. The problem with momentum is that it is fickle and for those who bought the stock expecting the stock split to be their big payday, if the results  fall short of expectations, there will be disappointment. If it sounds like I am playing both sides when I say this, I am, and that is one reason I stay on the sidelines as a trader. I am not good at it.
At the risk of sounding cynical, much of the commentary (including mine) that you read or hear on why stocks move is more post-mortem than analysis, an attempt to provide a rational veneer to a process where human beings move prices, sometimes for good reasons, and sometimes not. 

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Thursday, August 20, 2020

A Viral Market Update XIII: The Strong (FANGAM) get stronger!

When I started these updates on February 26, 2020, about two weeks after the markets went into free fall, my first six posts were titled "Viral Market Meltdowns", reflecting the sell off across the globe. About half way through this series, I changed the title, replacing the word "meltdown" with "update", as markets turned around. In fact, by August 14, the date of this update, US equities had recouped all of their crisis losses, and were trading higher than they were on February 14, the start of the crisis. In that six-month period, though, there has been a reallocation of value, from old to young, value to growth and manufacturing to technology companies, and I have tried to both chronicle and explain these shifts in earlier posts. In this one, I plan to focus on a subset of these companies, the FANG (Facebook, Amazon, Netflix and Google) stocks, younger companies  that have soared in value over the last decade, and two other tech companies of longer standing, Apple and Microsoft. These FANGAM stocks, which have dominated the market for the last decade, have become even more dominant during the crisis, and explaining (or trying to explain) that phenomenon is key to understanding both the market comeback and to assessing whether it is sustainable.

Market Outlook

My crisis clock started on February 14, 2020, and it is now six months since its start, and as with my previous updates, I will begin with a quick overview of financial market action over this period. I start by looking at selected equity indices, spread geographically, and how they have performed over the period:

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On August 14, the S&P 500 was almost back to where it was on February 14, which was an all-time high, and the NASDAQ was 13.46% higher than its February-levels, hitting new highs. In local currency terms, the Latin American indices were still showing double-digit declines, as of August 14, but the Asian indices have recouped much of their early losses. As equities have gone on a roller-coaster ride, US treasuries have settled into a holding pattern, with rates across maturities at much lower levels than prior to it:

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Almost all of the drop in rates occurred in the first few weeks of the crisis, but rates are now close to zero at the short end of the maturity spectrum, less than 1% for the 10-year treasuries and approaching 1.5% for the 30-year treasuries. The Fed's two big action announcements, the one of March 15 on expanding quantitative easing and the other on March 23, on operating as a backstop in lending markets, have had only a muted effect on treasury rates, but they do seem to have caused a shift in corporate bond markets, as can be seen in the graph below, showing corporate default spreads for bonds in different ratings classes:

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Corporate bond spreads, which surged in the first five weeks of the crisis, have dropped back almost to pre-crisis levels for the highest rated bonds. For the lowest rated bonds, spreads have followed the same pattern, but they remain at elevated levels, relative to pre-crisis values. The ebbs and flows in equity and bond markets have also played out in commodities, where I track oil and copper on a daily basis in the graph below:

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Copper, after dropping 15.36% between February 14 and March 20, has more than recovered its losses and was trading 10.57% higher on August 14, than on February 14. Oil had a much steeper fall in the early weeks, down more than 50% in the first five weeks of the crisis, and while it too has recovered, it was trading about 20% below where it was on February 14. Finally, I look at gold and bitcoin during the crisis period:

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Comparing Bitcoin to gold, the cumulative return over the six-month period is not dissimilar, with gold up about 23% from its February 14 level, while Bitcoin is up 14%, but the performance over the six month period is telling. Gold has held its value through the crisis, reinforcing its crisis investment status, but bitcoin has been on a wild ride, falling about 40% in the first five weeks, when stocks were down, and rallying almost 89% in the weeks since, as stocks have risen, behaving more like very risky equity than a crisis investment.

