Odds & Ends - July 31
Forced Selling, Chinese Tech, Expectations for the S&P 500, and Capital-light Compounders
This week, I’m trying a new format. Rather than diving deep into one business, I’m going to share some of the unpolished thoughts rolling around in my head. This blog was always about showing our work, and these should be considered works in progress.
Sound off in the comments below if I’ve missed the mark or you have any questions. Thank you for reading!
Forced Selling
One of the best ways to buy at a bargain price is to buy from forced or non-economic sellers.
A forced seller is someone who has to sell. They can’t wait for a better offer. So, you can usually low-ball them and nab a bargain. Similarly, a non-economic seller is someone selling in order to maximize something besides price.
For example, when a stock gets removed from the S&P 500, index funds have to sell it. The fund doesn’t care whether the stock they’re selling is a good value or has attractive prospects. They only care about matching the index. Given that there are trillions of dollars indexed to the S&P 500, removes can produce a torrent of selling pressure on stocks being removed for reasons entirely beyond their fundamentals.
Another classic example is spinoffs. A spinoff is like a merger in reverse: shareholders start with one company and split it into two. Often, investors indiscriminately sell small spinoffs they receive. Why? Unlike a merger, a spinoff doesn’t require a shareholder vote. So, shareholders get stock they didn’t ask for and may not know anything about. It’s easiest for them to clean up their portfolio by selling. Institutional investors mandate may not be allowed to own the spinoff, forcing them to sell. Last year we wrote about Kontoor Brands, which is a great example of these dynamics.
Lately, I’ve come across some less-obvious but nonetheless real forced sellers.
AT&T
AT&T is a capital allocation nightmare. They’ve consistently thrown good money after bad. In 2015 AT&T bought DIRECTV for $67 billion. Then, in 2018, they bought Time Warner for $104 billion. These two acquisitions left the company carry a colossal $161 billion in long-term debt.
The interest on this debt is soaking up cash AT&T would prefer to invest in 5G. So, it’s decided to unwind its mistakes. Earlier this year, it sold 30% of DIRECTV to TPG at a $16.25 billion valuation. This spring, it announced it would spin off Time Warner and merge it with Discovery.
The upside of this plan is that AT&T will be able to focus on its core telecommunications network. The downside is that AT&T will have to cut its dividend.
AT&T’s dividend costs $15 billion per year. The new, stand-alone AT&T will probably make about $20 billion, and management only wants to return 40% of that to shareholders. So, the new dividend will likely total about $8 billion, half of today’s.
AT&T shareholders tend to own it for the dividend, so the cut has prompted many of them to sell. Anytime a shareholder base turns over, expect volatility.
Liberated Syndication
Liberated Syndication is another company in turmoil. The micro-cap didn’t pay its European VAT (value-added tax) between 2015 and 2018. Now it’s in the process of going back through its financials to restate them.
Not only are lawyers and accountants going to cost the company a fortune, but the process has also made it impossible for the company to file its current financials on time. As a result, OTC Markets has now designated the stock as “Pink No Information.”
The Pink No Information category is for companies that “are unable or unwilling to provide disclosure of any kind to the public markets. They either provide no information to OTC Markets, or the information available is more than six months old.” (Source)
In 2020 the S.E.C. closed a loophole that allowed brokers to quote prices for OTC stocks that did not publish up-to-date financials. Come this September, brokers will no longer be able to quote prices for securities without up-to-date financials.
Unless Liberated Syndication (and the countless other “dark” OTC stocks) publish financials, the market for their stocks will soon disappear. This has lead to selling pressure as investors rush to get whatever they can for their stock before all liquidity disappears.
Compounding the company’s problems, it has neither a CEO nor a CFO. Both recently stepped down, leaving the company captain-less amidst a storm.
Check out Steel City Capital Investment’s latest letter for more on the situation
Chinese Tech
Last but not least, no discussion about forced selling would be complete without touching on China. Beijing has been increasing its regulatory scrutiny over its tech giants for almost a year now. Fear reached a fever pitch this week when the government banned profits in China’s for-profit education sector.
Some investors seem to read this as a sign that Beijing will soon bar national champions like Alibaba from making a profit too. Others seemed to think it means Beijing will forcibly unwind the VIE structures U.S.-listed Chinese firms rely on. So, there’s been a mass liquidation of Chinese tech stocks, including Cathie Wood’s ARK ETFs.
