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A look at some bubbles

The Days Ahead: More earnings and jobs numbers.  

One Minute Summary: A lot more economic news to feed off this week but not a lot of action. GDP numbers were soft with consumer expenditures and almost every category weaker than the last quarter of 2017. The high point was a build-up in inventories, which makes sense because consumers went on a mini spending binge last year and companies then had to build inventories back up. Anyway, the market yawned as they did with disappointing factory orders and lower home sales.

The S&P 500 was flat. Some oversold sectors like staples and telecomm did well. Europe was mostly flat but we think they're likely to outperform this year. Emerging Markets were flat but off 2% in dollar terms as the dollar rallied, particularly against the Euro. The 10-Year Treasury hitting 3% was not unexpected and soon retraced.

What we’re seeing with earnings is a pattern of selling on the news. Some of the biggest moves this week were companies that reported perfectly fine numbers but gave weak outlooks. Caterpillar (CAT) was a good example…down 9% on multiyear margins and net income. 3M (MMM), Teradyne (TER) and Freeport McMoRan (FCX) were the same. What’s going on? A lack of the next big thing. Earnings are good, economy okay, inflation ticking up gradually. These are all fine but there’s no big catalyst in the wings so stocks are taking a breather. No reason for any portfolio changes

1.     Bubbles: The problem with bubbles is that they're difficult to spot when you're in them (post hoc is a piece of cake). Having gone through two out of the three worst market corrections in the last 80 years, let's just say we’re on the lookout for any signs of exuberance, rational or not.

Two areas that have given us some concern are commercial real estate and (some) tech and we’ve written about both at length. The two came together spectacularly in a bond offering from WeWork, a company that creates a world where people work to make a life, not just a living. It’s basically shared office space for the tech firms, the gig economy with a lifestyle twist (like free beer and foozball) and has raised plenty of equity money to value it at $20 billion, which would make it the 150th most valuable company in the S&P 500, if it were listed. But to get into the S&P 500 you kinda have to make money, which WeWork does not. The 342 offices are all over the world and in some pretty nice locations too.

They came to market with a 7.85% seven-year $500m bond, with a rating B+, which is pure junk or as S&P put it, has:

“Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments.”

No kidding. You’d think with all those offices, it would be an asset intensive business. But WeWork doesn't own the properties, it leases them. So it’s more of an operating real estate company and should be asset light.

Why, then, does it need the money? Because it's tearing through cash. In 2017, it had revenues of $822m and lost $883m. At that rate, it will eat up its cash assets in two years. It has no equity cushion, unless SoftBank chips in another $4bn. Its EBITDA is so awful that the company has to adjust it like crazy:

Source: WeWork Prospectus via FT Alphaville

GAAP says you must produce a real, accountant certified earnings number. That’s around $771m in the above. But GAAP also says you can restate EBITDA if there are one-off expenses (like stock options you grant once), or you expect some earnings to come through for a full year (instead of a partial year). You don't have to disclose exactly how you got there but, from the above, all that gets WeWork to a $193m loss.

They then put in a “Community Adjusted EBITDA” to get it to a $233m profit (the bit in yellow). How did they get there? By adding back in all the sales and marketing expenses saying, in effect, they won't happen again. No investor has ever heard the phrase “Community Adjusted EBTDA” before or quite so aggressive an income restatement. Neat trick: turning a $933m loss into a $233m profit. 

Enough on accounting. But suffice to say it’s a very dodgy way to report your expenses but because it’s a private company, you have to go with it. So how did steely-eyed irascible bond investors take it? They over-subscribed and the company looks set to raise $702m.

So why are we concerned? Mainly because it's:

  1. A hunt for yield
  2. A basic business model (it's a landlord) masquerading as something new age
  3. A ton of debt sitting on a ton of debt because the properties they lease don't belong to them but leveraged real estate companies.
  4. An eye watering valuation

So, leverage on leverage, novel accounting and demand at-any-price is not a great combination. Add in that seven of the world largest tech companies are tech and that never before has one sector dominated the large cap universe, that tech is now 27% of the index (it was 33% at its peak) and, you know, the general euphoria around tech, and well, color us skeptical.

It's another reason why we focus on quality, dividends and companies with management discipline.

2.     ETF Screens: We attended a meeting with a major index provider and asset manager the other day, somewhat under Chatham House rules. The topic was social investing and index managers. Blackrock has made a big splash about corporate responsibility asking that companies account for their societal impact or risk the ire of the world’s largest asset manager. But Blackrock is the largest shareholder in multiple firearm manufacturers and doesn't have much of a choice except to invest in them as long as they are listed companies.

On the firearms side, we ran the performance of the four listed manufacturers (there are others but they're mostly private or foreign) against the Russell 2000 small cap index. They're terrible investments but that’s not really the point.

Most of them are small market capitalizations and together they're only 3 basis points (so, $15 for every $50,000) of the index. The lower line shows the performance of the four companies and, clearly, they have not performed well at all.

What we wanted to explore was whether we could use an ETF that excluded either i) firearm manufacturers ii) retailers of firearms or iii) some broader definition of societal good and responsibility. We'd like your thoughts and please let us know either here and jump to the comments section or here.

Bottom Line: We're in a range bound market for bonds and equities. We expect it to stay that way. We'll be looking for wage and hourly earnings increases in the job numbers. We don't expect to find any.

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Stuffed anteater disqualified

--Christian Thwaites, Brouwer & Janachowski, LLC

 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.