- Value stocks are up just 6.0% year-to-date, while growth stocks are up over 17.0%
- “Story” stocks like Facebook, Netflix, and Amazon are up even more
- We expect our current underperformance to reverse
- We think our investment approach offers higher long-term return potential with less risk
- Baupost Letter Points To Concern Over Risk Parity, Systematic Strategies During Crisis
- AI Hedge Fund Robots Beating Their Human Masters
It’s been a challenging year-to-date for our value-oriented investment approach. Value stocks are out of favor. We’ve had relatively limited exposure to the best performing sectors of the stock market (tech and health care). And we’ve had a couple of position-specific setbacks.
We’re up about 3.0% year-to-date, but we’re trailing the S&P 500’s 11.6% climb. This contrasts with our performance in 2016, when we outperformed the S&P 500 by more than 12.5%. Despite our slow start, we believe this year’s performance differential is largely transient.
Crossroads Capital up 55.8% YTD after 32.5% in 2019 explains how it did it
Crossroads Capital is up 55.8% net for this year through the end of October. The fund released its 2019 annual letter this month after scrapping its previous 2019 letter in March due to the changes brought about by the pandemic. For 2019, the fund was up 32.5% net. Since inception in June 2016, Crossroads Capital Read More
The Russell 1000 Value Index is up just 6.0%, while the Growth Index is up 17.0%. “Story” stocks, companies with high investor enthusiasm borne out of grand tales of rapid business growth–the types of stocks we shy away from–are up even more. Facebook, Netflix, and Amazon, for instance, are up 46%, 39%, and 29%, respectively. The question might be then, “Why didn’t you have positions in these stocks and other high-growth companies like them?”.
The simple answer would be that as value-oriented investors, we thought that their stock prices came with too high a risk of losing money should business performance fail to live up to lofty expectations. We had, in our opinion, ideas with better return potential that carried lower downside risks. And we still think that’s the case. That said, an example in contrast of idea-type should provide a much better illustration as to why we didn’t invest–and still won’t at today’s prices–in high-growth story stocks.
We believe our approach can generate the same high returns investors yearn for in the high-growth stocks that make headlines, but in a manner that lowers the risk of permanent loss that can occur when outsized growth expectations in highly-valued stocks fail to materialize.
Below we provide a basic analysis of two different companies, Amazon and WESCO International, and then offer some simple valuation and expected return considerations, with the intent to showcase why we tend to build portfolios that don’t contain the sexy stocks that you read about in the paper.
We offer the Amazon analysis with this caveat: because the stock has yet to offer what we see as a large enough margin of safety to buy, we haven’t done the weeks of research that we normally do on new ideas. So, we offer our analysis with due humility because we haven’t studied the company and its markets in significant depth. Also, we acknowledge that Amazon is one of the best performers of recent history, and we didn’t own it. However, we look at the opportunity as presented to us today, and analyze the stock and its return implications.
A Contrast in Investment Ideas - Amazon vs. WESCO International
Amazon is a phenomenally well-run, disruptive force of nature. Its stock, one of the “FANG” companies (Facebook, Amazon, Netflix, Google), has performed well this year, rising over 29%.
The company has grown sales 25% per year for the last decade, and most analysts expect it to grow revenues 20% a year for the next three to five years.
According to current analyst sales forecasts, Amazon is expected to grow revenues to $435 billion by 2023, which would likely make Amazon the second largest company in the world, behind only Wal-Mart. Topline growth is expected to slow to about 12% per year and then to decelerate further in the years beyond 2023.
The bulk of Amazon’s revenues (a little less than 90%) consists of retail sales of products sold on the company’s country-specific Amazon websites. Amazon’s internet cloud services offering, Amazon Web Services (AWS), makes up the remaining 11% of sales.
Company-wide, Amazon has averaged operating margins of a little less than 2.0% over the last five years, but analysts expect margins to approach 5.0% by 2019. Its North American retail sales segment has an operating margin of about 2.0%, less than half of competitor Wal-Mart’s 4.6% margin. Whole Foods, the upscale grocery Amazon is acquiring, also has a 4.6% operating margin. The company is losing money in its International retail sales segment, while its AWS segment currently carries a 22% operating margin.
Under some optimistic revenue growth and margin expansion assumptions, it’s feasible that the company’s operating margin could approach 10% in five to seven years.
If we assume that the retail businesses compound at 17% per year for the next seven years and ultimately reach a 5.0% operating margin (higher than Wal-Mart), while the AWS business grows at 29% per year and reaches a 33% operating margin (consistent with Microsoft’s “Intelligent Cloud” segment margin), Amazon would reach a 10% company-wide operating margin and could generate about $58 per share in earnings.
Under this scenario–which is consistent with investor expectations–AWS would grow from a $19 billion business (expected full-year 2017) into a $73 billion business. To put that into perspective, today Alphabet (formerly known as Google) has revenues of $88 billion, IBM has revenues of $77 billion, and Microsoft’s entire Intelligent Cloud segment has revenues of $27 billion.
If Amazon meets investor expectations, by 2023 the company will have become the second largest company in the world by revenue and more than likely the largest by market capitalization. It will likely have ongoing revenue growth potential of low-double-digits and carry a 10% operating margin. If that ends up being the case, what P/E multiple would make sense for Amazon in 2023?
