To my fellow shareholders,
I know I sound like a broken record when I say that I’m concerned about the strength of the stock market, but in the first quarter of 2021, the market climb has picked up pace. In fact, it’s not only the stock market which has been going up, bond prices are at all time highs, Australian house prices are rising at fastest pace in 32 years and even prices of 20-30 year old Japanese sports cars (e.g. Honda NSX, Toyota Supra, Nissan Skyline) have gone up 2-3 fold. So is the stock market (US market in particular) in a bubble? Let’s explore this a bit.
It is inherently difficult to identify a bubble before it burst. Most bubbles are only universally acknowledged as bubbles after they burst. But there are a few common features of a bubble, the first is overvaluation. Robert Shiller, the economist who famously picked the top for both the dot com and housing bubble produces the cyclically adjusted price earnings ratio (“Cape ratio”). Annual corporate earnings are unstable, so the Cape ratio uses the average 10 year earnings (inflation adjusted) to smooth out the earnings volatility to produce a more stable long term valuation metric. Although it has its issues, I believe it is still a better valuation yardstick than the simple price earnings ratio.
The chart below shows the Cape ratio for the S&P 500.
The S&P 500 Cape ratio is currently at the second highest level in 140 years. It is only eclipsed by the dot com bubble in 1999/2000. However, you’ll constantly hear punters play this down by arguing that the high stock prices are justified by the low long term government bond yields (long term interest rates). In fact, real long term government bond yields in the US have fallen to the lowest level in 140 years. Interest rates act like gravity on stock prices and when gravity is low, prices rise. To illustrate this point, the next chart shows the excess Cape yield which is basically the inverse of the Cape (1/Cape ratio) less the long term government bond yields (adjusted for inflation).
After adjusting for the current long term government bond yields, it appears that the excess Cape yield shows a far less extreme situation than just looking at the Cape level. However, that’s a relative way of looking at it and in my opinion, completely missing the forest for the trees. Bond yields are the inverse of their prices, so the reality is that real long term government bond prices in the US are at a 140 year highs and stock prices, relatively speaking are cheaper. It’s like saying a Porsche is cheap when compared to a Ferrari.
Looking at the Cape chart, the current situation looks to be the inverse of the situation in the late 70s/ early 80s, when prices of both stocks and long term bonds were very low (bond prices inverse of its yield) which was a great time to invest in both classes as prices rose over the subsequently decades.
The second feature of a bubble is euphoria and crazy investor behaviour especially on the part of individuals. Jeremy Grantham of GMO, a veteran market historian says that this is the single most dependable feature of the great bubbles in history (I encourage you to read his latest letter here). Some examples of current euphoric investor behaviours are:
- The value of Bitcoin hit A$72,000 and is about the same value as a 1kg gold bar. It seems digital gold is as a good as the real thing.
- Tesla Inc’s current market capitalisation is worth more than the world’s top 6 car manufacturers combined (Toyota, Volkswagen, Daimler, Ford, General Motors and Honda). In 2020, Tesla made 500,00 vehicles while Toyota alone made 8.8 million vehicles. But Elon is superhuman, no?
- Coinbase, a Bitcoin exchanged closed on the day of its IPO at a market capitalisation of US$86 billion, making it as valuable as Intercontinental Exchange Inc, the owner of the New York Stock Exchange.
- The $88 billion IPO boom in special-purpose acquisition companies (SPACs) so far in 2021. SPACs are shell corporations listed with the purpose of acquiring a private company at a future date (within 2 years). These are pure speculative vehicles as how can one possibly invest intelligently when one doesn’t even know what business the SPAC will end up acquiring? The last time we had a SPAC boom was in 2007, a year before the global financial crisis.
- Explosion in US trading volumes in 2021. The average daily volume in 2019, 2020 and 2021 are 7 billion, 10.9 billion and 14.7 billion trades. The average daily trading volume in 2021 has doubled from 2019. This has coincided with the rise of Robinhood (trading app) and the retail investors who have enthusiastically jumped into the market (speculation frenzy).
The trillion dollar question is how much more can it rise and when will it burst? I’m afraid I have no idea and I don’t think anyone can answer this will a great level of confidence, that’s just the nature of bubbles, they are totally unpredictable. Jeremy Grantham believes the party can last till early summer in the US, we will see. Luckily for us in Australia, the ASX does not seem as overvalued as the US market which is a good thing in my opinion. But on the other hand, when the US market sneezes, everyone else catches the cold. So we will not be immune if the US bubble bursts.
So the next question is, does it matter for a long term value investor like CV Capital? I would say it does but not from trying to prevent our portfolio from going down along with the market. Some stocks we plan to hold for decades so what does it matter if the stock drops by 50% tomorrow? We won’t be selling anyway. So from a paper loss perspective, I don’t think it matters that much.
Where it matters is that if we go into a market meltdown fully invested (i.e. no cash), then we lose the opportunity to invest at bargain prices. So there is an opportunity cost for going into a market meltdown fully invested. One reason why we have outperformed the market is that we put some cash to work when the market crashed in March 2020.
Portfolio management is about balancing the known with the unknown. So we’re proceeding forward with even more caution than usual. Post March, I have been liquidating some of our positions. I’ve been selling positions where I believe the share price has reached or gotten close to its intrinsic value (which we normally do anyway but now I’m being a bit more conservative with my intrinsic value assessments) or selling positions for stocks which have too small portfolio weightings to make a difference to our overall returns (spring cleaning if you like). We will continue to stay invested in positions which we believe to be still undervalued and companies which we believe are long term compounders (companies with comparative advantages who will continue to grow their intrinsic value over time).
Fund Activity
We have sold down our holdings in New Zealand Media and Entertainment (NZME). Overall, this has been a lousy investment and we lost 11.5% over 3 years. This was part of the group of stocks which I initially transferred into CV Capital at inception. NZME is the leading media company in New Zealand which owns newspapers, radio stations and some websites. My original thesis was that on a sum-of-parts basis it was cheap and although the newspaper part of the business was in decline, it was cutting costs, still had some growth assets (radio and home selling website One Roof) and was going to launch a paywall on its NZ Herald website, all of which could potentially offset the decline in newspaper revenue.
However, over the past 3 years, the radio business has declined rather than grown and both the paywall and OneRoof are starting from a very low base so it will take a long time before their earnings make a material impact on the group. So NZME’s management had to rely on cutting cost to preserve earnings and that is a very tough game as there is only so much fat you can trim. This has been a good lesson for me, that it is much better to buy a more expensive growing company than a cheap declining company.
Fund performance
CV Capital return for FY2021 (1 July – 31 March) is 36.5% and since inception is 14.7% on an annual compounded basis.
The chart below shows our returns on $100,000 from inception to 31 March 2020 compared to our benchmark.
Our cash and cash equivalents position are circa 11.8% of the portfolio and the unit price as at 31 March 2021 is $1.55. The share price can be broken down into the following:
