Not Enough U.S. Cash Burning IPOs for You? Here Comes China’s Luckin Coffee

Just as U.S. investors are trying to make sense of the Uber (UBER) and Lyft (LYFT) IPOs, both disastrous for those buying at the offer prices, on Friday we will get a U.S. listing of Chinese-operated, Cayman Island-incorporated coffee upstart Luckin Coffee. How much should investors pay for this so-called Starbucks of China (even though its business model is not copying the Seattle-based giant)? Quite frankly, who the heck knows? If that is not a sign that one should pass for now, I don’t know what is.

Below is a summary of Luckin’s financials from the IPO prospectus, though keep in mind its operating history is short (having gone from zero to 2,370 stores between October 2017 and March 2019).

This income statement reads like a Silicon Valley cloud-computing start-up, not a Chinese bricks and mortar coffee chain

As you can see, Luckin’s stores are run at a loss, with Q1 2019 sales of $71 million dwarfed by direct store operating costs of $83 million and another $25 million of marketing expense.

Investors should not exactly be enamored with Luckin’s growth rate. After all, selling coffee at a loss is an easy way to rack up sales and there is no way that the company has a detailed, refined, and proven unit expansion plan in place given that they are opening these money-losing locations as fast as humanly possible (an average of more than 4 new stores a day since they launched 18 months ago!).

None of this says anything about the long-term odds of success for Luckin Coffee. They could very well become China’s largest coffee seller and make money doing it. There is simply no way to know at this point, so investors are left deciding whether they want to take a gamble or not. Many will given that the company will list on a U.S. exchange this week, but with no sound financial model to back up the prices being paid for the shares, there is really no fundamental case to be made for buying the stock.

All one can do is estimate what they think margins could ultimately be based on the business model, assume long-term success, and calculate an imputed price-to-sales ratio worth paying today given certain growth assumptions. That is how Uber and Lyft are likely to be valued (assuming people care to value it at all), and the same idea applies to Luckin Coffee and whatever the next cash-burning IPO waiting in the wings happens to be.

Author’s note: To give you an example, assume that Uber can ultimately earn 20% EBITDA margins over the long-term and one can justify paying 15x EV/EBITDA given their potential growth outlook. That valuation equates to an EV/sales ratio of 3x, which based on 2020 revenue projections could yield a per-share fair value in the $30 ballpark (vs today’s quote of $40). And don’t even ask me to guess what Luckin Coffee’s margins could be.

What A Difference A Decade Makes!

There was a lot of talk on CNBC this week about the trailing 10-year returns of the S&P 500 index and what, if anything, they tell us about the duration of the current equity bull market. Interestingly, the U.S. stock market bottomed at 666 on March 6, 2009, and has since returned nearly 18% annually for a decade.

The consensus view is that periods of strong market returns are often bookended by low valuations on one side and high valuations on the other side. That is certainly the case in this instance, and I am not sure it tells us very much about the current bull market (in terms of when it loses steam). Using the intra-day bottom during the worst market environment in nearly 100 years, as a starting point, is almost assured to subsequently produce a decade of strong returns.



While we cannot use this data to predict the next bear market, it is noteworthy that the market does tend to go in cycles that last one or two decades. The last 10 years have been characterized by strong index returns, and the rise of the index fund as the go-to investment option for individual investors. But I would argue that recency bias is playing a large role in this trend.

Consider that from January 1, 2000 through December 31, 2009, the S&P 500 went from 1,469 to 1,115, a loss of 24%. Dividends made up for a lot of the decline, such that $1 invested in the index including dividends was worth 91 cents in the end, but still, that decade produced a cumulative loss of about 1% annually.

Perhaps that is why there were not nearly as many people piling into index funds 10 years ago. They work… until and unless they don’t. Just as the economy and the equity market are cyclical, so to will be the popularity of index funds.

Interestingly, even Warren Buffett (arguably the greatest active portfolio manager in history) has been bitten by the index fund bug, having recommended them many times in recent years.

