Finding Safe Harbors In Market Storms

I want people to understand is that you're not always getting information you think you're getting from what you believe to be good sources. This is one of my favorite slides. And look, Jim Cramer is a great entertainer, and many Wall Street analysts are very charismatic, but whenever you're dealing with people who are not truly independent, you really need to understand that the red flags are large. Many of you heard me say that if you've ever read the last 2 pages of a Wall Street report, the super small fine print, the disclaimers and disclosures, you see that what they say in those disclosures is that they may be doing just about anything, a lot of which is counter to the best interest of the reader of that report. For example, the report could say, we think you should buy this stock. And the firm could be short the stock. Uh, that's what's going on. So I think, look, everything's good in, in positive rising markets. Everything's happy when the markets are going up and Fed's— the Fed is easing and we're just pouring more and more money in the system and it's just going and going and going. Everything's good, right? But like Warren Buffett says, when they take the water out of the pool, we see who is and who is not wearing trunks. And what I recommend to you Only swim with people, only invest with people who are wearing their trunks. And if you don't want to just take my word for it, there are a couple articles here. You've seen us maybe write some reports on these articles, but 2 recent studies that point to really rampant manipulation from CFOs themselves. This is a survey of CFOs. It was highlighted on MarketWatch, right? CFOs themselves say earnings are fudged. All right, and it was approximately 400 public and private guys admitted that— 20% of them admitted that they intentionally misrepresent their earnings using discretion within GAAP. And the typical magnitude is about 10 cents on every dollar. Sell-side analysts don't usually actively detect the earnings issues either. You can— on the website, you get access to the full study. Financial Times, they did an article that was an interview with a former Credit Suisse analyst. And basically what he says is that a buy is not really a buy. And he gives out several reasons that a buy does not actually be a buy. And the way he puts it is that, you know, sometimes You can't change that buy rating because you might need to keep the CEO, who's the keynote speaker at your conference in a couple months, happy. You might have a big client that owns the stock, who owns hundreds of millions of dollars of the stock, and if you downgrade it, well, maybe your commission and your paycheck will go down quite a bit. There's the industry buy, where you have a mandate by your boss that you have to have a certain number of buy ratings. Then there's neglect. Oh shoot, I was wrong. Why bring attention to that by actually adjusting my rating? As a former Wall Street insider, I can tell you that this stuff happens. It happens all the time. I've seen it. The main thing is, again, let's focus on where interests are aligned and where they're not aligned. That really comes to new constructs. How many firms do you know of, can you mention, that talk about how long 10-Ks are and how much we like reading them? How many of them work with FASB and the SEC to help regulators and standard setters better understand investing? None of my competitors do that. They want it to remain murky. They want it to be tough because you know what? They play in those dark corners, not in new constructs. And the reason I'm willing to give away some of my secrets, you might say, to So FASB and to the SEC is because, look, I just want more attention on this stuff. I want more people to understand how important it is to understand cash flows. And by the way, the technology and the sophistication of our process— processes is so far ahead of where anyone else is. It only does me good for people to become more conscious of what kind of loopholes are out there and how they're being exploited. It's good for us for there to be more attention on on that front. And that's why we're recognized by some of the top firms in the world for the work we do. And we really like partnering with all these folks. So what does a safe kind of firm look like, right? You know, what is it? You know, we've talked about what's not safe. How do you find safe? Well, I think you want to focus on things that are a bit more objective. You want to focus on people that will give you research that isn't sort of based primarily on guessing. There we go. I'm making the screen a little bit bigger. And that means it's going to be— you know, look, if it is subjective, you better get some really good commentary around it, right? So like, for example, a stock that we've pointed out recently that's a great safe call where the technicals have been terrible. GM, right? Top quintile returns, strong economic earnings. These are things that we quantify, right? The economic earnings are positive and strong. The return on capital is, you know, for a car company, a top quintile return on capital, pretty much unheard of, right? And then valuation that's extremely low risk, right? This is what low risk is about. Buy low expectations, sell high expectations. A price-to-economic book value for GM of 0.6 means that the current stock price, almost $30, implies the company's profits are going to permanently decline by 40%. The current market price is baking in a future where GM's profits will permanently decline by 40%. Marry that With strong cash flows, high returns on capital, and you've really got a good story there, right? You've got good risk-reward, which is where we focus. And we actually, you know, Kyle wrote a great article on GM that points out so many great reasons as to why the cash flows are going to probably go up, not go down. They're going to continue this trend that we follow. Now, the accounting earnings don't show the same trend because they got a lot of unusual items. And by the way, when we take out the unusual items, we'll show you where. Here it is, page 21 of the filing. We recorded $2.9 billion in automotive cost of sales related to recall campaigns, a catch-up adjustment of $0.9 billion, right? $700 million due to Korean wage litigation. There it is, $0.7 billion resulting from reversal of Korean wage litigation. We're going to be transparent, right? We want you to know how much work we're doing for you. And then the big thing that I think that Kyle pointed out that was really good is that superior products and strengthened business model. Look, you know, I'm not going to say it's the best car company in the world, but they're earning a lot of rewards. