Category: Macro Analysis

Eurozone Equities are NOT that Cheap $VGK $EZU $IEUR $IEV

Are European equities cheap? I keep hearing that European that they are cheap relative to the US at least. It follows then that because the US has outperformed so much over the past 10 years, there is bound to be a reversion to the mean. This chart is often thrown around with no real context other than lower P/E means great buy:

I wanted to break that down and test the hypothesis. I downloaded the holdings for the S&P500 (from iShares IVV) and the Eurozone equities fund (EZU). But before we go through that, check out the relative performance.

Bottom line: Europe has gotten its A$$ kicked.

But wait – this isn’t totally true. We can’t forget currency’s impact on performance. The dollar has strengthened massively (since the US is the best house in a bad neighborhood). Here is the hedged Euro performance. Not nearly as bad as some pundits might have you believe over the past few years…

So how do the companies that make up the index compare? Here is my simple pivot tables using the weighted avg to assess the relative forward P/E multiples.

Note: the amounts don’t add to 100% due to rounding plus a small amount of cash held in the ETFs.

As we can see, looking 2 years out the S&P trades at 20.8x earnings compared to 16.0x for Eurozone. That does indeed seem steep. What is driving it?

Several sectors stick out: Consumer Discretionary, Tech, Real Estate and Financials.

Why does Consumer Discretionary trade so much higher in the US?

One word: Amazon. The company is labeled as consumer discretionary vs. Tech. Watch what happens when I relabel Amazon as a tech company.

It drops precipitously! Given Amazon is such a big weight in the index, it has a dramatic impact on the sector. It is still high relative to Eurozone, but not crazy.

Technology:

I personally thought that the US would rank higher in P/E solely because of Tech. And that does seem to be a big driver. Including Amazon, Tech weighs in at almost a quarter of the S&P500. If I include Facebook and Google (currently in the communication sector) it would be close to 30%!  

 

While remnants of the tech bubble make this a concern, I would rather have these businesses than not and think they actually trade at reasonable valuations. They grow 20% a year and are secular growth stories while also requiring little capital to grow.

So another adjustment here, but we’re starting to parse out the large drivers here.

Real Estate:

One reason for the high multiples in the US is REITs. These entities pay no income taxes and should therefore trade for higher multiples. However, that’s not the whole story. Think about the best businesses in the REIT space: oligopolies, contractual rent escalators, increasing demand each year… Yes the tower REITs.

American Tower, Crown Castle and SBA Communications dominate the real estate sector. Arguably tech exposed as well, this is the big driver. In addition, they are investing heavily for growth and REITs tend to carry higher leverage. This means increased EBITDA but EPS can be pinched by interest in the short-term.

Financials:

Last but not least… Financials. Look at where they trade in the US vs. Europe. More importantly, look at their relative weights. We all know the struggles of European banks due to (i) negative interest rates and (ii) weaker economies. Do I want to own those banks? Perhaps because some day their troubles will reverse… but for now, I’ll pass.

Bottom line: I don’t think Eurozone equities are THAT cheap. The further and further you peel back the onion, the more I want to buy the US vs. Europe. Is the multiple higher than Europe? Yes. Is it a concern how big tech has become in the US indices? Yes, but I also want to own those companies. As they continue to disrupt and change the way we do things, Europe’s older economy may be left holding the bag.

As one final comparison, here is what you are buying. In my view, missing secular growth and asset light businesses in exchange for “cheap” cyclical names (banks, Oil and  Gas, Autos, Chems). I think the US will compound at a much higher rate going forward as well and should perform much better in a recession. If you think the US$ will depreciate or that we are headed for a tech crash, then sure, go with europe.

Is a recession looming? past recessions have begun with unemployment bottoming… $SPY $TLT

The million dollar question 10 years into an expansion like this is, “When is the next recession?”

We have heard pundit after pundit claim that 2012 was the top. No 2013. No 2015. No 2018. Each, so far, has been wrong.

It makes sense why they do it. If they are seen as the investor that “called the top”, they instantly gain success for the balance of their careers. That means more media coverage, more book deals, and better asset inflows if they manage money.

This clearly has been one of the most hated bull markets in history, but even I, a “bottoms-up” investor, must admit that I am watching for signs of the top.

That brings me to the unemployment rate. Each time it has gone below 5%, this usually signaled that things can’t possibly get better and a recession would loom.

The unemployment rate got down to 3.7% in December 2018 which is one of the lowest levels since the 1960s. Does this mean the end is near?

Not so fast. The unemployment rate represents those people who are unemployed that are still in the labor force. Those who are not in the labor force are not counted. If we look at the labor force participation rate, it is at the lowest level in decades

Let’s put some math behind it then.