Side note: I think the saying “do as I do, not as I say” is fitting here. While Buffett now praises the index fund category, it is important to note how the 88 year old plans to transition his stock picking duties at Berkshire Hathaway when he is no longer around. Move all of his investments into index funds? Hardly. Instead, he has hired two hedge fund managers, Todd Combs and Ted Weschler, to take over management of Berkshire’s stock portfolio. Fascinating.

So what can we expect over the coming decade for the stock market? Well, it is not exactly going out on a limb to say that returns will likely average less than +18% and more than -1%, but that is a start. After all, the coming decade is unlikely to be as good as the go-go 1990’s, or as bad as the ten years immediately following them.

History would tell us that average returns will be somewhere in the single digits. I won’t hazard a guess as to whether we get 3%, 5%, or 7% a year, but I think mid single digits is as good of a guess as any based on historical data. It will be interesting to see if, in such an environment, index funds remain the asset of choice, or if tastes shift to something else (and if that something else is already in the marketplace or if it has yet to be created).

U.S. Stock Market Seems Like An Obvious Buy For First Time In A Long Time

With the S&P 500 index now down roughly 18% from its peak reached about three month ago, for the first time in years it appears the U.S. stock market is severely oversold and pricing in worse than likely economic conditions. In the two weeks since my last post discussing valuation, the S&P trailing price-to-earnings ratio has dropped by more than a full point and now stands at just above 15x.

I have previously posted that we should expect P/E ratios of between 16x and 17x with the 10-year bond yielding in the 3-5% range (current yield: 2.75%). Given that 2018 corporate profits are pretty much in the books already, the current valuation of the S&P 500 assuming ~$157 of earnings is 15.3x (at 2,400 on the S&P 500).

Let’s consider what this valuation implies. First, it presumes no further earnings gains, or put another way, 2018 is the peak of the cycle for profits. Could that be possible? Sure it could, but right now that is the base case. And even with that base case, stocks are 5-10% below the 16-17x P/E we would expect to see.



One could also make the argument that U.S. stocks are pricing in a mild, normal recession. Let’s assume a typical 6-9 month recession occurs over the next 12-24 months, and as a result, S&P 500 profits drop 11% to $140. If a normalized P/E ratio would be 16-17x, I would guess stocks would fetch about 18x trough earnings during a recession (investors often pay higher multiples on depressed earnings). If we assign an 18x multiple on $140 of earnings, we get an S&P 500 target of 2,520, or 5% above current levels.

If we take a more bearish stance and assume a normalized P/E (16.5x at the midpoint, given low interest rates) on that $140 profit number, we would peg the S&P 500 at 2,310, or less than 4% below current levels.

I am not in the game of predicting short-term economic paths or stock market movements. All I can say now is that stock prices for the first time in many years are pricing in several of the most likely economic outcomes (normal recession or materially slowing GDP growth). Furthermore, it appears that the S&P 500 will close out 2018 at the lowest valuation since 2012.

Given those conditions, I am aggressively buying stocks with the majority of current cash balances in the accounts of those clients who are aiming for more aggressive, long-term, growth-oriented investment strategies. Put simply, I am seeing a ton of bargains right now and am not content waiting for further downside to pounce. For those who have excess cash on the sidelines, now could turn out to be a great time to add to your equity exposure, assuming that fits with your risk tolerance and investment goals.

With The Elevated Valuation Issue Solved, 2019 Earnings Growth Takes Center Stage

With S&P 500 profits set to come in around $157 for 2018, the trailing P/E ratio for the broad market index has fallen from 21.5x on January 1st of this year to 16.5x today. Surging earnings due to lower corporate tax rates have allowed for such a significant drop in valuations despite share prices only falling by single digits this year, which is a great result for investors. Normally, a 5 point drop in multiple requires a far greater price decline.

With sky high valuations now corrected, the intermediate term outlook for stocks generally should fall squarely into the lap of future earnings growth in 2019. On that front, there are plenty of headwinds. With no tariff relief in sight, the steady inching up of interest rates, a surging federal budget deficit, and no incremental tax related tailwinds next year, it is hard to see a predictable path to strong profit growth from here.



