by Travis Johnson, Stock Gumshoe | May 3, 2019 4:45 pm
I’m a little sad not to be in Omaha this weekend for the Berkshire meeting, but I’ll be watching some of the Q&A tomorrow to see how Warren and Charlie are looking and try to get some little nuggets of wisdom from them.
The biggest news lately from Berkshire Hathaway (BRK-B) is that they’re at it again, using two of their most valuable assets (Warren Buffett’s reputation, and their ability to make fast decisions with massive amounts of money) to backstop a corporate takeover in exchange for preferred shares and warrants.
Berkshire has agreed to invest $10 billion in Occidental Petroleum (OXY) through preferred shares, in order to buttress their surprise offer for Anadarko Petroleum (APC) and help give them some heft to discourage Chevron (CVX) from upping its initial bid. Buffett’s involvement gives a stamp of approval that investors and management teams almost always respond positively to, at least subconsciously, and $10 billion in cash helps to make sure that Occidental’s higher bid doesn’t get drowned out by the “safer” bid from Chevron.
We don’t know what Occidental shareholders will decide, or if Chevron will up its bid, but if it works out Berkshire gets a nice position in a growing company, with preferred dividends (8%) and warrants (for 80 million shares at $62.50), with both the preferreds and the warrants apparently having long terms (about 10 years, which would mean that Berkshire is guaranteed to get back 80% of its investment just from dividends). That’s not unlike the “rescue” funding or deal financing Buffett has agreed to in the past with folks like Bank of America, Goldman Sachs, Kraft Heinz, Mars and GE, most of which have worked out very well for Berkshire not because the stocks always did well during the time Berkshire held them (though mostly they did fine), but because the preferred shares and warrants were on such good terms. Berkshire and Buffett don’t always win, of course, we need only look at Kraft Heinz to confirm that (though Berkshire still isn’t badly in the red on that deal, they just passed up on a lot of gains by overpaying and then holding too long), but they tend to do well.
And it’s notable, as well, that Buffett is so eager to deploy meaningful amounts of capital that he was available at a moment’s notice for Occidental to fly into Omaha to hammer out a deal on the weekend before Berkshire’s Annual Meeting brings 40,000 shareholders to town to ask Buffett questions, presumably the most hectic time of the year in Buffett’s calendar. There are not many places where you can go to get $10 billion in 24 hours (and Warren has recently said he was willing to go to $20 billion), but Omaha is one of them — Occidental could very likely have gotten a better deal elsewhere, given time, but not over a weekend and not with the “stamp of approval” from Buffett that might be enough to push the deal over the edge and convince both Occidental and Anadarko shareholders to go along.
That’s what Berkshire will really lose when Buffett is no longer at the helm — the basic operations shouldn’t change, and the investment decisions will probably still be good and the operating companies likely well-run and semi-independent… and they might even be able to make fast decisions, though I suspect the board will give the successor a shorter leash — but whoever succeeds Buffett will not have the same reputation and therefore won’t necessarily get the favorable “rescue” terms that Buffett gets, time and time again.
We can’t lament the passage of time, though, so we’ll just note that Berkshire is still very reasonably valued, and hope that Buffett gets the chance to make a handful more of these deals before he leaves Berkshire (and it might be a while, though you never know — Charlie Munger is seven years older than Buffett and still plenty active and sharp, though each year the two of them look just a little bit more frail sitting up at the head table at the Annual Meeting). We’ll see if any surprises come out of Berkshire’s quarterly update, beyond the over-hyped news that one of Berkshire’s other money managers bought some Amazon (AMZN) shares last quarter, and whether they say anything at the podium on Saturday that catches the world’s attention.
Also on the insurance conglomerate front, Markel (MKL) reported a reassuring quarter this week, getting back to underwriting profitability (combined ratio of about 95%) and posting earnings that were primarily the result of the recovery in the stock market following the swoon in last year’s fourth quarter, though revenue from their Markel Ventures arm also picked up, mostly because of acquisitions. Don’t get sucked into following earnings for Markel, that number is hugely volatile because of their large equity portfolio (with accounting rule changes, they now have to report the rise or fall in the value of the portfolio as earnings or losses even if they don’t actually buy or sell any stocks in that quarter), the real number to watch is their long-term growth in book value per share, which has tapered off in recent years (partly as they’ve invested in non-insurance businesses and in their catastophe bond businesses, which primarily uses other peoples’ capital, but also partly because insured losses have been large for a couple years), but is still decent.
No big surprises, though a good quarter seems to have reignited a little optimism. The two valuation triggers that I keep in mind these days are 1.5X book to nibble and 1.4X book value to buy a little more heavily, and now, with book value hitting $707 a share, that would be $1,060 and $990, so I did add very slightly to my MKL holdings this quarter (more on that in a minute). That number moves a lot with interest rates and stock prices even if the insurance operation gets some relative stability after a few catastrophe-laden years, but you have to start somewhere.
The more troublesome insurance conglomerate in my portfolio has been Fairfax Financial (FFH.TO, FRFHF), a stock I’ve owned for a much shorter time than Berkshire Hathaway and Markel. Fairfax had its annual meeting last week, and I wasn’t able to attend this time, but I’m generally finding that my feelings about Prem Watsa’s leadership on the investment side are getting less charitable.
Their latest quarter, released last night, was more of the same — Fairfax recovered a bit in book value just like Markel did, thanks to the bounce-back in their investment portfolio that pretty much everyone had this quarter (after the fourth quarter collapse), and their underwriting was OK but not great, so the book value is now about $450/share and the stock is still only about 10% above book value.
Fairfax carries a bit more leverage than Markel, in the form of preferred shares and debt (total of debt and preferreds is about 12% of assets, versus about 9% at Markel, so it’s not a huge deal for either of them), and is generally structured pretty similarly, though Fairfax has several insurance subsidiaries of which it owns less than 100%, and is far more aggressive in its investment portfolios, while Markel is aggressive in overweighting equities compared to many insurance companies but doesn’t tend to “go big” with stock ideas or make large macroeconomic bets or interest rate bets like Prem Watsa has done at Fairfax. Markel also buys into private companies and is building up its Markel Ventures subsidiary, which Fairfax doesn’t do (though Fairfax does bet big on some public companies with which it has close relationships and sometimes also private partnerships, like Seaspan and Kennedy-Wilson), and has placed some big bets on building their insurance-linked securities business (which is sort of like asset management, selling insurance exposure as an asset instead of keeping the risk entirely on your own books).
If you don’t know the background, Fairfax CEO Prem Watsa, who has often been called the “Warren Buffett of Canada,” built Fairfax quietly after starting with Markel’s old Canadian subsidiary that was being sold for scrap in the 1980s, and turned that insurance company into a large conglomerate by buying up bad insurance companies for about 25 years (though those companies generally got better over time, particularly in recent years). He really started to get attention when he made some huge profits in betting against the housing bubble leading up to the 2008 crash, when Fairfax was in about its 25th year, but then a few years later he was again hugely pessimistic about the markets and began to make some big macro bearish bets, wagering on deflation and a faltering economy.
That’s fun when it works, and I initially bought shares as a “what if the world falls apart” bet during the tumult of 2016, before the election… but then Watsa shifted gears, dropped most of his macro bets and hedges, took lots of losses as a result, and went “all in” on economic growth following President Trump’s initial wave of tax cut and deregulation chatter. That saved the portfolio, though even if you ignore the initial crash in Fairfax shares in late 2016 following the election, before Watsa’s strategy shift, the stock has underperformed mightily. Since 2017 began, here’s the chart of Fairfax (orange), Berkshire (red) and Markel (blue), along with the S&P 500 for context (green):
Berkshire is mostly keeping pace with the S&P, which is pretty much what I expect from them (I think they’ll beat the market in bad years, but not good ones)… Markel and Fairfax both clearly suffered because of their catastrophe exposure from the horrible year the world saw, catastrophe-wise, in 2017 (Berkshire is still a big insurer, but they have become so diversified in recent decades that a big catastrophe year doesn’t hurt them the way it does real insurance companies). Fairfax has also been hurt, however, by continued weakness from their investment portfolio, both in bonds and in equities.
Chris Mayer went to the annual meeting and wrote about it on his free blog, which is worth a read — and he has some of the same feelings as I do in being a bit nervous about whether or not we should trust Prem Watsa’s investment management after this past eight years of poor performance and macro betting. He concludes that he’s still holding shares and sees potential upside if Watsa hits his goal of growing book value by 15% (with the aim of getting there by insuring profitably, with a 95% combined ratio, and getting a 7% return on their investments), with relatively limited downside because the stock is trading at close to book value.
Part of my reason for staying in Fairfax after the surprise of late 2016/early 2017 was their acquisition of Allied World, which I thought had the potential to really bump up the portfolio and give Watsa more to work with… and that hasn’t really helped, at least not yet. Fairfax has grown their portfolio a bit as a result of that Allied World addition, but they haven’t had much to show for it (despite the huge surge in “float”, which Allied helped to grow by more than 20%), and Allied World is just eking along, a bit below average by the standards of Fairfax’s other insurance subsidiaries, with a combined ratio last year of 98%.
The other reason to hold the shares, beyond any faith in Watsa posting good investment returns again like he did in the past (all of the outperformance is from Fairfax’s first 25 years, not the most recent eight years), is that Fairfax has been aggressive in expanding overseas. They have bought and built insurance businesses in a lot of compelling high growth countries in South America and Asia, in particular, often from acquiring AIG’s businesses as they reorganized. That presents some future growth potential, but, again, hasn’t yet borne any fruit.
Some of Fairfax’s businesses are interesting still, and have been growing profitably, like their collection of Canadian restaurant chains (now called Recipe Unlimited, it was Cara) and their acquisition of Thomas Cook, which has continued to roll up some other tourist businesses. And I still like Fairfax India and hold a substantial position that I’ve been adding to, I think they are very well positioned for a long-term future as long as India’s economy continues on the industrialization/modernization track following the now-underway elections, and that Prem Watsa’s huge following in India has had a very positive impact on the opportunities available for Fairfax to invest (reputation is big when you’re looking to sell a private business, so selling to Prem in India probably feels a bit, for business owners, like selling to Warren in the US)… and I still have some interest in Fairfax Africa as they try to build a collection of growing businesses in Africa (though I’ve never owned that one).