Using the data from the Bureau of Labor Statistics, I can see that a 4% unemployment rate equates to 6.5MM people looking for jobs. The flip side of that is that 162.5MM are in the labor force, but we know some have dropped out since the recession.

As such, let’s try to “normalize” the numbers. In other words, what if the participation rate went back up to ~66%. That would mean the labor force would grow by about 3%. That equates to 4.9MM workers. If these workers were counted in the participation rate, that would mean that the current unemployment rate is more like 6.8%.

Of course, these workers won’t enter the workforce without prospects of jobs, but even if 1/3 don’t, the unemployment rate ticks up to 4.8% from 4.0%.

Another factor this doesn’t include is underemployed workers. Think, college educated engineer who drives for Uber for employment. This is an exaggeration, but also not factored in the results.

Bottom Line: Be careful of scary statistics. “There are three kinds of lies: lies, damned lies, and statistics” Clearly unemployment is low, but that only tells one part of the story.

Market Déjà vu… kind of…. $SPY $USO $MCHI

The current market action and headlines is starting to sound eerily similar to that of late 2015. As a reminder, the world was concerned about global growth and China surprised the market with a currency devaluation, very rare for a country that pegs its currency and only allowed it to move with a band. This suggested China’s economy was weakening and a devalued currency would help the exporter nation bounce back. Since China is essentially a black box and essentially no one actually trusts the numbers they put out, this allowed the market to write its own narrative and that China’s economy had to be weak and that would drive everyone else down with it.

Recall oil at the time had also fallen from $100/bbl to $50-$60/bbl (and was about to drop to a low in the mid-$20s). This too pointed to China weakening and slow global growth. Lastly, corporate earnings were not that great. Especially among industrial names, such a Caterpillar, which is a bellwether for the global economy.

However, that actually didn’t seem to be the case. The market eventually rallied strongly, commodity prices rebounded (as it turns out excess supply could be absorbed and production curtailed),  and people became more comfortable that if anything, China was headed for a soft landing and going to go through a bit of a deleveraging stage.

That placated the market for a bit… until now. The narrative sounds too similar to ignore, but the surrounding facts around it all are different. For example:

  1. People are concerned about China: China posted the slowest growth in a decade. Forget that its still growing amazingly quickly for the third largest economy. Forget the well documented commentary about Xi Jinping wanting to move China to a service economy like the US, a dramatic move from its current export economy. Focus on the negative.  This time, its business confidence in China is low and the tariffs wont help…
  2.  Oil posts a 9 day losing streak: For now, people are associating the decline with supply, a mistake from last time I assume they don’t want to repeat, but there are some headlines that say for example “Oil’s unraveling shows global economy is in a tough spot.” Forget US output at record levels and OPEC pumping as much as it can since 2016.
  3. Earnings have not been good so far. And to provide the context for this time vs. ’15/’16, Caterpillar was down nearly 30% since it reported Q3 earnings. However, companies today are reporting “some softness” and most earnings trouble has been related to “inflation”. I put inflation in quotes because it is difficult for me to look at many companies who have benefited from oil falling (decline in raw materials) and able to hold price steady (boost to margins) that now are complaining about giving that back.   Freight and labor I’ll admit are real. Labor obviously because the slack from the financial crisis has been absorbed and freight is higher after new rules limited hours truckers can be on the road… and actually enforced it…

There are obviously other issues at hand such as interest rates at 3.2% for the 10-year (20bps above where it ended 2013, but OK I guess that will stifle growth…) and the impacts to housing.

Bottom line: I am avoiding the headlines which have had very little predictive success. 

 

How much will rising rates actually impact stocks? A DCF-based impact analysis points to this selloff being overdone $SPY

With all the market volatility recently and the S&P near correction territory, investors are trying to find answers. One item that has been targeted is the increase in interest rates recently. Those who buy into this theory say that increasing rates will increase the discount rate on stocks and that will drive prices lower. Just from a competing for your-next-dollar standpoint, it is true that treasuries at 3% look a lot better than <2%.

10yr treasury.png

I have already argued that I am bearish on the notion that interest rates will rise much further from here. I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.

I also argued that the Fed has little impact on long-term rates actually (and check that with Aswath Damodaran writings on the subject as well)

given rates moved up quickly from their lows to ~3.2%, I wanted to show the impact on this move on a hypothetical company. I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).

Here’s a summary below of where it is currently trading and model:

mini model

As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.

DCFs

As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?

Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt. As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.

WACC

So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.

DCF Valuation

Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects.

A quick word about Tesla: It is not going bankrupt

Tesla’s bonds tested new all-time lows this week, hovering around 87.75 cents on the dollar as negative headlines continue to shake confidence of investors. To quickly review the updates, JP Morgan has now downgraded the company just after upgrading it up on the now infamous “Funding Secured” tweet from Elon, the Saudi Arabian sovereign wealth fund that was seen as the funding provider has now been reported to actually be in talks with Tesla rival Lucid Motors for investing a material stake, and lastly, Elon had a recent emotional interview in The New York Times.

