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ETFs: It’s One Thing to Not Know, It’s Another to Be Told What Isn’t So

Unpacking a Mainstream Index, the NASDAQ 100

  • Essential value of an index is that it is a passive form of investing, the opposite of active management
    • Active manager’s results are dependent upon security selection
    • Indexation’s foundational intent is that the results will derive from broad exposure to a vast array of securities – no individual security will dramatically impact the result
  • PowerShares NASDAQ 100 ETF (QQQ) has almost $50Bn of assets, making it one of the country’s 10 largest
    • Top 5 holdings in the NASDAQ 100, which are Apple, Google, Microsoft, Amazon, and Facebook, total 41% of the value of the entire index
  • Clearly, this index is the opposite of diversified – its results depend powerfully on individual securities
  • According to the QQQ fact sheet, P/E ratio of the NASDAQ 100 is 22.2x, calculated on a trailing basis, and that is roughly comparable to the P/E of the S&P 500
    • QQQ P/E is not the simple mathematical average of the P/E ratios as one might naturally expect
    • First, it is calculated by excluding all firms with negative earnings – also effectively excludes companies with excessively high P/E ratios
      • In reality, one knows that an unprofitable company makes an investment more expensive, while in the world of indexation (such as in the QQ), unprofitable companies are eliminated, making the P/E lower
    • A footnote on the fact sheet indicates that the P/E is calculated using the Weighted Harmonic Mean
    • Translating this into the 3-step recipe via which an egregiously high P/E ratio is cleansed into a harmless middling sort of group average (Example based on hypothetical equal-weighted 4-stock portfolio – Stock A: 10x; Stock B: 20x; Stock C: 30x; Stock D: 300x)
      • First step is to calculate the reciprocals of each P/E ratio (i.e. 10 is turned into 1/10 or 0.1 and 300 is turned into 1/300 or 0.003). This is done for each company and those reciprocals will be added up
      • Steps 2 and 3 involve taking an average of the reciprocals just summed and then taking the reciprocal of that number
      • That completes the strange journey of transforming a fairly understandable, if alarming, P/E of 90x into the more comforting Harmonic Mean P/E ratio of only 21.5x
    • A more representative and straightforward way of calculating the index P/E ratio would be to simply divide its market cap by the total GAAP net profit that all those companies produce
    • Measuring the NASDAQ 100 valuation in a manner more aligned with accepted procedure, by calculating the simple average of the P/E ratios of the 91 profitable companies, results in a valuation of 43.6x earnings
      • No active manager would be permitted to manage a concentrated, high P/E portfolio for an institutional client – only an index enjoys this privilege

 Can One Hide From The NASDAQ 100 In The S&P 500?

  • The NASDAQ 100 is a convenient way to observe some stark, un-indexlike distortions within a major index, distortions neither known to or expected by the typical index buyer, nor printed on the label – same issues impact the S&P 500 index, if perhaps less obviously
  • Amazon is now 1.85% of the S&P 500 – having appreciated by 29.1% in 2017 thus far, has produced 45 bps of the entire index’s YTD return which (as of 6/30) is about 9.3%
  • Facebook is 1.72% of the index and has appreciated by 31.2%, producing 44 bps of the YTD return of the S&P 500
  • If competing against the index, merely misjudging 2 securities in terms of return potential, one is automatically at a return disadvantage of 99 bps or more
    • Add to those Apple, Microsoft, Google, and those 5 stocks are responsible for 243 bps of the S&P 500 return thus far in 2017, or 26% of the total
  • Worded differently, a manager/analyst who was so brilliant as to have a stock selection error ratio of merely 1%, by not owning these 5 of the 500 stocks, would have underperformed by more than a quarter of the S&P 500 return – this is a degree of narrowness that is very un-indexlike
    • In 2015, the 10 best performing stocks in the S&P 500, 2% of the holdings, accounted for more than 100% of the return that year (Amazon, Microsoft, Google, Facebook, and Netflix)
    • In 2016, 5% of the S&P 500 companies accounted for 50% of the index return (failure to own those 25-odd names, and a manager would have underperformed by nearly 600 bps)

Right on Schedule: Google + Facebook Versus AOL, 18 Years and Counting

  • Facebook and Google (or Alphabet) are likely to generate $35Bn and $105Bn of revenue in 2017, respectively
  • Global advertising expenditure is unquestionably cyclical – assuming no recession in 2017, perhaps $602Bn will be spent in 2017 for advertising. Facebook and Alphabet alone should generate at least $140Bn of revenue (23.2% of worldwide advertising expenditure)
    • Assuming Facebook and Google grow by 25% per annum, they should collectively generate $273Bn by 2020
    • If we assume 4% per annum growth in worldwide advertising expenditure, total sum should equal $677Bn in 2020 – in which case, Google and Facebook should control 40% of the world’s advertising expenditures in 2020
    • This is a plausible figure and one that is reflected in these companies’ high P/E ratios
  • Eventually, the P/E ratios accorded to their shares will come to reflect the cyclicality of the industry – the problem is that no one can predict what their maximum market share % will be
    • Imponderables are: 1) maximum share of advertising revenue these firms can achieve; 2) time at which the maximum share will be reached; 3) P/E at the time that Google and Facebook absolutely dominate advertising; 4) whether there will be a cyclical decline in advertising expenditure that will disrupt the growth of these firms
  • Ultimately, the situation for an investor today is that of 2 cyclical firms that appear now and will continue to appear to be growth companies until they achieve true dominance of the industry – a position they are almost on the verge of achieving – and then there is likely to be valuation multiple compression
    • When will the market realize that? It is a very dangerous game to play
  • AOL, once the largest-market cap company in the world at $222Bn in December 1999 – even today, 18 years later, only 13 companies have a greater market cap
    • In January 2000, within a few inches of the tech bubble peak, AOL and Time Warner agreed to merge (one of the greatest cases of buyer’s regret in stock market history)
    • 90% of a $350Bn combined stock market cap dropped at the time of the merger

Horizon Kinetics 2nd Quarter Commentary, July 2017

Image Source: F. S. Comeau

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