But I’m really wondering whether Fairfax is again making macro bets or “pushing it” to recover their investment performance — they claim to have stepped back from that, at least when it comes to shorting, but Watsa has also very clearly emphasized over the past couple years that he is betting big on interest rates rising (he does that with an extremely short-term bond portfolio and large cash position, which has also cut into returns relative to a more market-agnostic bond portfolio), so if that doesn’t happen he’s also leaving a lot of earnings on the table. If he’s getting worse investment returns than other big insurers because he holds so much in cash and short-term bonds, he’s at a disadvantage because those insurers will be able to price their policies more competitively while booking similar profits. That’s a directional and macro bet, even if it’s one that I happen to agree with.
Mayer’s conclusion, and the reason he says he’s still holding shares, is not just that the upside is compelling if they get to Watsa’s return goals… but that he thinks he’s not going to lose money on Fairfax because it’s well-financed and trades right around book value. During times when Watsa had the faith of many more investors and Fairfax investments were performing better, it was not shocking to see the shares trade up to valuations of 1.3 or 1.4X book value, so if Fairfax does return to those more optimistic valuations the stock would respond with a lot of leverage from this price (if it went to 1.4X book today, for example, that would be $643 per share even if the book value per share were unchanged… but they would probably only get a better valuation if book value per share is also growing, so if book value also rose a few percent to, say, $470 — which would be a new record — then 1.4X that would be almost $660). That’s the benefit you get from leverage when a stock is both becoming more valuable and becoming more beloved.
On the flip side, I agree with Mayer that the downside is probably pretty limited — though I wouldn’t be shocked to see Fairfax another 10-20% lower at some point, there isn’t a likely scenario that I can gin up that has Fairfax causing big losses in my portfolio.
But I wouldn’t be at all surprised if it continues to disappoint in the coming years. I’ve really lost confidence in the idea that they’re going to be able to turn the investing ship around and generate meaningful gains, and the insurance companies, though well-run and probably better than they get credit for at 1.1X book value, are not going to cause a re-valuing of Fairfax shares unless the investment performance changes. I like several of Fairfax’s investments, including Kennedy-Wilson and Fairfax India, but I’d rather hold them on my own than keep these funds just in Watsa’s hands… I think he’s a nice guy and a great leader, and he had a tremendous couple decades as an investor, but I think the odds are pretty good that he’s either just stuck in a rut or swinging too hard right now in an attempt to make up for the past decade of disappointing performance, and the macro bets that might have made the company what it is now make me nervous.
I’m not going to sell out of Fairfax entirely, and the first quarter reported today was fine (book value is now $451 per share, thanks to the investment recovery in that first quarter), but I’m reducing this position to reflect my shrinking confidence in Watsa and the fact that I prefer his India investments to his broader strategy — I’ve sold about a quarter of my Fairfax stake and put a little bit of that into Markel, which is substantially more richly valued but in whose leadership I have a lot more confidence, and a little bit into more Fairfax India… but I will let more than half of that sale sit in cash for now. I would have also added a bit to my Kennedy-Wilson (KW) shares with some of that money, but they reported a strong quarter this week and the shares popped over the last couple days, so I’ll wait to add to that position when we get a better price closer to $20. KW is a good company for the long term, I like their “value investing” mind set in real estate and their ability to leverage fee-paying outside money (from investors like Fairfax Financial), but it’s not an exciting growth stock, there’s no reason to chase a pop.
Both Markel and Fairfax Financial have been hovering right at their “stop loss” trigger points, incidentally, so if you’re watching those this is your reminder that neither one is really making investors feel giddy at the moment (both have hit stop losses many times over the years, though I haven’t followed those signals and am very unlikely to ever sell Markel unless they have big management or strategic changes).
Incidentally, if you are interested in Fairfax India, I’d suggest you take a look at the “Fairness of Fair Value” comments made by a writer over at SeekingAlpha regarding the conflict of interests inherent in their self-valuation of their private assets, like Bangalore Airport — not necessarily because the valuations are inappropriate for these investments, but because incentives matter and Fairfax managers are incentivized the grow their assets under management, which means they’re incentivized to push for high valuations for their private companies. That’s reason for some caution, though I don’t suspect them of chicanery and I personally think the long-term value of the Fairfax India assets and their ability to access private Indian investments is worth paying up for.
That risk is present in all businesses that have a fee-based management team, including lots of REITs who have outside managers… you have to have some faith, particularly over shorter periods of time, in the auditors or consultants who help them determine the value of their illiquid investments.
Arista Networks (ANET) is one of the purest “big data center” plays out there, and has been whipsawed a few times by the wave of bullish and bearish sentiment over how much big players like Microsoft and Facebook are spending on building and upgrading their data centers (both are very large ANET customers)… all tied in with the stories of the major chip suppliers to the data center, many of whom have gone through a couple panic/party phases during just the past year as worries about that market go up and down.
I don’t have a handle on exactly where we’re going, but ANET got clobbered after reporting “just fine” earnings, and it was mostly because their second quarter revenue guidance was way below what Wall Street was projecting (~5-8% below), and that almost entirely because of the surprise “pause” in orders from one of the “Cloud Titan” customers starting in mid-March — most likely Microsoft, their largest customer, but it could have been one of the other biggies (they’re not saying). That drove the shares down about 15-20% and, to jump to the conclusion, I bought a bit more.
It’s an expensive stock by most measures, at almost 10X revenue, and it trades at a rich premium both because of the rapid growth they’ve seen and because of the next cycle of growth expected by investors, especially the upgrade that we should start to see soon to 400G data center connections, though they and others have also spent the past six months cautioning investors that the 400G upgrade cycle is going to be long and probably slow, at least in part because fiber optic connections are not available yet to upgrade to 400G at scale.