Even if 10-year bond rates go back into the 3’s, market valuations should stabilize in the 15-18x range, so stocks today appear to be fully priced for a relatively stable economic environment. Although current profit estimates for 2019 are quite high (double digit growth into the $170+ area), I suspect those figures will come down meaningfully once companies issue 2019 guidance in late January and into February (analysts don’t often go out on a limb so they will wait for companies to tell them what to expect).

Putting all of this together and we are unlikely to make new highs in the market anytime soon, in my view. We probably have 10% downside and 10% upside depending on various economic outcomes over the next few quarters. In the meantime, there are plenty of cheap stocks to accumulate and hold for the long term, until attractive exit points present themselves. Goldman Sachs (GS) is a perfect example, at it inexplicably trades for $176 today, below tangible book value of $186 per share.

Full Disclosure: Long GS at the time of writing, but positions may change at any time.

Rising Interest Rate Shock: 2019 Edition

Back in February I published the table below to show investors where the S&P 500 index would likely trade if interest rates normalized (10-year bond between 3% and 5% is how I defined it):

Published 2/27/18

The point of that post was to show what the typical equity valuation multiple was during such conditions (the answer is 16x-17x and we don’t have to go back too far to find such conditions). Now that 2018 is coming to an end and earnings are likely to come in at the high end of the range shown in that table ($157 is the current consensus forecast), let’s look ahead to 2019.

I have added a gray section to the chart (see below) to include a range of profit outcomes for 2019. The current forecast is $176 but I believe there is more downside risk to that than upside, so I did not add any outcome in the $180+ area.

As you can see, the equity market today is adjusting rationally to higher rates, with a current 16.1x multiple on consensus 2019 profit projections. The big question for 2019, therefore, is not huge valuation contraction. Rather, it comes down to whether earnings can grow impressively again after a tax cut-powered 26% increase in 2018. If the current consensus forecast for earnings comes to fruition, the market does not appear to be headed for a material fall from today’s levels.



Given that the long-run historical average for annual earnings growth is just 6%, assuming that in the face of rising rates the S&P 500 can post a 12% jump in 2019 seems quite optimistic to me. Frankly, even getting that 6% long-term mean next year – resulting in  $166 of earnings – would be solid.

For perspective, at that profit level, a 16x-17x P/E would translate into 2,650-2,825 on the S&P 500, or 3% lower than current quotes at the midpoint. Add in about 2% in dividends and a flattish equity market overall seems possible over coming quarters if earnings fall to post double-digit gains next year and valuations retreat to more normal levels.

Would Moving To Six Month Financial Reporting Solve Anything?

News that President Trump has asked the SEC to study the potential benefits of moving from quarterly to biannual financial reporting for public companies has stoked a debate as to the merits of such a proposal.

While it is certainly true that short-term thinking, often motivated by the desire to please Wall Street, should not be a focus of management teams of public companies (I can’t stand it when I see quarterly financial press releases tout how actual results beat the average analyst forecast), I am not sure that six-month reporting would materially help solve the problem. From my perch, there are several reasons why I would not expect much to change if such a proposal was enacted:

