Is It Supposed To Be This Easy
Should Tesla be worth more than Wal-Mart and JP Morgan combined? Should just six stocks make up nearly 30% of the value of the S&P 500? Should bitcoin, a “currency” with no government backing and subject to massive swings in value be worth one trillion dollars? Should it be possible to bring companies public based on sales and earnings projections five years from now? Maybe not!
But in a world where interest rates are zero and even negative. Where there is a major recession, but it seems to mostly impact the bottom half of society. Where nations can borrow unlimited amounts of money, regardless of their ability to repay it. In that world maybe it all makes sense.
Granted, our reliance on technology increased in a work from home world so investors are justified in paying a premium for that growth. But somewhere over the summer the price of an investment no longer seemed to matter. What mattered was that it went up after you bought it. Instant gratification.
That happens in every bubble. Traditional valuation metrics are thrown out the window and easy money can be made by buying the winners, regardless of price. This time is particularly perplexing given that the pre-recission winners are also the post-recission winners. History tells us quite clearly this can’t last, but maybe this time is different?
When it feels this easy to make money in markets over short periods of time it’s good to check back in with our principals as investors. Our principles are simple: We can’t predict the future, but we know that buying good companies at reasonable prices gives us the highest probability of long-term success. Stay away from areas with overwhelming investor interest where momentum overtakes rationality, and investment reflects popularity rather than value.
The best way to check in on these principles is to take a pulse of the hottest trends in the market.
Where is the easy money being made?
SPACS (Special Purpose Acquisition Companies)
Hot new issue markets are nothing new to Wall Street. Good markets lead to more companies going public. The hottest way to go public right now is through a structure called a SPAC. SPACs are blank-check IPO companies, meaning investors give the company cash and management has two years to find another company to buy with it (take public). In 2019, there were 59 SPACs issued for $13bn. Last year there were 248 worth $83bn. This year we are on pace to more than triple that!
Conceptually, the idea is great. In the last two decades the number of public companies shrunk by 50%. SPACs helped ignite the IPO market with hundreds of new companies now available to the public. They also generate a ton of fees for banks and their sponsors and often have misaligned incentive structures. SPACs must announce a deal in two years or investors get their money back. No harm, no foul, except management doesn’t get paid without a deal! Think about that. You have hundreds of blank check “companies” that all have two years to get deals done or management won’t get paid.
How many of these companies are just going to return money to the original investors without announcing a deal? The better question is how many of them are going to compete and bid up prices so that whoever wins overpays? According to the NY Times, “There are more than 300 SPACs with some $100 billion in cash currently seeking acquisitions…Since SPACs typically buy companies five times their size, thanks to outside investments, that implies something like $500 billion in potential buying power.”
ENVIROMENTAL, SOCIAL, AND GOVERNANCE (ESG) INVESTING
We love environmentally friendly companies and try to avoid companies that aren’t because we know that being on the wrong side of the ESG movement is just bad business. Defining exactly what ESG means from an investment standpoint is a bit more tricky given the way different businesses in different sectors operate. That hasn’t stopped Wall Street from responding to the trend. Last year, 200 ESG Exchange Traded Funds were launched and ESG funds saw inflows over 200%. Every company’s annual report has a section dedicated to ESG, with carbon targets, diversity goals, and visions for a more sustainable world.
Part of the trend in ESG has been the funneling of billions of dollars into renewable energy companies. Electric vehicles are leading the charge, and it’s not just Tesla. In the last 12 months, there has been 30 newly listed EV (electric vehicle) focused companies with a market value of $150 billion, most without any significant revenue. That doesn’t even include Churchill Capital Corp IV, a SPAC buying Lucid Motors. That SPAC was up 500% on rumors before a deal was even announced!
The hype in EVs extends to all areas of renewable energy: Hydrogen, solar, fuel cells, and wind power. These stocks are all up well into the triple digits in the last 12 months. Some are growing quickly and many of them have great ideas, but their contributions to a better energy ecosystem are still largely unknown. Some will be winners, many won’t live up to the hype, and others will just turn out to be bad investments even if they are good companies.
INDEX INVESTING AND NO-COST TRADING
One of the marvels of modern finance is the ability to buy the entire market through a low-cost, tax efficient index fund. On top of that, most retail brokerage accounts no-longer charge commissions for trades. Getting access to financial markets has never been easier or cheaper!