So… Arista is seeing pretty much the same story as all the other suppliers that you can lump into either “data center” or “5G”, there is building up a huge expectation that the first half of 2019 is going to be weak but the business will rebound in the second half of the year. 5G and data center cycles aren’t specifically connected or correlated, that’s mostly just a coincidence, but it’s worrisome that so much hope is now being placed on the second half of this year across a really broad swathe of the technology sector.
That’s risky, of course, because no one really knows what will happen. Microsoft and Google and Amazon might take longer to digest their huge investments in new data centers and stay “paused” or “slowed” in building out new capacity… big telecom companies might slow down on their data center upgrades even more as they decide how to allocate capital expenditure budgets… or they might double down, no one knows.
That’s reason to keep these positions smallish as we wade through the uncertainty, but I do still like Arista’s exposure to the next wave of data center upgrades, and I like what they said on the call about prioritizing their spending to focus on selling and building up their enterprise and campus businesses, which are higher margin but also harder sells than the “cloud titan” businesses, and I like their continued R&D leadership in routing and switching, and their focus on building better software to manage these products. They also co-developed some new equipment with Facebook, which is showing no signs of slowing down on its expansion as far as I can tell, so not every huge customer is “paused.”
I’m not going “all in” on this position today, but I had targeted the $260-270 range as a reasonable buying opportunity earlier this year, based on the expectation that they should be seeing earnings of $10+ in 2020, with 15-20% earnings growth after that (meaning you’ve got a forward PE of about 25 and earnings growth of 15-20%, which is a decent value in this market), and I still think that makes sense for the long term — I still like the company, the addressable market is massive, and I think they could well reignite growth after this “clout titan” slowdown, and we have not yet hit the stop loss trigger of about $235 that would indicate a real shift in sentiment (though we might, of course). I increased my position by about 20% at $264.
There’s clearly some uncertainty about whether the second half of the year is strong or weak when it comes to their big customers and the CapEx cycle, but they are still winning business, presumably from Cisco, and still see a multi-year 400G upgrade cycle as likely (though really starting next year, not this year). It’s still a fast-growing company, we’re just not sure how fast it will grow in the next 6-12 months.
I expect we’ll see the news digested over the next week or two, but that analysts will be hesitant to make many predictions about the second half of the year until the company gets some more clarity on its order flow (the “pause” in orders in mid-March obviously came as a big surprise to them) — the next news on that front should come at Arista’s June Analyst Day, and they said on the conference call that they’re being cautious about projecting what the second half of the year will look like until then. Patience is easier with relatively small positions, and ANET is now roughly a 1% position with an average cost of about $242/share… and I’ll be watching what they say about that big customer and the second half of 2019 at the analyst day next month, they could easily send the stock down below $200 or up to $400 with a few choice words about the future.
Here’s the summary of one analyst response from Briefing.com this morning… I imagine we’ll have some more changes to the forecast in the days to come as analysts digest:
“Needham notes Arista reported another solid quarter of strong growth against the last of the tough 50% Revenue growth comparisons. They also sustained their rich Margins at 64.5% GMs and 37.5% Operating Margins. But that’s where the good news ends. Arista offered a soft guide for the June quarter citing a halt in purchases at one large Web 2.0 Titan and slow demand at two others. The Revenue guidance of $600-$610 is below Street estimates of $639 million and represents only a 16%-17% growth rate at the mid-point, well below the nromal mid-20’s growth. Arista stated business slowed sharply in late March and persisted through April leading to the lowered outlook. Arista stated they didnt know how long it would last as they didn’t have enough data. They think its likely a temporary lull. With ANET indicating down 15% to $260, they are a buyer on this weakness.”
The risk I’m keeping an eye on now is mostly portfolio risk due to all of this “second half of 2019” expectation building for both 5G investment and data center suppliers. Even though none of these are huge positions individually, that has an impact, direct or indirect, on a fairly good chunk of my portfolio — if you include ANET, Nokia (NOK), Zayo (ZAYO), Qualcomm (QCOM), CoreSite (COR), NVIDIA (NVDA), Ericsson (ERIC), Xilinx (XLNX) and Crown Castle (CCI) that’s almost 12% of my individual equity portfolio which is pretty explicitly looking for the second half of this year to be much better than the first. They won’t all move together, and ZAYO, CCI and COR are owners of infrastructure, not sellers of equipment, but if this “the year ends strong” narrative for much of the tech sector changes quickly those stocks will likely all move accordingly.
Nokia (NOK), incidentally, tickled the stop loss level today — I did not sell, and had in fact just bought a little more a few cents above this price a couple weeks ago, but I thought you might want to know.
While we’re talking “5G,” Crown Castle (CCI) saw a good-sized insider buy last week, which is reminding me that I’ve been perhaps too cautious with this one. Their Chairman, J. Landis Martin, added about 20% to his holdings with an at-the-market buy around $123 after earnings (the earnings were solid, not a shocking “beat” but good, like most of their quarters).
The stock has seen plenty of insider selling over the past year or two, too, so it may be just that Martin has more money to risk or is a stronger believer than other members of management, but it’s good to see. On the flip side, the risk is certainly elevated for a company with a heavy debt load and a relatively low dividend yield (3.6% now, the best among the tower companies but still relatively low for a REIT), even though we’re heading into a new “investment” era in communication infrastructure that should increase demand for CCI’s portfolio of small cell locations, towers, and connecting fiber to fuel the 5G rollout. Part of the reason for my cautious take, and the fact that I started with a small position and haven’t yet added to it, is that I’ve been expecting (OK, hoping) that the Sprint/T-Mobile merger will bring a dip in the shares (going from four big customers to three would shake investors a big, even if the financial impact would probably be relatively small at first since both networks would be maintained for a while).