      1. Many companies already do not spend time predicting or caring about short-term financial results, and those firms adopted such a strategy on their own. They did so because the boards and management teams of those firms decided it was the best way to run their business. Those calls fall under their job descriptions, and they take them seriously regardless of what guidance they receive from regulatory bodies.
      2. For companies that choose to give forward-looking financial guidance today, they would likely continue to do so on a six-month basis. If they tried hard to hit their quarterly numbers, sometimes doing so at the expense of longer term thinking, the same would be true when dealing with six-month financial targets. Behavior would not change, just the outward frequency of such behavior would.
      3. Reducing the frequency of financial reporting would only serve to make companies less transparent with their own shareholders. Since we are talking about public companies that are serving their shareholder base first and foremost, it should be up to the investors to voice concerns about what metrics are being prioritized at the management and board level. There is a reason activist investing has found a place in the marketplace (and the goals are not always short-term in nature, despite media claims to the contrary).
      4. Just because companies are required to file quarterly financials does not mean they need to spend much time on them, or communicating them. Jeff Bezos likes to brag to his shareholders at Amazon’s annual meetings that the company has no investor relations department and does not travel around the country to tell their story to the investment community. He does not think it is a good use of his time. Plenty of smaller firms simply file their 10-Q report every 90 days and hold no conference call to discuss their results. In essence, they spend minimal time on financial reporting (10-Q reports are not super time consuming when the same template is used every quarter and the company has to close their books every period regardless of external reporting requirements).
      5. There is an argument that less frequent financial reporting will result in more volatile stock prices when companies do publish their financials. Essentially, if things are going unexpectedly, the surprise could be twice as large if the gap between reporting periods is twice as long. For many companies, this might be true. But I am not sure of the net impact, given that it can work the opposite way too. If a company has a poor Q1 but makes it up with a strong Q2, it could be a wash when it comes time to report mid-year results, whereas quarterly reports would have resulted in surprising investors twice, in opposite directions.

     

  1. It seems the core problem people are trying to solve here is the focus on windows of just 90 days from a management and investor perspective. I firmly believe that whether a company takes a long term view, at the possible expense of short-term results, or not, that decision is a reflection of top management and the board, with input from shareholders hopefully playing a role. If that is true, then reporting frequency itself is not the core determinant of the behaviors we see. As such, we should expect companies to continue their chosen management styles and strategies, whether they have to publish financial reports every 3, 6, or even 12 months.

    From an investor standpoint, if I am going to be given information less frequently, I would want to at least believe that performance will be superior, in exchange. In this case, I do not see how six-month reporting would benefit shareholders by changing behavior at the corporate level, leading to improved revenue and earnings growth over the long term.

    If a simple financial reporting rule change would dramatically change decision making inside public companies, then the same managers who are pushing for six-month reporting should take responsibility for how they are running their companies and simply de-emphasize short term results.

  2. They can do so without rule changes at the SEC, and they can go further if they want. For instance, there is no rule that says you need to host quarterly conference calls after reporting earnings. Companies could easily host one or two calls per year if they chose to (or none for that matter), which would send a clear message to their investors and free up time (albeit not that much) to focus on the long term.

     

The Price of “FAAAM” – 5 Tech Stocks Now Worth Over $4 Trillion

We hear a lot about the “FAANG” stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet) leading the S&P 500 higher in recent years, which is undeniably true, so I decided to take a look at a slightly modified version to see where valuations are within the group.

Below you will find data on “FAAAM” which I have coined to represent the top 5 most valuable companies in the S&P 500 today. By adding Microsoft in place of Netflix, we have a fivesome worth more than $4.1 trillion, or about 16.5% of the entire S&P 500 index ($25 trillion total value).

There are many conclusions investors can gleam from this group of tech stocks, and not everyone will agree. I will share a few of my views and feel free to chime in.

  • While not unprecedented, having such concentration within the dominant U.S. equity index means that near to intermediate returns for the market are largely correlated with large cap tech leaders. Given that none of the valuations are inexpensive, and Apple is probably the only one that looks to be no worse than fairly valued, investors relying on this group for future returns will need growth rates (in revenue and earnings) to continue at high rates for quite a while. It is hard to know whether this expectation is reasonable. For instance, will the size of these firms lead to slower growth by default, or are they dominant enough to continue to garner the lion share of the sector’s growth overall?
  • At 18x EV/EBITDA, are the valuation of this group reasonable enough to expect that the stocks, on average, can generate double-digit annualized returns over, say, the next 5-10 years? If 20% annual growth rates in the underlying businesses persist, then the valuations are not likely too high, but that is a big open question. For instance, Amazon’s revenue in 2018 is projected to reach $235 billion (current analyst consensus estimate). To keep growing at 20% per year, the company needs to find an incremental $50 billion of revenue every year, which equates to $1 billion every week! The stock is priced as though such an outcome is likely. What happens if revenue growth slows to 10%?
  • Of the five companies in “FAAAM” the only ones I would consider putting fresh money into, based on growth and valuation, would be Apple and Facebook. Apple’s run to $1 trillion this week on the heels of a strong earnings report could signal the stock is topped out in the near-term. Facebook, however, trading down lately after ratcheting down growth expectations on their latest conference call, is really the only FAAAM stock that is down materially at all. While I am not exciting to buy any names in the group at current prices, they could very well have the best mix of untapped growth opportunities and less-than-exuberant investor sentiment.

