Adding Two Stocks Down 50%
Risk-off is on
Along with the cessation of quantitative easing (QE) in two months, several Federal Reserve officials have confirmed an interest rate rise in March 2022. The market is now pricing in four rate rises in 2022. We are now in a risk-off (high inflation and slower growth) environment. As I have mentioned in recent issues, I believe risk-on assets (growth stocks) which benefitted from the easy money, expanding economy, and lower inflation during 2020/21 will feel the pain most. We have seen that in market moves this week.
Central banks around the world insisted during 2020/21 that inflation was transitory, therefore the market did not price in high inflation. This is now the number one issue that we face. The stock markets have historically hated high inflation. Outside of 2021/22, the highest ever valuation of the S&P500 when inflation was above 5% was 23x. The market is currently at 40x earnings.
The US CPI reading printed in line with market expectations at 7%, however, we continue to see risk off sentiment. The Federal Reserve (Fed) Chair Jerome Powell assured the market that quantitative tightening (QT) would not commence in March 2022, but the markets still sold off on negative retail sales numbers (-1.9%). This is usually not a market-moving figure, and this movement shows how market breadth (and high valuations) can affect volatility. Passive flows into S&P and NASDAQ ETFs have helped hold up the index’, but big tech has now rolled over. Strap yourselves in because the volatility has only just begun.
The markets are rising 86% of the time, so it is a loser’s game to call the top. I am unsure whether there will be a market crash or a rotation out of highly speculative growth stocks, so I continue to remain invested, with a higher portion of cash in reserve. The NASDAQ 100 has consolidated since November 2021 and is now making new lows, signaling a downtrend (see below). Alongside this, both the short and long bonds continue to sell off (yields are spiking), and therefore the yield curve is moving lower once again. A continuation of highly restrictive monetary policy in an environment of slowing growth and record-high valuations will likely lead to a bear market.
NASDAQ 100 has broken through support , source: TradingView
Across the pond in the UK, inflation is at 7.1% if you measure by the old Retail Price Index (RPI), but 5.1% if you measure by the new measure (CPI)… but we don’t use the RPI anymore – I wonder why? Real income (after inflation) is declining and tax increases coming in April will reduce disposable income. A YouGov poll also found that one in three Britons think they won’t be able to pay their energy bills this year, estimated to rise by £1,200 p.a.
If the bull market is to continue in 2022, we need to see cooler inflation numbers, which will lead to more accommodative policy. We also need to see continued earnings growth as this will bring valuations down gradually (releasing air from the bubble rather than popping it).
I have read several white papers this week from those who have studied periods of high inflation and bear markets. It has been observed that (see table below), conservative investment in companies with robust profitability tends to outperform hugely during both drawdowns and recessions. I would say 55% of the portfolio currently fits this category, with the exception of the Consumer Discretionary stocks such as ASOS (ASC), as well as Transocean (RIG), Cameco (CCJ), and the precious metal miners.
Defensive stocks perform better in downturns, Source: SSRN
Gold does its job
This week the gold price held strong as much of the market sold off. I mentioned last week that I would sell Polymetal International (POLY) if gold performed poorly. Inflation is still rising and although yields are also rising, real interest rates are deeply negative (currently -5.2%). Any blip in growth will cause gold to boom. Gold miners sold off despite the gold price holding up because of the risk-off environment. I am not concerned about this. I have learned from the past that hasty decisions are often proved wrong in the markets, so I will continue to hold POLY. If markets can deal with the restrictive policy of the central banks, and inflation begins to turn lower, I will not hesitate to reduce exposure to precious metals. However, this remains to be seen.
Gold has been one of the best performing assets since 2000, only being taken over by the NASDAQ100 in 2021 - how long will that last?, Source: TradingView
Gold has performed well in previous rate-hiking cycles, Source: TradingView
Changing outlook
Discovery PLC (DISCA) released a statement earlier this week that it would commit $18bn in capital expenditure (capex) to compete with other streaming powerhouses such as Disney and Netflix. Higher capex means revising Discovery’s EBITDA lower. Originally, I had estimated a fair value of $65 per share for DISCA. With lower future EBITDA trickling into lower free cash flow, I am revising my target price. EBTIDA will now be around $10bn, and on a more conservative 15x multiple, the implied share price is $45. However, the position has already risen 26% since I bought it, and with the new revised share price, there is still 50% on the upside. There is still plenty of opportunity here. Committing $18bn to new productions will generate higher revenue and cash flow for the merged business of Warner Bros and Discovery, and who is to say that they cannot produce another blockbuster show like the Game of Thrones? This would provide a step function for revenue and profit growth of the merged business, so $45 is a baseline target price. I believe that this is a very astute decision by management, and I am by no means stating that $45 is the price at which I will sell.