That’s good news but remember that most successful investors trade very little and hold stocks through good and bad markets while most index funds are actively traded. With the friction from a trading fee completely removed (a good thing!), traders are free to buy and sell on emotion (a bad thing!). What’s going to happen if stocks stop going up every day?
Beyond that, there is good reason to believe that the success of passive index funds is distorting the market making it harder for indices to replicate their past performance. When you buy the S&P 500 index, you are buying a fractional share of each stock weighted by its relative size. As a stock goes up new money that is invested into an index buys more and more of the winners regardless of price, risk or valuation. Is that the way you want your money invested?
As far as no cost trading is concerned, yes there is no commission, but do you really believe that that market makers are paying your broker for the privilege of executing your trade and not making money on it? Wall Street does a lot of silly things but giving away money for nothing is not one of them. There are a lot of ways for the street to make money on retail orders but one of the easiest is to be on the other side of the losing trades that most undisciplined day traders make on their way to financial ruin.
We’ll save the debate on the viability of cryptocurrencies for another time. What can’t be debated is the meteoric rise in price of the leading coins. Bitcoin is up 500% in the last 12 months, Etherum 600%, even Dodgecoin (a coin that was created as a joke) is up nearly 2000%. The world has printed a ton of fiat currency over the last year giving justification to the rise of other units of exchange, but it is difficult to segregate the rise in other hot asset classes from the swiftness of crypto’s rise.
TIME AND PRICE
Market exuberance makes it hard to remember that the easiest part about investing is not having to do a lot to be successful. Extend your time horizon, reduce your trading, stay away from fads, and the stock market will be your best friend. It shouldn’t be all that exciting over the short-run. In fact, when it’s going well you should be preparing yourself for the next time it’s going to drop 20%.
Human nature inevitably leads to bouts of irrational markets and exuberance. In one of Warren Buffet’s favorite books, Supermoney, Adam Smith tells a story of the Go-Go years of the late 1960’s and 70’s when blue-chip growth stocks (the Nifty Fifty) dominated markets:
“In the old days, some investors did not want small companies which might or might not grow up to be Xerox. These small companies needed all the cash they could generate, so they did not pay dividends… But gradually, as a small growing company kept growing, more conservative investors become interested…The adventurous investor would take early risks, and then sell to the more prudent investor who required more convincing. Then two things happened. One we have already seen in the history of the sixties; the prudent investors got just as aggressive as the old risk-takers. They did not wait for a stock to become a seasoned and proper and judicious fiduciary holding…The second thing that happened was quite amazing. Growth? Is that what they want, growth? Is that the highest price Supercurrency? Is that how it’s done? Wow! The supply of growth companies grew to meet the demand. Now, common sense, that great Yankee virtue, will tell you that there is one Xerox, not seventeen. But everywhere you looked, there was a company with a neat stepladder of growing earnings. Magic! Growth companies everywhere!”
With all the excitement in the market and the flood of new product to appease it, it’s a good time to remember what makes investing in stocks so easy. When you invest based on a company’s fundamentals, speculation becomes noise. It’s distracting and sometimes it means underperforming the overall markets for a period, but discipline makes it possible to avoid the hype. Occasionally it pulls some of our companies into the mix, but that just allows us to pare down exposure and rebalance towards better value.
What we don’t want to do is to give up on the whole market just because there are pockets of speculation. In fact, we think we are staring at some of the best fundamentals we’ve seen in decades. Global markets have nearly unlimited support from monetary and fiscal stimulus. Covid is peaking and vaccines are rolling out in mass. World trade is improving, so much so that the biggest risk to a recovery is not having enough stuff (commodities) for production. Corporate balance sheets are mostly strong, flush with cash, and anticipating broad recovery in the most beaten-up sectors.
We are patient investors and continue to see compelling opportunities, but usually it didn’t start as a SPAC and it didn’t get overwhelmed by demand simply because it fit a certain style of investment. The rotation that’s taken place over the last three months is finally giving life to our much maligned financial, energy and industrial stocks. These companies are well positioned for a recovery, and don’t need a decade of uninhibited growth to justify today’s valuations. It’s a great reminder that the easy money is made over decades, not in a few months.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.