Are Stock Buybacks Really A Big Problem?

I read a recent article in the Wall Street Journal entitled The Real Problem with Stock Buybacks (WSJ paywall)  which spent a lot of time discussing multiple pitfalls of stock buybacks and touched on some lawmakers in Washington who would like to limit, or completely outlaw, the practice. To say I was dumbstruck by the piece would almost be an understatement.

Let me go through some of the article’s points.

First, the idea that the SEC should have the ability to limit corporate buybacks, if in its judgment, carrying them out would hurt workers or is not in the long-term best interest of the company.

To be fair, the authors disagreed with this idea. They were simply bringing to readers’ attention that it was out there. Public companies are owned by shareholders, and those shareholders are represented by the board of directors (whom they vote for). The CEO serves the board on behalf of those shareholders, though admittedly this is a problem when the CEO is also Chairman. As such, the government really has no place to tell boards how to allocate profits from the business that belong to the shareholders. This should be obvious, but evidently it is not to some. The entire activist investor concept is based on the idea that too few times investors pressure boards to act more strongly on their behalf. The system works, and should stay as-is.

The authors, however, do make an assertion of their own that I fail to understand. They claim that the real problem with stock buybacks is that they transfer wealth from shareholders to executives. More specifically, they state:

“Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses. Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity. Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity. Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.”

This paragraph makes no sense, and of course, the authors (a couple of Harvard professors unlikely to have much real world financial market experience) offer up zero data or evidence to support their claims.

So let’s address their claims one sentence at a time:

“Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses.”

This statement implies that a shrinking share count and earnings per share growth are bad, or at least suboptimal. Why? The reason executive bonuses are based, in many cases, on earnings per share, is because company boards are working for the shareholders, and those shareholders want to see their stock prices rise over time. Since earnings per share are the single most important factor in establishing market prices for public stock, it is entirely rational to reward executives when they grow earnings.

“Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity.”

Insiders are notorious for owning very little of their own company’s stock. Aside from founder/CEO situations, most CEOs own less than 1% of their company’s stock. In fact, many boards are now requiring executives to own more company stock, in order to align their interests with the other shareholders even more. As such, the idea that executives unload stock at alarming rates, and that such actions form the bulk of their compensation, is not close to the truth in aggregate.

In addition, if the stock price is being supported, in part, by stock buybacks, does that not help all investors equally? Just as insiders can sell shares at these supposed elevated prices, can’t every other shareholder do the same? At that case, how are the executives benefiting more than other shareholders?

“Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity.”

This one makes no sense. Insiders buyback stock when it’s cheap?! Oh no, what a calamity! In reality, company’s have a poor record of buying back stock when it is cheap and often overpay for shares. Every investor in the world would be ecstatic if managers bought back stock only when it was cheap.

And how are buybacks a secret? Boards disclose buyback authorizations in advance and every quarter the company will announce how many shares they bought and at what price. It is true that such data is between 2 and 14 weeks delayed before it is published, but that hardly matters.

Again, the authors imply that increasing the value of stock is bad for investors, unless those investors are company insiders. In those cases they are getting away with something nefarious. In reality, each shareholder benefits from stock buybacks in proportion to their ownership level (i.e. equally).

“Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.”

Huh? Buying back cheap stock reduces investor returns and hurts public shareholders? I can only assume that the authors simply do not understand as well as they should what exactly buybacks accomplish and what good capital allocation looks like. It is a shame that the Wall Street Journal would publish an opinion so clearly misguided.

What Are Typical S&P 500 P/E Multiples Under More Normal Interest Rate Environments?