That hasn’t happened yet, perhaps because the merger is in more trouble than I expected last year — the companies just extended their deadline again and public sentiment against the merger seems to be having some impact, though that’s a very squishy sentiment to nail down. Last year, I think the expectation really was that this would be a slam dunk under a business-friendly president and his Justice Dept. and FCC, but for whatever reason Sprint and T-Mobile still haven’t convinced the government to approve their combination. Their new (self-imposed) deadline is July 29, and the odds are apparently now not much better than 50/50 according to the “experts” (Raymond James lowered the odds from 80% to 55% this week, MoffettNathanson had dropped them to 33% a few weeks ago).
So I still haven’t bought more CCI… but I still want to. Fingers crossed.
And on to some other tech holdings…
Apple (AAPL) released its quarterly earnings, as I’m sure everyone heard, and saw some signs of life from iPad sales and wearables (watch and earpods) as iPhones had a weak quarter (though started to bounce back late in the quarter, they said), and continues to morph to be pitched less as an iPhone company and more as a subscription company… with an install base of now well over a billion and 390 million people paying for some kind of subscription (storage, Apple Music, etc.) The risk continues to be that sales outside the US are still pretty weak, thanks to competition from much cheaper Chinese phonemakers, and that the lack of a whiz-bang feature set in recent iPhone releases (and the increased durability and reliability of the phones, I’d argue) has allowed the upgrade cycle to continue to get extended.
None of that is new or surprising, and the results didn’t really delight anyone, but the financial update did — Apple surprisingly added $75 billion to their stock buyback arsenal, so it looks like buybacks will continue to boost per-share performance this year even if the actual top-line growth isn’t spectacular… and they were a little more optimistic with their guidance for the future than Wall Street had been, which also helped the stock.
There seems little reason to expect a dramatic iPhone cycle this year, there are no new products that people are clamoring for as far as I can tell… and the company no longer seems capable of really keeping a secret like it did in the early iPhone days under Steve Jobs (it’s just too big, with too many employees and suppliers who are “in the know”), so we’d probably know if there was something big coming down the pike.
After the latest Samsung failure, though, with their embarrassing folding phone that broke for so many reviewers, it may well be that for the upper end of the market Apple doesn’t have to lead… they usually have not led in technology (they weren’t first to 3G, or 4G, or wireless charging, or phone-based payments), they have waited until technology is established and working until they release it. I assume that the Qualcomm settlement means Apple will likely release a 5G iPhone in 2020, whereas it probably would have been 2021 if they waited for Intel to perfect a 5G modem, so next year is our next likely chance for another meaningful upgrade cycle to begin — but even then, there won’t be much 5G service available outside some core cities so there will probably have to be some features that really rely on 5G or are otherwise new and exciting to spur a lot of buyers. Apple should have a huge refresh cycle in the first few years of 5G, but not necessarily within the next year and a half.
The big disappointment, at least for me, was the pathetic dividend increase. Apple is pitching itself as increasingly stable, with a growing subscription base and a loyal user base that upgrades to new equipment regularly (just not quite as regularly as before), but it’s not cheaper than the market anymore, and it’s not going to be a big growth company anytime soon, so much of the reason to own the stock is for the dividend. Dividend growth is compelling, but for a relatively low-yield stock like Apple (current yield below 1.5%), you need meaningful dividend growth — and they just barely hurdled that bar, with an increase to the dividend of just over 5%. Previous increases were all in the 10-15% neighborhood, so this clearly sends a signal that your returns from owning Apple shares will not be primarily from the dividend.
That doesn’t mean it’s a bad stock, just that they’re more focused on getting the share price up and improving per-share earnings metrics by buying back shares. That’s fine, I suppose, and buybacks are actually more efficient than dividends, but it doesn’t send the same kind of “hold this dividend grower forever” kind of message to investors. Maybe because Apple would like to be seen as a growth company again, who knows. I would be more inclined to take profits on Apple than to buy more here, but I sold down my position substantially last year (most recently at $190 in November) so I’m comfortable holding this smaller position for now.
And speaking of Qualcomm (QCOM)… the Apple settlement was by far the biggest news item for them in years, completely overshadowing the relatively tepid quarterly results that came out this week (which helped to clarify some of the Apple numbers and further reinforce that “5G is going to big, but not just yet, wait ’til late 2019 and 2020” sentiment, but otherwise was pretty much ignored).
I think the Qualcomm/Apple agreement and future cooperation are probably the best possible news for those who want to see 5G investment and adoption move forward quickly, and they reported pretty much exactly what Wall Street expected in the wake of that settlement so the stock didn’t move much this week… but we should also remember that they’re not completely out of the woods yet on the legal front. They settled with Apple and its suppliers, so they’ll be making a lot more money next year than they did last year, but they are still in court with the Federal Trade Commission on the anti-monopoly case the FTC brought a while back — and the Judge is expected to rule fairly soon, probably within a few weeks. The Department of Justice even took the step of opining a bit on this, asking the Judge to think about punishments, if any, because of the impact a harshly negative ruling (which is possible) would have on 5G competitiveness in the US. That was part of the Kerrisdale short thesis earlier this year, now largely forgotten, but the FTC is still a substantial risk factor even if I think it’s not likely to be as big a risk as the Apple lawsuits were.