Equities Breakdown

While looking at equity indices can provide a big-picture perspective on how stocks are doing, looking at individual companies can yield much richer insights. As in prior weeks, I updated my company-level data on market capitalizations to include the four weeks since my last update, and I report the changes in market capitalization, by region, in the table below:

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All of these returns are computed in US dollar terms, for comparability, and they are based upon the aggregate market capitalization of all companies traded in each of these markets. As you can see,  a subset of emerging markets (Africa, Eastern Europe, Latin America), are showing the most damage, with weakening local currencies exacerbating market damage. Collectively, global equities on August 14 are back to where they were on February 14, reflecting the comeback story that the indices were telling. Breaking down global stocks by sector, here is what I see:

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Of the eleven sectors that S&P uses to classify stocks, six now have positive returns over the crisis period, and technology has now overtaken health care as the best performing sector. The worst performing sectors are energy, real estate and utilities, all businesses that are capital intensive and debt laden, and default worries about that debt burden may explain why financials remain the worst performing sector. Breaking sectors down into finer detail in industry groups, I list the ten worst performing and best performing industries, over the six-month period:

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The message in this table reinforces what you saw in the sector returns, with infrastructure, commodity and financial service industries making up the bulk of the loser list, and technology, health care and retail dominating the winner list.

The FANGAM Phenomenon

In my earlier posts, I argued that the market effects of this crisis have been disparate, with capital-intensive, debt-laden and rigid firms being worse affected than firms that are capital-light and flexible. You see this play out in the returns you see across sectors, industries and regions. In fact, with returns updated through August 14, 2020, technology companies are now showing healthy gains from where they were at the start of this crisis, up 11.82% since February 14, 2020. There is an inside story to this success, and it revolves around six companies - the original FANG stocks and Apple and Microsoft. They have been responsible not just for the bulk of the returns among technology companies, but  have also provided the thrust for the overall market's recovery.

FANGAM - Tale of the Tape

To understand the FANGAM story, let's retrace our steps to when there were only four young companies in this group, Facebook, Amazon, Netflix and Google (FANG) and look at how two of their senior counterparts, Apple and Microsoft, entered this group. In the table below, I list out the founding date for each of these companies, together with the date of their public offerings, the market capitalization at the time of the offering and the years in which each company hit market cap milestones ($100 billion, $500 billion and $1 trillion):

Looking at the six companies, they vary in age, with Microsoft being the oldest and Facebook the youngest, but they have also had extraordinary revenue growth in the last two decades, albeit from different bases. Coming into 2020, Apple, Amazon and Microsoft had already hit trillion-dollar market caps, and they were joined by Alphabet in 2020, and Apple crossed the $2 trillion threshold just two days prior to this post. I find the construct of a corporate life cycle useful in explaining the evolution of companies over time, in both corporate finance and valuations. 

For most companies, aging is accompanied by three phenomena. The first is that revenue growth decreases as companies scale up, with the speed of deceleration in growth a function of competition in the business. The second is that profit margins, which are negative or very low when companies are young, improve as companies grow, with the magnitude of improvement depending upon the economies of scale in the business, but plateau as new competitors emerge. The third is that even the very best companies reach mature growth, where they remain profitable, but struggle to grow and create value at the same time. The FANGAM stocks stand out from the rest of the market, since they have, at least so far, found the antidote to aging, continuing to grow even as they get larger, while sustaining or even improving profit margins. Breaking down how each of these companies deviate from the norm, here is what I conclude:

  • Amazon, the Original: In an era, where every company claims to be the "next Amazon", it is worth remembering that the original company's rise to global dominance came with hiccups and interruptions. After its stint as the poster child for the dot com boom, Amazon's online retail business flirted with failure in 2001, but survived and prospered in the next decade. By the end of the decade, though, it seemed like Amazon's story had run its course, but just as investors were readying for the company becoming a mature retailer, the company reinvented itself as a disruption platform, ready to go after any business it chose to, with an army (Amazon Prime) backing it up.
  • Apple and Microsoft, the Reincarnation Duo: By tech company standards, Apple and Microsoft are old companies that should be struggling to hold on to their customers and fighting off competition. Both companies though seem to have found a way to move the clock back, and retain their status as growth companies. Apple, given up for dead in the late 1990s, found its answer in streamed music, smartphones and tablets in the following decade. Office and Windows were the cash cows that kept Microsoft going for much of its corporate life, but after seeing growth flatline in the software business, the company found new growth in a subscription model (Office 365) and the cloud business.
  • Alphabet and Facebook, the Advertising Juggernauts: Google and Facebook have had almost uninterrupted growth, since their founding, as they have not only taken advantage of the shift to online advertising, but also dominated that shift, while also delivering profit margins in the stratosphere. Along the way, they have accumulated huge user bases, giving them the power to influence not only where people shop, but also what they think, and perhaps even how they vote.
  • Netflix, the Shape Shifter: Of the six stocks, the one that has had to make the most mid-course corrections, changing its business model to reflect a changing world, is Netflix. It started life as a video rental service, mailing DVDs to its customers, and undercutting Blockbuster, the dominant player in the business then. It pivoted quickly to become the leading streaming player, renting its content from movie and TV producers, and offering them to subscribers. As content producers squeezed the company, it shifted its business model again to make its own shows and movies, becoming the largest spender on content in the business. Along the way, it has gone global, and its business machine not only has a huge base of subscribers, but finds ways to keep adding to that base.

Every investing generation has its share of legendary companies, but I do not believe that there has been another grouping of companies that has dominated the market as completely as these six have done over the recent past.

A Decade of Domination

To understand how the FANGAM stocks made the last decade their own, you need to go back to the start of 2010, and see how the market viewed each one then:

  • The Lagging Giant: At the start of 2010, Microsoft had a market capitalization in excess of $270 billion, and was second only to Exxon Mobil, with a market cap of $320 billion, among US companies, but that represented a come down from its status as the largest market cap company at the start of 2000, with a market cap exceeding $500 billion.
  • The Rising Star: At the start of 2010, Apple's market cap was approaching $200 billion, making it the fifth largest US company in terms of market cap, but that was a quantum leap from its market cap of $16 billion, ten years earlier.
  • The Field of Dreams Company: By early 2010, Amazon had cemented its status as online retailer, capable of growing its revenues at the expense of its brick and mortar competitors, but without a clear pathway to profitability. The market seemed to be willing to overlook this limitation, giving the company a market cap of more than $50 billion, a significant comeback from the dot-com bust days of 2001, when it was valued at less than $4 billion. 
  • The New Tech Prototype: In January 2010, Google was already the prototype for the new tech company model, having reached a hundred-billion dollar market cap threshold faster (a little more than a year after going public) than any other company in history, and with its market capitalization of more than $160 billion in early 2010, the company was already on the top ten list among US companies.
  • On the cusp: In early 2010, it is unlikely that anyone would have put Netflix on the list of big-time winners, since its market capitalization was less than $4 billion and its business model of renting content and signing up subscribers was seen as successful, but not scalable.
  • The glimmer in the market's eye: At the start of 2010, Facebook was still a private business, though venture capitalists were clearly excited about its prospects, pricing it at roughly $14 billion in January 2010, based primarily on its user numbers. 
Looking at the FANG or FANGAM grouping, there is an element of revisionist history at play, since the stocks that are part of this group are there primarily because they have done so well in the last decade. In short, no one was talking about FANG stocks in early 2010, and Microsoft would never have made this list even as late as 2012, when it was viewed as a stodgy and fading company.  Notwithstanding this hindsight bias, the FANGAM stocks collectively saw their market capitalizations increase from $719 billion (albeit without Facebook) to a staggering $5 trillion between January 1, 2010 and January 1, 2020. In the graph below, I show that collective market cap figure as well as the market capitalizations of all other US equities, each year from the start of 2010 to the start of 2020.

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It is true that US equities did well over the decade, but the FANGAM stocks rose much more, rising from 6.5% of the overall market capitalization of all US equities, in January 2010, to close to 15% in January 2020. To provide perspective on how much the FANGAM stocks contributed to the overall equity market's rise, I compute the change in market capitalization each year at the FANGAM stocks and all other US equities, each year from 2010 to 2019:

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The $4.35 trillion in market cap added by the FANGAM stocks accounted for 19% of the overall increase in equity value across all US equities (>7000 stocks). 