On a side note, the movement of DISCA shows the insanity of markets. An analyst used data from six months ago in his upgrade for the stock, and it rallied 17%. This shows you not to take anything an analyst (or major bank) says as gospel. The smart money doesn’t seem to be that smart – further evident in the below photograph. This further conveys my mantra to always do your own research.
3 Hedge Funds beat the index in 2021, Source: Linkedin
Alongside DISCA’s update, ASOS PLC (ASC) also provided positive news during the week. It announced that it will be moving to the main market on the LSE, from the Junior market (AIM). This will provide an opportunity for larger institutional funds to gain exposure to the stock, as many are restricted to only investment on the main market. The stock rallied 11% on the news. The company also provided a trading update, and it seems to be managing well with the supply chain issues faced.
Unfortunately, although ASOS is coping well so far, the same cannot be said for RMG. This week’s headlines are littered with stories about huge delays in Royal Mail’s sorting offices due to staff shortages. Both ASOS and RMG were purchased in December 2021 with the belief that management could adapt to these issues quickly. This is worrying for RMGs image and revenue. I do not want to sit around and wait for the outcome of this; therefore, I believe it is prudent to close the position.
Adding two companies down more than 50%
The great thing about Mr Market is that he gets overly excited and overly worried unnecessarily on different occasions. The indiscriminate selling of growth stocks this week has created several opportunities. Note that, while many growth stocks such as Big Tech, renewables, and cannabis sectors are making double-digit losses, my GARP plays are in double-digit profit. This conveys how much valuations matter.
With the sale of Royal Mail, I am rotating capital into another growth at a reasonable price (GARP) stock – BioNTech SE (BNTX). We all know BioNTech for its success in creating the COVID-19 vaccines. Net income margins currently stand at 53% for 2021 (estimated) due to this success. However, it is expected that both revenue and net income will fade dramatically into 2025, with revenue falling from $17bn to just $4.2bn. The market is currently discounting the vaccine revenue to zero, and as such, the share price has fallen from a high of $447 to $196 today. The market is completely ignoring BNTX’s current 10 preclinical trials, 13 Phase one trials, and 4 Phase two trials for various oncology and related medicines. This is much the same GARP play as Vertex Pharmaceuticals (VRTX), which has performed tremendously so far.
BNTX Price Chart - Source: TradingView
These trials are in BNTX’s price for free, along with the huge amount of free cash flow BNTX is predicted to have by 2023 ($22bn). This can be utilised for research and development, or to acquire other profitable healthcare businesses. The indiscriminate selling of growth over the past several months has hit the stock, and it now trades on just 3x earnings or 5x free cash flow.
Another stock unjustifiably hit by last week’s selling pressure is Overstock (OSTK). This is an online home decor seller in the US, with a kicker. The company is asset-light and dropships its stock to customers. They are currently the fourth-largest retailer in the world, competing with Amazon, Wayfair, and Walmart. OSTK beat last quarter’s earnings by 25% and the stock rallied 32%, to then sell off 56% with no negative updates released. It has $500mn in cash and trades at 0.7x sales, with revenue predicted to grow at 10% a year into 2025. The S&P 500 trades at 3.2x sales with revenue growth of 14%.
The kicker is that it has over 20 investments in other businesses outside of the furniture and home décor sector, the top two being Medici Ventures and tZERO. Medici Ventures is a wholly owned subsidy of Overstock, which focuses on blockchain technology. It is essentially a venture capital arm investing in the newest tech. I love businesses that have a core source of revenue, with other smaller but fast-growing segments which can provide huge growth and margin expansion in the future. Lockheed Martin, through its space exploration segment, is one example. Overstock is another. The second major investment is in tZERO. This is a brokerage platform for investors to trade and invest in cryptocurrencies – much like Coinbase. Only 200mn people worldwide have cryptocurrency wallets at present. That is the equivalent of the number of people who used the internet in 2000. Although I am sceptical of the cryptocurrency market at present (it is a risk-on asset and will sell off in tandem with growth stocks), I believe the long-term opportunity with these equity stakes is huge. The furniture business provides cash flow and assured revenue for Overstock, while tZERO and Medici Ventures provide huge potential upside.
Although both BNTX and OSTK are growth stocks, I believe the opportunity is too good to pass up on. At current valuations, I would consider both as GARP.
#Postbox
“Why don’t you use leverage for investments that you are sure of, such as Discovery?”
