Notz Stucki Q3 2018 Investment Outlook


At 10x revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have 0 COGS, which is very hard for a computer company. That assumes 0 expenses, which is really hard for a company with 39,000 employees. That assumes I pay 0 taxes, which is very hard. And that assumes that you pay no taxes on your dividends, which is kind of illegal. And that assumes with 0 R&D for the next 10 years I can maintain my current revenue rate… what are you thinking

-Scott McNeely, CEO of Sun Microsystems at the time of the dotcom crash when the shares were selling at 10x sales

  • At mid-year world bond and equity markets have struggled, with bonds delivering a slightly negative return and equities fell 1.3% as measured by the MSCI World Index, a poor return given that S&P earnings are estimated to increase by 25% this year
  • Emerging markets have been particularly poor performers
    • Liquidity has been tightening
  • In the US, QE easing is being steadily drained from the system at a rate of $30bn/month, which rises to $40bn from July 1st, and then $50bn on October 1st
  • Oil price has risen by 30% over the past year, which resulted in a severe drain of liquidity
  • Labor markets have also been tightening creating some wage pressure and with inflation measures trending higher, bond yields have risen
  • On top of this, investors have been unnerved by a number of political developments, most obviously the trade disputes as the Trump Administration has now specified particular areas against China and Europe, and in Europe an Italian political crisis has threatened the stability of the Eurozone
  • All markets have been buoyed on an ocean of liquidity for the past few years, so as that is removed a major support to asset prices disappears
  • With growth reasonably strong, which underpin earnings, an accident is most likely to come from the bond market
  • Investors have crowded into bond funds in an attempt to avoid risk. There is clearly room for disappointment. Financial markets which have been awash with liquidity from the accommodative policies of governments and central banks are facing a change of music
  • Although yields have risen in the last two years they remain at historically low levels. Given the level of debt rising interest rates would be an increasing problem
  • Scale of debt problem is worth considering. In 2000, US government debt was about $6 trillion and the debt service was about 6% or $360bn. Today, the debt has grown to $20 trillion, with the debt service about 2.25% or $450bn
    • On top of this, the budget deficit is estimated to grow by $1 trillion a year
  • With the 10 year bond yield approaching 3%, up from 2.4% at the start of the year, this may become more of a concern for the market
  • Corporate debt is also significant with non-financial corporate debt rising from $6.5bn to $14bn between 2000 and now
  • According to the Bank of International Settlements, nearly 16% of companies in the US and 10% in the Eurozone can’t cover their interest payments
    • The traditional sources of late cycle inflation like oil and wages are rising so pressure is likely to increase
  • Based on experience of the bull market from 1982 onwards this would be the case, but that was a period of structural deflation. The forty year period before 1982 experienced a bear market during which the 10-year bond yield rose from under 2% to over 15%. During that period the US had nine recessions. Yields did fall during the recessions but the structural trend was for them to rise
    • The worry must be that the July 2016 low in the 10-year yield of 1.36% marked the turn into a multi decade inflation cycle
  • The mounting evidence of brewing inflation from tightening labor markets, reduced disinflation from Asian manufacturing, and political exhaustion on austerity policies all point to the possibility that bonds have finally turned
  • Portfolios are naturally constructed on the basis of the last 35 years of experience. There is potentially a huge upheaval coming if they need to be reorganized for a different world
    • As one illustration imagine how owners of bond proxies such as a ‘growth’ stocks will start to question why they are owning something which gives only 1% more yield than a government bond but which could lose 30% of its value if interest rates spike
  • The last few years, stock markets have been increasingly dominated by either growth or momentum strategies, and this trend has been exacerbated by ETFs
  • FANGs have lost their sense of invincibility this year, chiefly due to questions surrounding the privacy of personal data. Issues of monopoly power and fiscal avoidance could cause legal, regulatory and tax costs to soar
  • There are 28 companies in the S&P 500 trading at over 10x revenues, compared to 29 at the peak of dotcom mania in 2000
    • The likes of Facebook, Nvidia and Netflix fall into this category, though they have far more robust business models than were the case of some companies in 2000
  • Value always feels lonely, which is the reason it has outperformed as a style over the last hundred years, because a stock only becomes a bargain when something very uncomfortable has happened to it
  • In any event, investors are likely to have to be far more discriminating from this point onward, and if interest rates rise much from here, stock picking skills will become valued for the first time in more than a decade

Notz Stucki Investment Outlook Q3 2018, July 2018

Image Source: Notz Stucki Group