Altus Insight June, 2018

~~The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: June 30, 2018
FR: Forrest Jinks
RE: Bubble Territory

Fleer Chewing Gum Company from Philadelphia invented and first marketed bubble gum in 1928. Chewing gum had been around for decades commercially, and centuries non-commercially (toss a handful of wheat in your mouth and chew and chew without swallowing – viola’: chewing gum…seriously), but bubble gum was both a candy making and marketing break through. The date of the first bubble gum release was, of course, not related to one of the largest stock market crashes in US history which occurred the following year in 1929, but it must be noted that bubble gum was released while stock valuations were, without argument, in their own bubble territory.

But were they really? While stock prices had soared in the 1920s so had earnings and dividends. Using the twelve months trailing price to earnings ratio (PE) of the S&P 500, the PE peaked in September of 1929 at 20.2 . High? Yes. Historic? Not really. In 2001, trailing PE ratios were almost 45. In 2008, they were off the charts. Currently, the trailing PE ratio is 24.72. Doesn’t seem so bad, but it is the fourth highest in US history, so while there could be more room to run, there is probably more downside risk than there is upside potential.

This is something you’ve heard me say before. I have warned prices are elevated on several occasions, possibly even starting to sound like the boy that cried “wolf!”.

But let me parse the data for you a little more. A massive bifurcation in the market has developed. Value stocks, those boring companies that produce products and lots of income, have vastly under performed the market as a whole. Meanwhile growth stocks, fueled by dreams of buying into a unicorn, have followed the hockey stick up, up, and to the right. According to the Wall Street Journal, value stocks relative price (compared to the market) is the lowest it has been in 10 years, while growth stocks….well…up, up, and away.

 
I fully admit that something of a “perma-bear”, but these things just don’t make sense. Maybe they make sense to others and I just don’t get it, a definite possibility. And I understand that investment  

professionals might see things differently than I do. For instance, an Investor’s Business Daily headline screams “Ignore PE Ratios When Evaluating High Growth Stocks”.

Let me take the other side of that argument with just two of the most egregious examples:

Amazon (AMZN): No one is complaining about Amazon if they have owned it for the last twelve months. The stock price has increase 45%. No doubt a very successful investment. But a successful investment and a good investment are two different things, and as we hear ad nauseum, past performance is not indicative of future results.

Every first-year finance student learns how to value a stock using a discounted cash flow model. Basically, it says a dollar tomorrow is worth less than a dollar today (duh – that is why we invest) and the expectation of future income needs to be included in the calculation of today valuation. This makes sense, and explains why a growth stock making very little income can be worth more than a value stock making lots of income AND both stocks be priced correctly. But with irrational exuberance investors forget they are buying an operating company expected to produce income. Maybe not today, but someday. Instead they start buying/gambling on stock because they like the company or because they think the stock price will go up (forever). It could work out well for them, but normally it won’t, which is why very few people outperform the market over the long run. Another thing first-year finance students learn is if a company can’t reinvest their profits internally at a higher rate of return than their stock holders can invest the earning elsewhere, they should pay out dividends, but if they can, they should pay out zero dividends and reinvest the earnings to create compounding growth.

Back to Amazon. With that 45% stock price increase the PE ratio is now 262. That means an investor is getting 0.4 cents of profit for every dollar paid in buying the company. Of course, that profit isn’t distributed, it is reinvested within the company, supposedly creating that compound growth. So, lets go with that theory and forward look over a 10-year horizon (due to the time value of money, the discounting of profits beyond 10 years have little impact on todays stock price). If we assume the stock price doesn’t budge for the next 10 years, AND we assume that profits double every single year for the next ten years (which I don’t know has ever been done, ever – especially not by a company that already has that much market share), the IRR created is 19%. Don’t get me wrong, 19% is a pretty decent IRR, but it isn’t a return that can’t be had other places (we have had several investments over the past decade with far better IRRs). There is one other point worth noting, and it is a big one. This IRR is the companies internal IRR, not you as the stock investor. As the stock investor you invest either for stock price growth or for dividends. In this scenario the stock price doesn’t change and the dividends aren’t paid out, they are reinvested. AND it is contingent on the doubling of profit EVERY YEAR for TEN CONSECUTIVE YEARS.

I like Amazon as a company. They are doing some amazing things. But I don’t like owning a stock that has to stay flat for ten years while the company’s profits increase 51,000% just to get back to a decent internal return. Whether I like the company or not, and whether this is the mother of all growth stocks or not, this, is, a, bubble!

WeWork – And then WeWork’s valuation makes Amazon look like child’s play. For those of you who haven’t heard of WeWork, it is a company that leases office space to make communal work environments (not unlike your neighborhood Starbucks but with more bells and whistles) which they then rent out to people to use by the hour (or some other subscription-based use). The spaces are nice, millennials love the atmosphere, and usership is growing rapidly. Some stats:

  1. Some of the largest investors in the world recently invested in a private priced equity round valuing the company at $20 B (with a “B). And by largest investors, I mean THE largest investor: Softbank (plus Harvard Corp, JP Morgan, and others).
  2. At the end of the 1st quarter of this year they had 220,000 “members” across 234 locations in 60 cities across 22 countries.
  3. WeWork’s internal studies indicate the “independent workforce” (start-up entrepreneurs and free lancers) in the US will grow to 60 million people in 2020 from 45 million people in 2014, an astounding target market size increase of 33% in only 6 years.  

What’s not to love? How about:

  1. Has never made an operating profit.
  2. Doesn’t own any of its real estate.
  3. Has $700,000,000 in outstanding bonds at a 7.875% coupon rate. It is hard to make debt payments without any operating profitability (at least when all the cash infusion runs out).
  4. The rent on the 234 locations mentioned above is $18 Billion over the next 5 years (yep, with a B), or almost as much in rent as the elevated valuation of the company. Revenue in 2016 was $436 M.

So, what’s the big deal, you ask?

  1. IWG (Previously known as Regus), a publicly traded co-working company, has more members and more real estate than WeWork but is valued by the markets at $2 Billion, 10% that of WeWork.
  2. Every workstation in WeWork facility has an implicit value of $135,000.
  3. And the biggie – If every square foot of the 13 million square feet of office currently leased by WeWork (leased = liability) was instead owned by WeWork without debt (owned = asset) AND every square foot of that portfolio, inside the country and out, was valued at $500/ft, their value would still only be 1/3rd of their current market cap.

This is a bubble! You want more evidence?

Tesla (TSLA): Na…too easy.

Happy Investing.

Forrest Jinks
Altus Equity Group, LP
off: 707/932-5887
fax: 707/544-2972
www.altusequity.com

About the Author: Forrest Jinks is a managing director of Altus Equity Group, LP and licensed real estate broker. Forrest has many years of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start up (online marketing and site retail). He can be reached at fjinks@altusequity.com.