But now with reports of concern among suppliers related to Tesla and headlines coming out about the company’s bankruptcy, I want to make something very clear…

It is not going bankrupt.

At least not yet, that is. First of all, we need to separate the recourse debt vs. non-recourse debt. The company has ~$3.2BN  of non-recourse debt, mostly related to Solar backed notes and other auto and dealer plan securities in which debtors have no recourse to Tesla, but do have recourse to some certain collateral. A lot of these are asset-backed bonds related to Solar City, which are issued from a bankruptcy remote vehicle, have claim on cash flows from solar assets only and are also very long-dated and not of much concern (2038-2049 maturities).

TSLA Cap Table

 

Second, Tesla has $4.2BN of unsecured convertible notes, some of which the company can settle in stock and some of which are well out of the money. The 0.25% due 2019, the 1.25% due 2021, and the 2.375% due 2022 will be settled in cash. The converts due 2020 are also in the money and will likely be settled in stock and is relatively small. The rest are out of the money. As such, you can subtract ~$1bn off of this number.

Lastly, the bulk of the remaining debt is the unsecured notes quoted above that are trading at ~88 cents on the dollar.

To make one thing clear, just because the bonds are trading at 88 cents DOES NOT IMPLY BANKRUPTCY. It simply reflects the higher risk associated with the bond. As interest rates moved up recently, a lot of longer dated bonds have gotten crushed. Do you think 3M is going bankrupt too? Because their 2026 bonds trade at 92. What about Microsoft? Their 2026 bonds are trading at 93.5. If treasuries move up and credit spreads of the issuer stay the same or widen slightly, then bond prices must fall. Tesla’s credit spreads widen some, sure, but they were issued with a 5.3% coupon when treasuries were super low.

Therefore, while Tesla is funding a lot of its growth with capex that is hurting cash flow that is only one reason why the bonds are where they are. The move in rates had a larger impact, in my view, and the yield on the bonds is still ~7.3%, which is somewhat high, but not implying bankruptcy. (Some companies issue new debt in the high yield market with 10% yields… investors would not buy that if they thought it was a greater than expected chance of bankruptcy than surviving, it just reflects higher chance of it happening or higher credit risk).

Plus, I’ve mentioned it a lot, but this is a 2025 bond. There are no covenants. The company literally doesn’t have to worry about it until August 2025. The thing to also keep in mind is that $1.6BN of debt with banks (at a super low rate of 1% + LIBOR) and this $1.8BN debt due 2025, is $3.4BN in the context of a $54BN equity capitalization.


Let’s say Tesla wanted to reduce its debt TODAY, but needed to take it out with equity issued at an extreme discount to today’s levels. As shown below, it could take out all the convertible debt and all the credit agreement debt by issuing equity at a 25% discount, or $240 / share, and easily take it down. Sure, they would dilute themselves, but the company survives. This is just a simple example and we will show further below how large the equity cap is in relation to the the debt and total capitalization of the company.

TSLA Share Issuance 2

While headlines try to make Tesla’s debt load seem large… $5.8 BILLION or even $11 BILLION (which includes non-recourse debt which is not correct), the amount is simply is not that big compared to the $55 BILLION market cap. If it had this much debt and only a $1BN market cap, then OK, I’ll start to buy the bankruptcy case. Let’s also not forget that they have $2.2BN of unrestricted cash on the balance sheet…

Capitalization of TSLA


Lastly, reports of Tesla suppliers are complaining about Tesla asking for better terms? Well welcome to Auto companies friends! Auto OEMs always pressure their suppliers for better terms. Why? Because the suppliers are beholden to a select few companies (GM, Ford, Honda, etc.) and those select few companies operate in very hard and bad businesses. As such, they are always squeezing their suppliers margins to stay afloat.

Sorry to disappoint — This article has nothing to do with valuing Tesla’s equity.

But since you asked, would I buy it here? No. I’ve always viewed Tesla as just another auto company operating in a space where they are all piling tons and tons of cash into the industry to catch up. Does Tesla have a great competitive advantage? I don’t really think so, they just have the first mover advantage. As Warrant Buffett says,

“ You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.”

I think others will put a dent in Tesla because I view auto companies as challenged. The industry is hyper competitive, so I think people will pour cash to chase Tesla, as mentioned. People also have a wide variety of tastes that auto companies must keep up with year-after-year and make sure they stand out against competition.  The companies also must simultaneously manage very complex supply chains on a global scale. Lastly, cars are high-ticket items, so if consumer confidence falls or we enter a recession, its easy to defer a car purchase. Meanwhile, car companies must then eat the fixed costs.

They are just bad businesses. Simple as that.