Both of these seem scenarios like a leap too far.
China’s Crack Down
My take is that investors are overreacting. China has not once hinted that it will unwind existing VIEs. Nor has China suggested that it will prohibit profits anywhere else. In fact, the Chinese government is in damage control mode to assuage investors that what they did to the for-profit education sector won’t happen again.
Reasonable people could disagree about whether to trust the Chinese government on this. Their actions certainly set a dangerous precedent. They’ve likely impaired the multiple Chinese firms will trade in the future since investors will always price in a small chance that the government will step in and decimate the industry.
It helps to understand the motivation behind the crackdown. Chinese culture places a high value on education. It’s a carryover of the Confucian tradition. Parents are prepared to spend anything on education if it will give their kids a leg up. A business (or under-paid teacher) can make a lot of money selling a product that has infinite demand and zero price sensitivity, but that’s not necessarily the best thing for society.
Look no further than the U.S., where cheap student loans and a high cultural value on a college education made an entire generation of students completely price insensitive. Now, those students are getting crushed by their loan payments and delaying having kids for fear that they can’t afford a family. Beijing does not want that to happen in China, where the fallout from the one-child policy has made demographic trends ugly.
Besides, China’s new tech regulations appear reasonable. For example, Alibaba will no longer be able to enforce its “pick one out of two” policy on merchants. Imagine if Amazon refused to work with merchants if they also sold through Walmart. We take for granted that our government stopped this monopolistic behavior generations ago, but China is just beginning to address it.
Or take Didi, Chin’s Uber, which charged higher fares to older customers. Imagine if Uber charged you more for the same car and the same ride just because you were older and could afford it? Americans would be up in arms!
China is an emerging market, and its regulatory framework is nascent. The country’s tech sector sped past the existing regulations, and now the government is playing catch up. A one-party state means China can move a lot faster than the U.S., but both countries are pursuing similar goals.
This week’s panic is a case of investors selling first and asking questions later. If you want to invest in China, you have to understand the government’s motivation. So far as I can tell, the government has zero incentive to decimate its tech sector or withdraw from foreign markets. So long as Chinese tech companies can create value for society and shareholders, they’ll be fine.
In fact, a new paradigm that prioritizes fairness over hyper-growth will probably entrench China’s tech giants’ market position. When U.S. regulators banned tobacco advertising, the tobacco companies became more profitable and more entrenched. They became more profitable because they pocketed the money they would have otherwise spent on advertising. They became more entrenched because no one could build a new, competing brand without advertising.
Similarly, Chinese tech companies that can no longer sell at a loss in order to steal market share may become more profitable. At the same time, upstarts without scale who can’t underprice won’t be able to enter the market.
Investors like to quote Baron Rothschild’s aphorism “the time to buy is when there's blood in the streets” at the top, but few follow through when the time actually comes. Well, there’s blood in the streets now.
Blood in the streets isn’t a license to buy indiscriminately, however. China’s tech sector will change after this, and tomorrow’s winners may not be yesterday’s.
Forward Return Expectations
Jason Zweig is my favorite writer at the Wall Street Journal. Last week, he wrote about a recent survey of individual investors’ expectations for the stock market.
The people in the Natixis survey anticipate earning an average of 17.5% annually, after inflation... That’s up from the 10.9% long-term return they expected in 2019, the previous round of the survey. It’s also more than twice the return on U.S. stocks since 1926, which has averaged 7.1% annually after inflation. (Source)
Are 17.5% average annual returns realistic? The short answer is no. I’ll explain why.
A stock’s forward return can be estimated as the sum of its growth, yield, and the change in P/E multiple. This framework works just as well for the entire S&P 500 as it does for single stocks. Note that this framework produces estimates and only endeavors to be directionally correct.
Growth is the product of a company’s incremental return on equity and its reinvestment rate. That is,
G = ROE * RR
Yield equals the money not reinvested divided by the stock’s average P/E ratio. That is,
Y = (1-RR)/PEavg
The sum of growth and yield is a stock’s business return. It’s the return a private, 100% owner would earn.
Business Return = G + Y = ROE * RR + (1-RR)/PEavg
As minority investors in public securities, we have to add the change in the stock’s P/E multiple to its business return to get the stock’s total return. That is,
∆M = (Mf/Mi)^(1/N)-1 where N equals the number of years held.