The art of investing is all about playing the odds. When investing you should make sure that the odds of success are stacked strongly in your favour. This comes through detailed analysis and purchasing at a discount to the stocks justified (intrinsic) valuation, therefore giving you a margin of safety. If a stock is trading at a price-to-earnings multiple of 2, and it issues a profit warning, the stock price may not even react. But if a stock trades at a P/E ratio of 100, a profit warning could lead to a double-digit decline – as witnessed with Peloton (PTON). This may be an extreme example (as a stock trading on a 2x multiple may be very attractive as with BNTX above), but it conveys the reason why valuation is extremely important.
However, this example doesn’t account for growth. A company trading at a 100x PE may be considered a bargain if its revenue is growing at 70% a year, for example. So don’t write off a company just because you see a high multiple– this was a mistake that I once made. However, this example explains in a simple way why I avoid the current boom in AI, renewables, and other related growth stocks. I struggle to find value in a lot of the companies that I have researched in many of these sectors, so I would like to wait for their valuations to come down before I invest. As the saying goes, a rising tide lifts all boats (2020/21), but when the tide goes out, we shall see who was swimming naked. These stocks have been lifted by easy money from the central banks, and many portfolio managers and retail investors have therefore benefitted. But now we see many were swimming naked.
Alongside playing the odds, position sizing is a huge consideration. My three largest holdings are Discovery (DISCA), Airtel Africa (AAF), and iShares Oil & Gas ETF (SPOG). I have high conviction in all three securities and believe the story behind each is compelling. I hold no more than 7% of capital in any one of these positions. Regarding the question outlined above, there are two issues with this statement. First of all, I am not sure of any investment. There are always exogenous risks that you cannot account for when investing in a stock, such as a market crash or a breaking news story relating to the sector or company. The update from Discovery this week is the perfect example of this. In a long-only portfolio, there is a limited number of ways you can hedge out risk, especially for retail investors. One way is to diversify across sectors, asset classes, and geographies, as this prevents events in one segment effecting your entire portfolio’s return. Another way to manage risk is through astute position sizing. Putting 30% of capital into one position is a fast way to lose a fortune. It may pay off once or twice, but if you do it for long enough, it will come back to bite you. I know my limitations. I know I can’t predict a market crash. But I also know I can see when markets are frothy and fundamentals are deteriorating, and therefore continue to be invested but switch between a low and a high level of cash as the outlook changes.
“It ain’t so much the things that people don’t know that makes trouble, it is the things that people know that just ain’t so.”
The second issue I have with the statement is why I don’t use leverage. Both issues are two sides of the same coin. For anyone who is unsure, there are two types of leverage. You can buy a structured product which offers a multiple of the share price return of the underlying asset, or you can use debt (margin) to purchase stocks with less capital, therefore multiplying your return on the upside... and the downside. The first type has several risks. First of all, as discussed above, you cannot hedge out every risk, so it is a risky strategy. Second, even as the share price appreciates, one pullback in price can wipe out your entire return.
Let’s use the example of a 3x leveraged NASDAQ 100 ETF (QQQ3). Let’s say I purchase £100 of this ETF, and the NASDAQ index appreciates 5% the next day. This 3x leveraged ETF will triple that, therefore appreciating 15%. Great, I now have £115. Now, let’s say the following day, the Index falls 5%. You would assume you would be back to breakeven of £100 as with normal stocks. Wrong. 15% of £115 is £17.25, so now you are losing money, not including fees.
The second type of leverage above is arguably worse. Although losses are amplified with the above ETF, using margin for positions is suicide for inexperienced investors. This type of leverage involves using debt (supplied by your broker) to fund the majority of your position; therefore, you only have to put up a small amount of capital. For example, if I was to buy one share in Company A at £100 per share with 10:1 leverage, I only have to put up £10 of capital, and the other £90 is supplied by the broker on margin. Along with this initial margin (£10), there is also variation margin. Variation margin is additional capital the broker requires you to put up as the stock price moves. If there is one sharp decline in a stock’s price (say 10%), the amount of capital you must put up increases. If you cannot fund this position, you receive a ‘margin call’ – i.e. deposit more money in your account, or you will be in debt to the broker. For these reasons, I unequivocally state – do not use leverage. Investing is hard enough without such additional headaches and risks. It is as much about using common sense and good judgement as it is about understanding how to value a company and time the market.
Action:
Buying Overstock PLC (LSE: OSTK) at $49.15, investing 3.3% of capital
Buying BioNTech (QQQ: BNTX) at $196, investing 2.6% of capital
Selling 100% of Royal Mail (LSE: RMG) at £4.97, making a 0% return on the position (Breakeven)
Prices taken at COB on Friday 14th of January 2022.
Portfolio as of 16/01/2022 - Return of 2.65% YTD
See you in two weeks!
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.