Alphabet (GOOG) dropped sharply after earnings this week, mostly because the revenue growth disappointed (by a lot, the report was a billion dollars short on the top line and represented only 17% growth, versus the 20% predicted) and the narrative quickly shifted to “Google is facing too much competition from Amazon and Facebook now, panic!”
Alphabet does not provide guidance, and never provides as much detail as analysts want, so there’s always a little gnashing of teeth around their earnings… and especially so when the numbers disappoint. This time the teeth-gnashing was generally about YouTube and about changes to core advertising offerings, with YouTube expenses going way up (much like Facebook’s, under pressure to review and screen more content and avoid offending viewers or advertisers) and the revenue “deceleration” seemingly blamed mostly on the advertising changes that the company didn’t really explain.
The expenses were down for Alphabet, so they have not suddenly lost the cost discipline that Ruth Porat brought to the table a couple years ago, which is good, but we have no idea how it will shake out. They’ve invested heavily in real estate and new data centers in years past and will probably continue to do that (their Google Cloud offering is growing nicely, though is still much smaller than Amazon Web Services or Microsoft Azure). They are much more analyst-friendly than they were five years ago, but still notably focused on operating the business and making long-term decisions and less inclined to provide analysts with the precise guidance they crave… or to excite investors with big buybacks, though they do have a relatively modest ongoing buyback authorization and bought back about $3 billion in shares in the first quarter (that sounds big, as does their addition of $12.5 billion to the buyback authorization, but Alphabet has $109 billion in net cash and had $31 billion in net income last year… and the buybacks don’t quite erase their ongoing share increases from employee grants and options, so the share count continues to rise).
Google isn’t a stock I like to chase on the upside, since it’s so big and not overly focused on “beat and raise” quarters and pleasing Wall Street (at this size, and with all their “other bets” and various opaque divisions and massive cash pile, they could probably manage earnings to report pretty much whatever they want in a given quarter), but I am happy to have it as one of my largest holdings and I’d be willing to add a little more if it drops enough — my latest price target for buying is $1,050, and I don’t see a need to change that right now. Analysts so far are coalescing behind the story that this quarter was a “blip” in revenue growth, and they’ve generally lowered their price targets and estimates a bit but, on average, kept GOOG as a “buy.” That “blip” theory, by the way, further puts us into the “things will be fine later this year” sentiment, so that’s another company that’s risking some investor revolt if performance doesn’t pick up late in the year to make up for the softer beginning to 2019… not a reason to sell, I don’t think, but a reason to be mindful of your portfolio risk if you end up having a lot of companies who are all predicted to be weak right now but recover later in the year, it’s probably some of the same drivers that are causing the current weakness and setting future expectations, so these “wait’ll the second half” companies could all move together next time sentiment shifts, whether that’s to relief or anger when the next updates come.
In ad-tech news, Criteo (CRTO) also reported (that’s a stock I owned a few years ago, and got out of when it became clear they were being squeezed out a bit by improved browser anti-tracking security), with disappointing numbers… that combination of falling GOOG revenue and falling CRTO revenue seemed to indicate some underlying weakness in the online advertising space, I gather, because it also drove down shares of The Trade Desk (TTD), which hasn’t yet reported (and is, as you’ve probably seen, trading at a nutty valuation). That will put a lot of pressure on TTD shares if they disappoint next week (they report before the market opens on Thursday), so if you’re sitting on some big profits in TTD shares like I am you might want to be prepared for a jolt that day. I don’t know if they’ll beat, but the stock has been soaring (up 15% just since the last quarterly release) even though the estimates are all for a fairly tepid earnings year (with earnings expected to be lower than 2018), so I’d expect something to break — either they’ll beat handily again and investors will party again, with yet another upside surprise, or they’ll reinforce those “2019 weaker than 2018” estimates with a weak forecast and the stock will drop dramatically. I’d be surprised if we don’t see at least a 10% move up or a 20% move down on Thursday, I just don’t know if it will be up or down… and the risk of a down move seem pretty high, given the general weakness in the other online advertising companies that have reported so far (with the exception of Facebook), but it’s also quite possible that The Trade Desk is still taking share and helping to cause some of that weakness. We’ll know more on Thursday, I’ve got a little heartburn settling in just because TTD has become a large part of my portfolio… but I haven’t done anything with my position, and now I’ve written about it here so my three-day trading embargo means I won’t have a chance to trade the shares until after earnings. That’s probably for the best, but I might sneak off to the closet to do some therapeutic yelling.
Speaking of tech stocks with nosebleed valuations, Shopify (SHOP) posted another huge revenue growth quarter and raised their forecast for revenue and income for the year, and they actually posted a small profit — at least in “adjusted” earnings (they reported 9 cents in earnings, analysts had expected a five cent loss). The growth is still nutty, they grew revenue at 50% year over year in the quarter, but the costs are surging, too, as they add thousands of workers and invest heavily in continuing their expansion.
SHOP had good growth in both high-margin subscription revenue (companies paying for their software platform) and in lower-margin merchant solutions (payment processing, other services for merchants, etc.), and is still pushing more into overseas investments and bolstering its marketing to continue to bring in more sellers.