Pausing a moment, it’s important to note that the change in multiple is raised to the power of one over years held. This means that as holding period increases, the effect of changing multiples decreases. Said differently, the longer you hold, the closer a stock’s total return will converge with its business’s return. That’s why everyone says to invest for the long term. Business returns are more stable and more predictable than changes in multiple.
Putting it all together, a stock’s long-term forward return equals:
Total Return = G + Y + ∆M = ROE*RR + (1-RR)/PEavg + (Mf/Mi)^(1/N)-1
Now that we have our formula, we can plug in our values. Over the long run, the S&P 500 has averaged:
A 14% ROE;
A 45% dividend payout ratio (which implies a 55% reinvestment rate); and
A 15x P/E multiple.
Today, Value Line reports that the market’s median P/E multiple is 19.0.
Plugging these in suggests that the S&P 500’s business return will be approximately 10.1%. That’s only if P/E multiples don’t change.
Business Return = 0.14*0.55 + (1-0.55)/19 = 10.1%
This squares with the S&P 500’s return of 10.9% since 1971. It also squares with the 7.1% after-inflation return since 1926 Zweig quotes, since inflation have averaged about 3% since then.
Investors should start with this 10.1% number and then decide if they want to adjust it up or down based on their expectations for how the S&P 500’s P/E multiple will change.
Assuming today’s 19x multiple reverts to the long-term average of 15x over 10 years, the S&P 500’s total return will get knocked down to 8.0%.
Total Return = 0.55*0.14 + (1-0.55)/17 + (15/19)^(1/10)-1 = 8.0%
Assuming even more rapid multiple compression — over five years — knocks the total return down to 5.7%
Total Return = 0.55*0.14 + (1-0.55)/17 + (15/19)^(1/5)-1 = 5.7%
Not only is a 17.5% return unlikely, it’s impossible without multiple expansion. Multiples would have to expand to 27x over five years or 38x over 10 years to bring a 10% business return up to a 17.5% total return. While anything is possible, I would not bank on a 38x P/E in 2031.
The good news is that while the average stock may be priced for below-average returns going forward, they aren’t all.
How can investors maximize forward returns?
A surefire way is to pay less. Paying less always increase forward returns. Low average multiples are especially important for businesses that cannot reinvest much of their earnings, like AutoZone, Altria, and NVR.
Another way is to own businesses with “reinvestment moats.” These have high incremental ROEs and high reinvestment rates. Think Berkshire Hathaway in it heyday, HEICO, or WingStop.
“Capital-light compounders” are even better. These earn nearly infinite incremental ROEs because their growth requires minimal capital. Think Facebook, Altria, Moody’s, or See’s Candy. So, they can grow while simultaneously returning virtually all their earnings as yield. For example, a capital-light compounder might earn a 300% incremental ROE, reinvest 5%, and pay the rest of their earnings out at yield.
Business Return = 3.00*0.05 + (1-0.05)/19 = 20%
At a market-average multiple of 19x, a capital-light compounder would be a bargain and produce an above-average return.
Occasionally, capital-light compounders are available at below-average prices. One example is Diamond Hill - a company we own, have written about, and that announced earnings this week. The company is currently earning at a $56 million annualized rate and owns $200 million of cash and investments with no debt. The stock trades for $550 million, which is only 6.2x times earnings after subtracting out its cash. If it returns all of its earnings (which it usually comes close to), it would yield 16% - while still growing.
The Best Of The Rest
Here are a few of the best things I read this week.
Alta Fox is bullish on IDT and expects two new spinoffs.
Alluvial Capital and McIntyre Partnerships are bullish on Garrett Motion’s emergence from bankruptcy.
Howard Marks on how to think about macro.
Quote Of The Week
“I might pump, but I don’t dump.”
Elon Musk on cryptocurrencies
If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com. Thank you for reading!
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.
I really enjoy the new format, Matt. The blogs that deep dive into a specific company help me refine my own investing process or draw my eyes to a new potential opportunity--they are wonderful! I think it's a great idea to occasionally do a broad based blog on recent market developments and especially what you've been reading over the past few weeks. With so many news sources, blogs on seeking alpha, books to read, etc... it's invaluable to me to see what you and Dan are reading. On a side note, I'm eager to see how IDT unfolds over the next few years. Alta Fox's slide deck very convincingly highlighted the opportunity and why it exists--it appears the market agrees with them so far!
-Joe D.