Today, the market is pricing Microsoft’s 2018 earnings at 22 times and Google’s 2018 earnings at 24 times. These two businesses carry much higher margins than Amazon ever will, but have similar revenue growth expectations today as Amazon might in 2023. Apple, the largest company in the world today by market capitalization, has a P/E multiple of just 16 times 2018 earnings because investors fear the company might not be able to grow as fast as the world’s largest company by market cap. Amazon currently trades for 120 times 2018 earnings expectations.
Below is the expected return of Amazon at different P/E multiples on our 2023 EPS estimate:
In order for Amazon to provide mid-single-digit to low-double-digit average annual returns for its investors, it will have to:
- continue to grow rapidly, scaling its AWS segment to revenues of over $73 billion,
- grow profit margins fivefold to 10%, and
- trade for a P/E multiple higher in 2023 than Microsoft and Google (the principal competitors of AWS, neither of which carry a lower-margin retail operation) do today.
The point is, Amazon must continue to disrupt, grow, and execute at astronomical levels of efficiency and speed, and permanently maintain multiples twice that of principal competitors to generate an average double-digit long-term return. Amazon may certainly accomplish all that–we consider it one of the best run companies in the world and have profound respect for CEO Jeff Bezos and his vision–but we would still pass on investing in Amazon today and other highly-valued story stocks like it.
At today’s stock price, we think an awful lot must go right with Amazon to capture a market-like return. Conversely, what return would we earn if the company fails to meet the grand underlying expectations?
A business we like today and continue to own stock in is WESCO International. In contrast to Amazon, WESCO is an investment idea that doesn’t require gargantuan revenue growth and margin assumptions to provide a high return.
WESCO is a wholesale distributor that provides industrial products and services and supply chain expertise to utilities, construction companies, industrial businesses, and other commercial, institutional, and government entities. The company differentiates its offering through technical expertise and customer and application-specific service that extends beyond a product’s delivery. This helps better insulate WESCO from web-based threats, Amazon Business included, and makes for stickier customer relationships. It’s a superior business model compared to its competitors that generate significant sales through “walk-up” customers, whether at a physical counter or on an e-commerce website.
WESCO and its end-markets have experienced a very difficult sales environment over the last several years. In fact, until the most recent quarter, company organic sales had declined every single quarter for two years. These sales declines were consistent with the economy-wide weakness in capital expenditures. Core cap ex, or new orders for non-defense capital goods excluding the volatile aircraft sector–a decent proxy for WESCO’s end-markets–peaked in late 2012 and have declined for several years:
Today, core cap ex, adjusted for inflation and population growth, is at levels typically not seen outside of full-blown recessions. While the entire economy has performed well over the last several years, WESCO has operated within an industrial recession. That past weakness is why the company’s current stock appears to be a compelling investment opportunity.
If history is a guide, the prolonged period of underinvestment in infrastructure should pave the way for growth in the years ahead. Core cap ex would need to grow over 5.0% per year for the next seven years just to recover to its inflation and population-adjusted long-term average. When infrastructure spending does return, WESCO, which serves as a distributor to these markets, should benefit.
Over the last decade, WESCO generated average operating margins of 5.3%. Under the difficult demand environment that still exists today, WESCO expects to post an operating margin between 4.1% to 4.3%. The company has provided low-end earnings guidance of $3.60 per share for 2017.
At today’s stock price of $50, the company trades for 14 times this year’s earnings. That’s below the company’s long-term P/E of 15 times and is on earnings that management believes represent the current down-cycle trough. Company order backlog, which hasn’t been higher since 2012, provides some evidence of a return to growth.
What kind of return could we expect to earn if WESCO’s sales rise consistent with a recovery in economy-wide core cap ex over the next seven years and operating margins return to historical average levels? WESCO would likely earn over $7.00 per share, trade for $105, and deliver compounded returns north of 12.0% per year.
Of these two companies, Amazon and WESCO, which would you rather own at today’s prices?
For Amazon investors to earn 12% per year, the company must build AWS into a business the size of Alphabet, generate higher margins than its competition while charging the significantly lower prices necessary to capture market share, it must become the largest company in the world by market cap, and continue to trade for P/E multiples twice that of competitors. While that’s possible, we wouldn’t invest when success like that depends on it.
On the other hand, for investors to earn 12% a year in WESCO, the company needs to participate in the eventual recovery of economy-wide cap ex and generate an operating margin consistent with company history. And WESCO, due to its small size, will still have a low-single digit share of its addressable market after seven years of growth.
We choose WESCO and the investment ideas like it because the underlying assumptions required to generate a higher-than-market return are less heroic and as such, come with less downside risk should things not work out quite as we expect.
We don’t own Facebook, Netflix, Tesla, or Amazon today because the underlying assumptions imbedded in the stock prices require a lot from the companies, significantly more than asking WESCO to benefit from a cap ex recovery. And that’s hurt us this year. Story stocks have done extremely well.
While we’re off to a slow start so far this year, we think things will turn around. We like our portfolio’s positioning compared to stock markets and expect to generate much higher absolute and relative returns in the years ahead.
In our October 2015 commentary, we wrote, “today, we think our portfolio is about as well-positioned against the market as it has ever been. We like value’s prospects over the next five years and our portfolio in particular.” While we’ve outperformed the S&P 500 since then, including this year’s tough start, we still believe the resurgence of our portfolio and value stocks in general lies ahead.
While we cannot predict the performance differential we’ll ultimately have, we feel good about what we own and our comparative prospects.
Article by Black Cypress Capital