Monday, September 10, 2018

Trillion Dollar Toppers: Market Triggers, Value Drivers and Pricing Catalysts!

In the last few weeks, the market capitalization of Apple and Amazon each hit a trillion dollars, a threshold not seen before in public markets. Predictably, that has drawn press attention and commentary about what this moment means for markets, investors and the companies themselves. As readers of this blog know, I have followed both companies and valued them for more than two decades, and this is as good a time as any to see how they got to where they are today, and what the future holds for each company. I will do that in my next post, but in this one, I want to look at the far more basic question of whether hitting a trillion dollar value (or a hundred billion or a billion or any other number) should matter to investors.

Market Triggers
Does the market capitalization rising above a trillion dollars change Amazon or Apple as companies? After all, $1,000,000,000,000 is only a dollar higher than $999,999,999,999 and nothing is changed fundamentally in either company by the event. That said, as human beings, we do make more of a fuss around some numbers than others, especially with age and birthdays. In some cases, the fuss is merited, as when you turn eighteen, since you will be able to vote and be treated as an adult in the legal system, or sixty five, since you may be entitled to your pension and social security benefits. In others, it is a concocted milestone, as is the case when you turn thirty or forty or fifty years old, since little changes in your life, as a consequence.

Investors also seem to endow some numbers with more weight than others, sometimes with reason, and sometimes without. When a publicly traded company’s stock price drops below a dollar, it is often punished, often because it risks being delisted, putting liquidity at risk. When the stock prices rises above $1,000, the company may come under pressure to do a stock split, because it has become “too expensive” for retail investors to buy. With young, privately owned companies, getting a pricing of more than a billion dollars gets you unicorn status, though it not clear what that branding entitles you to, other than a little public attention. Within corporate finance, there are similar triggers built around revenues and profits, with management contracts tied to revenues reaching a billion dollars or EBITDA cresting one hundred million. Collectively, I will call these market triggers, and the focus of this post is to examine how much attention we should pay to them, if any.

The Market Reaction to Triggers
Before we embark on the discussion on whether, and if yes, how much attention to pay to market triggers, note that the degree to which these triggers matter varies widely across investors. While some investors view them as side games, there are others who build much of their investing around market triggers. Value investors, and especially those raised on the classics, scoff at price triggers as distractions from their focus on earnings and moats but they often have their own triggers, based upon earnings or book value. In contrast, a great deal of technical analysis, as an investment philosophy, is built on triggers, many built around price per share. Support and resistance lines, the cresting of which have long been viewed as an indicator of future price movements, are based upon prices that may reflect the company’s past history but often have no intrinsic basis. Similarly, chartists often pay heed to historical high and low prices for the stock, arguing that cresting either number could have consequences for future returns. Many technical indicators are built around price or volume metrics with rules of thumb that often have no fundamental justification. 

At this stage, by making this a contest between value investors and chartists, I have probably already forced you to pick a side, and that would be a pity, since I think that both sides have something to learn from the other. For those who believe in efficient markets, it remains an enduring frustration that markets seem to move in response to what looks like, at least on the surface, to be a cosmetic change in the company. In particular, there is research that stock prices seem to react to stock splits, 
  • With stock splits, where the share count changes in proportion to existing holdings, and nothing fundamentally changes about the company, the market not only reacts positively to the split but these stocks continue to do better than expected in the months after.
  • When a stock approaches its 52-week high, there is some evidence that the high price acts as a barrier, making it more likely that the stock will go down than up.
  • There is some evidence that support and resistance lines have price effects; one study focusing on exchange rates concluded that pricing trends in currency rates are more likely to be interrupted at support and resistance lines. 
  • A general study of technical analysis (and price patterns) concludes that technical indicators, such as head-and-shoulders and double bottoms do have a price impact, though it is unclear that you can make money of these price movements.
In short, much as you may be inclined to dismiss technical research as baseless, there is evidence that past price paths can drive future returns.

Some researchers have managed to convince themselves that the market behavior is consistent with an efficient market, with the rationale that these actions operate as signals about future fundamentals, thus explaining the price changes. A stock split, we are therefore told, is a signal to markets that companies feel that they have the cash flows to sustain higher dividends in the future, translating into higher value. I find most signaling stories to be unconvincing, reflecting almost desperate attempts to reconcile a belief in efficient markets with market behavior that is not consistent with that belief. In my experience, market triggers often affect stock prices, sometimes substantially, and it has little to do with signals. Rather than dismiss these triggers as irrational and useless, I need to understand them better, with the intent of separating ones that may be able to incorporate into my investing from those that I am better off ignoring.

Value Drivers and Pricing Catalysts
In the pursuit of understanding why market triggers matter, I find it useful to go back to a contrast between pricing and value that I have talked about before, and draw a distinction between value drivers and price movers.

In short, the value of a business is driven by its fundamentals, but the pricing of a business is determined by demand and supply, and the two processes can yield different numbers, resulting in a gap between price and value. In this framework, market trigger effects can be classified into three groups:
  1. Value effects: If a market trigger has an effect on one or more of the three drivers of value, which are cash flows, growth and business risk, it can affect value. Revenue or earnings triggers set by companies can have an effect on value, if management compensation is tied to them. With some corporate borrowings, there are covenants tied to stock prices or earnings, the violation of which may lead to consequences for the firm, sometimes taking the form of higher interest expenses and sometimes a change in control. With convertible bonds and preferred shares, the conversion price can become a trigger for a change in value, if it results in a significant increase in shares outstanding and in debt ratios. Consider the grant that Tesla’s board of directors gave Elon Musk in March 2018, where he will get billions of dollars in shares and options in the company, if he can deliver on a variety of targets, some related to market capitalization and some to operating performance. Specifically, the board of directors has listed 12 market capitalization tiggers, each of which can result in shares being granted to Mr. Mush, and 16 operating triggers, with eight relating to revenues and  eight to EBITDA. For a Tesla investor, meeting each of these thresholds will be a cause for mixed feelings, joy that revenues, EBITDA and capitalization are increasing, tempered by dilution occurring at the same time. 
  2. Pricing effects: If a market trigger has an effect on market mood or momentum, it can affect prices, even though it has no effect on fundamentals. For instance, the argument that technical analysts use for paying attention to support lines, often based upon historical prices, is that when a company’s stock price drops below its support line, it creates a negative psychological effect that can cause more selling, with prices falling even further. A pricing trigger can also have a liquidity effect, which can affect prices. This has often been the rationale used by some companies, especially those with high priced shares, for stock splits, arguing that retail investors are more likely to trade a $100 stock than a $1000 stock, and that the increased liquidity can translate into higher prices. The liquidity story can also be used the push by many start-ups to get to unicorn status, since doing so may attract more venture capital money, which, in turn, can push up pricing. Finally, there is the herd effect, where crossing a pricing or value trigger can lead people who have been sitting on the sidelines to act, pushing up prices if they decide to buy and pushing down prices when they sell.
  3. Gap (Catalyst) effects: There is a third and more subtle effect from market triggers, which comes from the attention garnered by crossing even an arbitrary threshold. This is especially the case with smaller and lower profile companies, which can often be ignored by investors and analysts, in a market where larger and higher profile companies garner the bulk of coverage. To the extent that these companies are being mispriced, the attention leading from hitting a trigger can lead to a reassessment of the company and perhaps a closing of the gap. Note that this reassessment can cut in both directions, with unnoticed strengths coming to the surface, and increasing the prices of some companies, and unnoticed weaknesses being unearthed in other companies, resulting in prices dropping. 
This framework can be used to judge whether and why market triggers can affect prices. Some do so, because they have value consequences, some because they affect mood and liquidity, some because they are attention gatherers and some because they have all three effects. Most pricing and volume indicators used by technical analysts, for instance, are pure pricing effects, but since the name of the game in pricing is to gauge shifts in mood and momentum, that is understandable. With companies that have management options and convertibles outstanding, crossing some price barriers can create value effects, by diluting share ownership. With companies that have been operating under the radar, a market trigger can lead to more attention being paid to the company, leading to a closing in gaps between value and price.

So, what effect will crossing the trillion-dollar threshold have on Apple and Amazon? Neither company has options or convertibles that will unlock at the trillion dollar capitalization and thus there should be no value effect. There may be a pricing effect, but it is not clear in which direction. On the one hand, you can argue that for some long term holders of the stock, crossing the trillion dollars may be a culmination of a long and successful journey, leading to selling. On the other hand, there are others who may have resisted both stocks as overpriced, who may decide that this is the time to capitulate and buy the stock. As two of the most widely tracked and followed companies in the world already, it is not likely that there will be any major reassessments in either company, on the part of stockholders, nullifying the gap effect. There is one potential black cloud that comes with the increased attention, at least for Amazon, which is that the company's success may be drawing the attention of anti-trust and regulatory authorities, perhaps putting a crimp on its future growth plans globally. I will return to that issue in my next post.

Market Triggers and Investment Philosophies
If market triggers can have value, price and gap effects, how do you incorporate them into investing? The answer depends upon your investment philosophy:
  1. If you are a trader: The essence of trading is that you are playing the pricing game, and to the extent that you are, your success will depend upon how well you can ride the trend and how quickly you spot changes in momentum. Thus, it does not surprise me that charting and technical indicators are built heavily around these triggers. If you are a good trader, and I believe that they are some, your strength is in assessing how these triggers change mood  and getting ahead of the market on these shifts.
  2. If you are a value investor: As someone focused on value, your first instinct may be to ignore market triggers, viewing them as a distraction from your central mission of valuing companies based upon their fundamentals, and then buying undervalued stocks and selling overvalued ones. While I understand that focus, I think that you should consider incorporating pricing triggers into your value mission for two reasons. The first is that a few of these triggers have value effects and ignoring them will mean that you are mis-valuing companies. The second is that to make money as a value investor, you not only have to get value right, but you have to trust the market to correct its mistake, by moving price towards value. Since the latter is often out of your control, I believe that one of the keys to being a good value investor is finding catalysts that can cause the price correction. If market triggers can operate as catalysts, incorporating them into your investment process can unlock the value mistake that you have found. 
I am a value investor, albeit one with perhaps a broader definition of what comprises value than some old time value investors, but I do look at pricing triggers, especially with small cap, lightly followed and emerging market companies. Thus, if I value a stock at $6 a share and it is trading at $4.10/share, but its historical low price is $4 (the support line), I may wait to buy it, hoping for one of two outcomes. The first is that it hits the support line and does not drop below it, signaling a positive shift in momentum, indicating that this would be a good time to buy. The second is that it drops below its support line, resulting in a negative shift in momentum and more selling, allowing me to buy the stock at an even lower price. Thus, while my primary decision of whether to buy or sell a stock is driven by value judgments, the question of when to do it can be affected by market triggers.

My Bottom Line
I own shares in Apple and I don’t own any (right now) in Amazon, and I have explained why in prior posts on both companies.  With my Apple shares, I have been rewarded well over my almost three-year holding period, and the question then becomes whether the trillion dollar market capitalization should make a difference in whether I continue to hold the shares. With Amazon, I saw little reason to buy the stock a few months ago, as I noted in this post, where I argued that it was a great company but not a great investment. The question then becomes whether market capitalization crossing trillion dollars changes that assessment. The final judgment has to wait until the next post, where I will revalue both companies, and look at whether the trillion-dollar trigger has made a difference.

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brisance said...

Do you think that Apple benefited when it split its stock 7-to-1? One could argue that its inclusion into the DJIA and other price-weighted indices, plus the trend towards passive index investing, could've played a role in its current market valuation since there are a large number of funds that track these price-weighted indices.

Anonymous said...

Thank you for your insightful and stimulating blog entry.

The framework that you are offering on these so-called market triggers seems to add incrementally to Chapter 12 News and Narratives in your book 'Narratives And Numbers'.

I still need a bit of brainpower concerning the three subcategories for the ‘market trigger effects’ that you used in your framework. While I think I understand the concepts of ‘value effects’ and ‘pricing effects’, I currently stumble a bit about the name and location/arrows of the ‘gap (catalyst) effects’ in the framework and I guess, I need some help.

'Value and price effects' seem to be present whenever a ‘driver’ of intrinsic value or price is affected, respectively. Thus, these effects are defined as by which of the 'conventional six listed drivers' triggers their effect for a potential value or price adjustment. With respect to the graphic representation, I would thus almost be inclined to consider placing the effect boxes right below their respective 'conventional drivers' – as there seems to be a direct and logical connection.

The gap (catalyst) effect seems to be currently defined as news that has an attention garnering capacity, independent of the 'six conventional drivers', potentially triggering a major revaluation.

While I completely understand, that this is an important category, I think a name such as 'behavioural number trigger' or 'attention grabbing effect' could be alternate considerations. This could possibly simplifying the intuitivity of the concept for some readers. The gap effect seems to be not so much about closing or widening the gap or how over- or undervaluation is adjusted in the calculations. The key seems here to be rather: the stimulation of a re-evaluation or first evaluation. I think rating agencies sometimes deliberately define and use numeric and non-numeric red flag indicators that may trigger a new rating process for their clients. The gap effect seems to go beyond this on many dimensions.

Also, intuitively, I favor currently to see the ‘gap effect’ mostly as a special kind of the ‘price effect’. After all, incremental information is the secondly listed driver of price. News on numbers to which we attach a symbolic meaning, rationally or not, is incremental information. Having said this, it is understood, that the same piece of news can equally have a ‘value effect’, if it effects one of the three listed value drivers.

‘The Gap’ can be readjusted from both sides. Thus, I would possibly consider putting the position of the ‘gap effect’ box in-line with the other two effects, directly below the two boxes with the drivers.

With respect to the arrows, I would consider deleting the direct connecting arrow between the 'gap effect' and 'The Gap' and rather putting arrows between the 'gap effect' and the value and price effect boxes, each arrow pointing outward.

Again, I might not yet have fully understood the three categories. In any case, these are currently my thoughts. Thanks for sharing your insightful and stimulating posts.

Anonymous said...

Prof., Have you recently valued Microsoft? Would love to get your thoughts as the company hit 'Refresh' over the past 4+ years.

Anonymous said...


Have you recently valued Microsoft? Would love to get your thought as the company hit 'Refresh' for past 4+ years.

Mike D

Anonymous said...

Thank you for the great posts of which I am a great fan, and you've been teaching me since 1997 :)

I have one slight disagreement with your methodology for calculating the implied ERP, which I think is quite material and runs through a lot of how to think of intrinsic value, and your recent posts on valuation.

When you model cash flows to year 5 (say at 6%) and then grow out for the long term perpetuity (say at 2-3% or whatever LT bond yield is), your model simply takes the year 5 cash flows and grows it out by that long term rate. That's incorrect and internally inconsistent for two reasons:

1) When you drop your growth from year 5 to the long term, your payout ratio also changes (1-g/ROE). For a constant ROE, you will have much higher levels of cash to distribute. To be internally consistent, you would have to grow out your earnings as before, but have a materially higher payout ratio for the terminal year as you're growing at a lower rate.

2) Related to that you, are implictly assuming that ROEs stay where they are into perpetuity, and that there is no convergence to the COE, which is also incorrect. If ROE = COE in perpetuity, then the growth rate for the terminal year is a moot point, as in an internally consistent terminal value/payout calculation, the growth rate won't impact the terminal valuation.

In a model built to incorporate these (simply by changing the payout ratio in the terminal year, and assuming ROE = COE), you get a model that is pretty much not at all sensitive to interest rates or indeed the terminal year's growth. If interest rates go from 2 to 4%, and ERP drops from 6% to 4%, the model's intrinsic value output will remain the same -- intrinsic value doesn't change.

In your model, in the same scenario, intrinsic value actually goes down because you have a static COE and a declining terminal growth rate -- so less cash flows discounted at the same level, so naturally a lower intrinsic value. This is a problem. It would be great to get your thoughts on this... thank you again and all the points here are from your own teachings!