So… it’s good to see that demand remains robust for SHOP’s merchant tools, but it is, obviously, a richly-valued momentum name that you have to be careful with. I love the company and their management, and I think they’re doing all the right things, but the valuation assumes so much growth and dominance that I have kept the size of my position relatively small. If they turn into Amazon, which is arguably how they’re being valued now, then I’ll regret not having bet more — but only one Amazon has been created over the past 25 years, so the odds are not fantastic.
It’s always tough to value a company like Shopify, partly because the growth and the rich valuation is intrinsic to them being a good investment. If SHOP can continue to grow faster than competitors, and have a nice high stock price that attracts more and more of the best employees, and which also draws attention to the company and makes its product seem more established as the leader, then that snowballs into more growth. In order to be comfortable owning Shopify you have to “buy in” to that virtuous cycle to some degree.
If that sounds crazy, you should sell part of your stake — as I’ve often been tempted to do. It’s obviously ludicrous to pay 25X sales for a pretty big company (market cap is now $27 billion)… though rules of “too big to grow” have seemingly been suspended in the past decade, and we can, of course, keep that optimistic eye on Amazon — Shopify could increase in size 30X and still be smaller than Amazon. That is a a crazy idea for a company whose addressable market is really unknown at this point, and you really have to decide whether their addressable market is just “small entrepreneurs trying to sell stuff in a side hustle” or “serving every independent retailer on earth”… if it’s the former, the story runs out of fuel sometime soon unless their international business hits a rich new vein of customers; if it’s the latter, they’re just getting started. The very essence of a “story” stock.
My concerns aren’t really about competition, though. I’m not worried about Facebook beating Shopify to the punch with their Instagram selling, or about Wix.com or other companies who can build online shopping cards. Any retailer worth its salt will want to have a multiple-platform selling operation, if you give up control to Facebook and only sell through FB or Instagram, you’re hostage to them. I don’t know a single person who built a business and following on Facebook who doesn’t also regret not having some independent access or control — Instagram might work great to sell a product if you have a hot idea or some good marketing strategies, but Shopify will also be able to manage Instagram sales for you, and without giving up control of your entire store to the scary Facebook empire. Serving small stores requires really good software and service, and a clear and simple process, and Facebook is a lot of things but it is not good at making things simple and transparent on the admin side — the specialist, I expect, will always do better than the big guy.
I was very cautious on SHOP early this year and pegged it with a “buy below $140” target, so that certainly wasn’t very helpful (it jumped above that within a few weeks of the new year’s beginning), but the stock also spent 2018 roughly unchanged, with several 20-40% moves up and down, so I’d expect that there will be meaningful dips if you’re looking to start a small position… who knows, maybe Citron will come out with another short attack now that the stock has doubled from the late December lows.
Speaking of technology, I’ve been watching the eSports-related companies to see if there’s a reasonable time to buy back in, hoping that the bleeding from Fortnite competition is letting up (Epic’s Fortnite has been sucking up all the oxygen in the room for gamers, sagging interest in the titles published by the big players Activistion Blizzard (ATVI), Electronic Arts (EA) and Take Two Interactive (TTWO), and the stock charts of all three of those illustrate the struggle to form a new narrative and find a new trend. Professional video gaming is still surging, but even Activision’s big expansion of the Overwatch league is not yet adding to growing viewership.
So while I risk missing the recovery because I’m dithering, I’m still on the fence with eSports, and still watching these stocks (along with Modern Times Group (MTG in Stockholm), which runs eSports events) and not buying yet. Candy Crush is still doing well for Activision, and EA’s Fortnite Competitor Apex Legends got off to a good start (but tailed off after that, and hasn’t really caught the attention of kids in my town, at least), but if Fortnite dominates the video game landscape for another summer these stocks will continue to suffer even as they release successful games and even as Activision’s new Call of Duty league starts up. I expect that both Activision and EA will do well over the next ten years because they have invested so much in building hit franchises and the infrastructure to support them (including eSports teams and leagues), but I’m not so sure about the next year. Feeling a little greedy, and hoping for some more suffering in the sector that will make me feel better about buying… we’ll see.
In non-e gaming, MGM Resorts (MGM) missed on earnings in the quarter, though analysts are still pretty confident in their longer-term prospects as Las Vegas seems to be doing fine, Macau is expected to bounce back, and Japan presents a huge longer-term opportunity. I’ll keep my position small and unchanged here, I think MGM has a uniquely valuable brand and footprint in US gambling, and strong positioning for sports gambling’s expansion, but I don’t expect windfall returns anytime soon and there doesn’t seem to be a rush to build a big position.
And now, some answers to reader questions that have been submitted either in comments or via email…
First one about Uber, which is expected to IPO next week…
Q:How exactly are they arriving at the almost 100 billion dollar estimate ? All of their drivers are contractors so they don’t own the cars or have any control over their employees. Do they have a sizeable cash on hand amount or some giant bank of servers or infrastructure that I have not read about it ? I just don’t see it myself. It would not be hard for someone else to start another Uber to compete against them.
With Uber you’d be buying the “network effect” to some degree (more Uber drivers equals better service for riders, means more riders use Uber than competitors, more riders means busier drivers, which keeps drivers in Uber network), and we’ve seen that it is possible for a competitor to take share, since Lyft has done so in many areas over the past few years by cutting costs or offering better driver compensation… but it’s so expensive to do so that there may not be others who attempt it (it was possible for Microsoft’s Bing to take share from Google search, too, but it never happened despite Microsoft’s free spending attempts).