The COVID Rally

At the start of 2020, there was no denying the dominance of the FANGAM stocks in US equity markets, but there was a debate about whether they were over priced, at least collectively. For many old-time value investors, the FANGAM stocks had became a symbol of growth and momentum run amok,  though a legendary member of this group (Warren Buffet) had invested in one of the companies (Apple). Between January 1, 2020 and February 14, 2020, the FANGAM stocks continued to rise more than the rest of the market and they collectively accounted for 16.08% of the market cap of all US equities on February 14, up from the 14.94% at the start of the year. When the crisis hit, there were some value investors who felt that the market correction would be felt disproportionately by this group, given their run-up in the years before. In the graph below, I look at the market capitalization of the FANGAM stocks and the rest of US equities, on a week-to-week basis from February 14, 2020 to August 14, 2020:

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During the first five weeks of the crisis (2/14- 3/20), the FANGAM stocks lost about $1.44 trillion in value, providing partial vindication to value investors, but in spite of that loss, saw their share of the market rise to 17.94% of US equities. Between March 20 and August 14, the FANGAM stocks more than recouped the early losses, and were up $1.39 trillion from their February 14 levels, on August 14, while the rest of US equities have collectively lost $1.29 trillion in market capitalization. On August 14, 2020, the FANGAM stocks accounted for 19.94% of the market capitalization of all US equities. While much has been made about how technology has led the comeback on stocks, it is worth noting that US technology companies collectively are up only $973 billion in the last six months, implying that without the FANGAM stocks, there would be no tech comeback. 

From Strength to Strength

We may lump the FANGAM stocks as a group, but these are different companies in different businesses. In fact, lumping them together as technology companies misses the fact that Netflix is closer to Disney in its business than it is to Microsoft's software offerings, and Google and Facebook are advertising companies built on very different technology platforms. There are three elements that they do share in common:

  1. Cash Machines: Each of these companies has a business or segment that is a cash machine, generating large profits and huge amounts of cash for the company. With Apple, it is the iPhone business that allows it to generate tens of billions in cash flows each year, and with Microsoft, it is a combination of its legacy products (Office & Windows) and cloud services that plays this role. With Facebook and Google, their core online advertising businesses not only generate sky high margins, but require very little capital investment to grow. Amazon, until a few years ago, had no segment of equivalent profitability, but AWS (Amazon’s cloud business) is now delivering those cash flows. Netflix remains the weakest of the six companies on this dimension, but even it can count on the subscription revenues from its "sticky" subscriber base for its cash needs. 
  2. Platform of users/subscribers: The FANGAM stocks also share user bases that are immense, with Facebook leading that numbers game with close to 2.7 billion users, many of whom spend large portions of each day in its ecosystem. Microsoft, Google and Apple all also have more than a billion users apiece, with multiple ways to entangle them. Amazon and Netflix may not be able to match the other four companies on sheer numbers, but each has hundreds of millions of users.
  3. Proprietary and Actionable Data: I know that big data is the buzzword of business today, and in the hands of most companies, that big data is of little use, since it is neither exclusive to them, nor the basis for action. What sets the FANMAG companies apart is that they use big data to create value, partly because the data that they collect is proprietary (Facebook from your posts, Amazon/Alexa from your shopping/interactions, Netflix from your watching habits, Google from your search history and Apple from your device usage). Even Microsoft, a late entrant into big data, has stepped up its game. On top of the data is actionable, since these companies clearly use the data to advance their business models, 
Each of these strengths has contributed to helping these companies not just ride out the COVID storm, but to also emerge stronger from it. The cash machines embedded in each company, combined with light debt loads (relative to their earnings and valuations), have left them unscathed, while their debt-laden competitors are hamstrung by default and distress concerns. The economic shut down has left people home-bound and more dependent than ever before on the FANGAM companies to get through the day, increasing the power of the user platforms and the data collected on them by these companies.