The U.S. stock market has been skittish lately, largely on fears of higher interest rates. As new Fed Chairman Jerome Powell takes over for Janet Yellen, and Congress passes multiple pieces of legislation that will swell the budget deficit, investors are getting more nervous about higher rates.

What is amazing about this dialogue is that a 3% yield on the 10-year bond is scaring some people, whereas throughout history 3% would look like a dream come true for equity investors. The issue, of course, is that a 3% 10-year yield is only problematic when the market’s valuation has been elevated due to such low rates. It does not really matter if 3% is still low, but rather, if 3% is higher than the 1.5-2.5% range we have seen for many years now.



So let’s assume that rates are heading higher and a sub-3% 10-year bond will become a thing of the past over the next year or two (I will not even hazard a guess as to exact timing). The S&P 500 ended 2017 trading at more than 21x trailing 12-month earnings, so that multiple will need to come down as rates rise. But by how much?

Fortunately, we do not have to go back very far in time to find instances of the 10-year bond trading in the 3-5% range. In fact, from 2002 through 2010, it traded in that range most of the time:

During that near-decade long period of time the S&P 500 index traded for between 13 and 20x trailing earnings, with the mean and median both coming out to around 17x. If we use price-to-peak earnings ratios (to smooth out earnings volatility due to the economic cycle (P/E ratios are artificially high during earnings recessions), the mean and medians are around 16x.

So it is fair to say that a more normalized interest rate environment could bring P/E ratios down to around 16.5x, on average, with the 10-year bond yielding 5% or less, but more than it does today. Well, that tells is a lot about where stock prices could trend in coming years. Consider the table below:

The consensus forecast for 2018 S&P 500 earnings is about $155 but that could prove a bit optimistic (companies are always very positive about their go-forward prospects when a new year begins). Above I showed a range of $145-$155, which would still represent strong year-over-year growth of 20% at the midpoint (due largely to the recently enacted tax cuts).

You can see that if P/E ratios were to come back down to the 16-17x range, assuming the 10-year yield moved towards 4% by year-end 2018 on the back of 3-4 Fed rate hikes), the U.S. market could be in for some sideways to slightly down price action. Today the market trades for about 19x the current $155 earnings projection.

The good news is that valuation and interest rate normalization should not, in and of itself, be hugely detrimental to stock prices as long as earnings hold firm. Assuming no recession, my worst case scenario would probably be a 16x multiple on $145 of earnings (S&P 500 at 2,320), which while not a fun path to take, would only represent about 8.5% additional downside relative to the market’s recent low earlier this month.  That is not exactly a super-scary outcome, and it probably is not even the most likely base case scenario. Buyers could easily come in at 17x earnings and if profits reached $150 this year, that would mean we have already seen the low point for the S&P 500 this year.

 

Momentum Trading Cuts Both Directions

Back on Monday October 19, 1987, the Dow fell 508 points, which was a decline of more than 22% in a single day. Today that same decline equates to roughly 2%. With the Dow trading at such high levels, in absolute point terms, a large decline might seem scary if not presented in percentage terms. The same is true when the financial media likes to focus on every 1,000 Dow points, as if a move from 25,000 to 26,000 is anything more than a simple 4% gain that historically takes less than 6 months, on average.

So rather than care about “a 1,000 point Dow decline!” let’s look at a one-year chart of the S&P 500 for some perspective:

As you can see, all we have done over the last two days, when the Dow has dropped 1,600 points, is give back the gains booked in January! When I look at this chart, I don’t see the mother load of all buying opportunities yet. I probably would not get even a little bit giddy about buying U.S. stocks unless we got back down to 2,400 or 2,500. That does not mean it will get there, or that I think it might (I — like anybody else — have no clue).

Momentum markets work in both directions, and when computerized algorithms conduct much of the daily trading in the stock market, moves like we see today can happen with ease, and most importantly, without tangible “reasons” behind them.

Most of the time I wish we could go back to the days when stocks were less volatile, a 10% correction occurred about once a year, on average, and the media did not over-hype days like today. It will make for good, scary headlines, but that’s about it.