But what you’d really be buying at this price is the idea that Uber can become a “platform” for planning and allocating all kinds of transportation, from food delivery to cargo to ride sharing, and that once they become embedded enough in those businesses their unit economics will improve, either because they can charge more or because they somehow become more efficient (or, one might note cynically, through the application of magic).
That’s much like the argument for Amazon a decade ago, I guess, though Amazon’s unit economics, though bad, were not nearly as bad as Uber’s in my recollection. And that isn’t lost on anyone — Uber is definitely selling itself as an Amazon-like platform to try to justify their valuation… but, of course, it takes incredible luck, patience and foresight to build an Amazon, and it has only been done once so far.
One great benefit to society that we’ve seen from venture capital is that the greed dream of “next Amazon” global dominance in many sectors has led those early-stage investors to sink billions into funding great businesses with terrible unit economics — businesses that provide amazing services at a dramatically subsidized price and face little pressure to become profitable as long as they are growing and keeping the dream alive.
I own AMZN shares, FWIW, and I’m not interested in buying UBER at this point — though I do love the service.
And one about an options selling pitch:
Q. It’s Altucher again…want’s $1,250 for his “2 minute retirement rescue”. Apparently it’s a way to make “instant income” by selling options. Of course I’d like to know IF and HOW it works. Can you help please?
Yes, you can make “instant income” by selling options. People do this every day. But there’s no such thing as a free lunch, as you’ve no doubt been told, so what you’re actually doing is more akin to selling insurance — which means you take on some risk in exchange for the money you earn as “instant income.”
And selling insurance is almost by definition a high-return business and a high-probability business. You make good money almost all the time, and you rarely have to pay out on a claim, but when you do it can sometimes be a doozy. For an insurance company that’s fine, even when there’s a horrible catastrophe year with lots of wildfires and hurricanes like we saw in 2017, because they build up huge amounts of capital and they don’t assume they’re going to be right 100% of the time… for an investor who doesn’t understand that they’re taking this risk, or doesn’t have a large enough portfolio to really diversify across a bunch of different risks (selling option contracts on different stocks with different expirations), it can blow up. How much it can blow up is pretty much correlated directly with how much “instant income” you try to harvest — you get paid more, obviously, for taking larger risks, or holding that risk for a longer period of time.
What I usually say about options-selling services is that the good and disciplined ones probably work really well until they don’t, and you never know when they’re going to stop working. There are also lots of bad services, I’m sure, that recommend selling illiquid contracts so they can claim a much better price than their subscribers could ever get, or who just make a lot of mistakes or take big chances (since their risk in being wrong — a subscriber who doesn’t renew — is far less than the risk investors are taking in possibly actually losing money), but there are probably good ones, too. My understanding is that a good option seller should probably be able to pretty consistently clear 10-15% per year selling call and put options (and backing those option positions with cash — the returns would be a bit higher if using margin, but then risk is higher as well), but that a couple bad trades can easily wipe out several years worth of returns. The risk is a lot higher than it might seem, and you’ll probably see reviews from subscribers who are both delighted with and angry about different options-selling services… which is probably, for the most part, an indication of whether those subscribers were investing the last time that service had a nasty loss. The returns seem solid and safe until that loss hits, since it seems like a “system” and people want to believe in systems, but if you do ever try one of these pay close attention to risk controls and don’t let the fact that they generate nice returns for months at a time cause you to “double down” and risk more next time.
And about a 5G ETF…
f/u on kyle dennis string. Will try the FIVG new ETF which has some exposure to 5 G and SWKS (5.66%) et al. Thoughts?
Sure, that ETF includes a lot of companies that should be expected to do well as a rising tide of investment in 5G helps to boost revenues for all the equipment makers and service companies who benefit from both the installation of 5G networks and the increased bandwidth and data usage that will flow through those networks and through data centers as a result of the demand that 5G will likely create.
These are the top holdings of FIVG:
I own XLNX, ERIC, NOK, QCOM among those top 20, so I can’t complain overly much, but I personally prefer picking and choosing a few companies that I think will do unusually well. I think Arista Networks (ANET) will have better growth than Cisco (CSCO) as data centers ugprade to 400G service, which seems almost required to handle the increased data speeds of 5G mobile networks and the demands they’ll place on the whole system in the years to come… and I think Crown Castle (CCI) is better positioned (and a better value) than American Tower (AMT).
That said, I could easily be wrong in those judgement calls, and while I don’t know all of those companies it’s likely that the group, on average, will do well if we see a new wave of infrastructure investment and, following that, an upgrade cycle for mobile and other network equipment and devices and continuing growth in data usage. The ETF is not terribly expensive, with a 0.3% expense ratio, so I wouldn’t try to talk you out of it.
And that’s all I’ve got for you today, dear friends — have an excellent weekend, and we’ll be back with another boatload of blather for you next week!
Disclosure: As is mostly noted above, I owns shares of Amazon, Alphabet, Apple, Arista Networks, Berkshire Hathaway, Crown Castle, Facebook, Fairfax Financial, Fairfax India, Markel, MGM Resorts, Nokia, Qualcomm, Shopify, and The Trade Desk among the stocks covered in today’s article. Per Stock Gumshoe’s rules, I will not trade in any covered stock for at least three days.
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