In fact, it is the fact that these companies are doing so well that is giving rise to the biggest threat to their continued success, which is regulatory and legal pushback. With Facebook and Google, this is already a reality, especially in the aftermath of the privacy debates and worries about their platforms being used for political influence, with the EU being the forefront of writing restrictions on their data collection and usage. Amazon's disruption of retail, and the devastation it has wrought on its brick and mortar competitors has long been a source of concern for critics, but voices pushing for the use of legal restraints and anti-trust laws on the company are growing louder. Apple has been able to operate under the radar of political and legal scrutiny for a long time, but  recent attempts to force app sellers to sell only through its App Store, leaving it with a hefty slice of revenues, has drawn calls for government action. While Microsoft is now viewed as the most virtuous of the six, and is in fact the most widely held stock in ESG portfolios, I am old enough to remember when Microsoft was viewed as the Darth Vader of technology and targeted by the Justice department for breakup, because of its monopoly power.

Value and Pricing

I know that this has been a long lead in, but interesting though it might be to explain why the FANMAG stocks are where they are, the question of the moment in investing is whether you should buy, sell or just watch these stocks. Having valued all these stocks in the past, and acted on those valuations, with mixed results, I will draw on my past history with each company, to craft my stories and valuations of the companies. 

Download valuations: FacebookAmazonNetflixGoogleApple and Microsoft
Simulation resultsFacebookAmazonNetflixGoogleApple and Microsoft

With each company, I report an estimated median (or most likely) value, as well as the range (1st decile, 1st Quartile, 3rd Quartile and ninth decile) of values that I estimated from running simulations. Given how much these stocks have gone up over the last six months, it should come as no surprise that I find only one (Facebook) to be under valued. Among the remaining, Apple looks the most overvalued (>30%), to me, followed by Amazon and Microsoft (10%-20%) and Netflix and Alphabet (<10%). I have also computed the internal rates of return for these stock, based upon the current market capitalization, and my estimates of expected cash flows. I would expect to earn an IRR of 7.16% on Facebook, for instance, if I bought at its current market capitalization, and it generates the cash flows I expect it to. That may not sound like much to you, but in a world of low interest rates and equity risk premiums, it is high enough for the stock to be undervalued. Even Apple, the most overvalued stock in this group can be expected to generate a 5.30% IRR, at its current market capitalization, lower than what I would need it to make, given its risk, but not bad given the alternatives.  That said, I expect you to disagree with me, perhaps even strongly, on my stories and assumptions, which is one reason the spreadsheets are yours to download and change to reflect your views.

In Closing

In the interests of full disclosure, at the time that I started on this post, I owned three of these six stocks, Apple, Facebook and Microsoft, with each having spent significant time in my portfolio; my posts detailing their acquisitions are here, here and here. As you look back at the valuations that I used to justify those investments, they seem laughably low, and I will not claim any semblance of clairvoyance. In fact, I bought Microsoft in 2013, even though I perceived it to be an aging company with little left in the tank in 2013, Apple in 2016, notwithstanding my expectations of low growth in the future, and Facebook in 2018, in the aftermath of the Cambridge Analytica scandal, because I found the companies cheap, even with my stilted narratives. 

I did sell my Apple holdings today (August 19, 2020) as the company crested the $2 trillion mark, will continue to hold Microsoft, even though I believe that it is moderately overvalued, and Facebook, hoping for more upside.  In case you are tempted to follow my lead, let me hasten to add that I also sold my Tesla holdings in January 2020 at $640, and the stock is now trading at close to $2000. Google and Netflix will remain on my watch list, and I plan to add either stock, on weakness. I will not tempt fate, and sell short on Amazon, partly because I have seen what the market does to Amazon short sellers and partly because I struggle to think of a catalyst that will cause the price to adjust. If history is any guide, these companies, unstoppable though they seem now, will hand the baton, for carrying the market forward in this decade, to other companies. 

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  1. Market data (August 14, 2020)
  2. Regional breakdown - Market Changes and Pricing (August 14, 2020)
  3. Sector breakdown - Market Changes and Pricing (August 14 2020)
  4. Industry breakdown - Market Changes and Pricing (August 14, 2020)

FANMAG: Valuations and Simulation Results

  1. Facebook: Valuation and Simulation Results
  2. Amazon: Valuation and Simulation Results
  3. Netflix: Valuation and Simulation Results
  4. Google/Alphabet: Valuation and Simulation Results
  5. Apple: Valuation and Simulation Results
  6. Microsoft: Valuation and Simulation Results

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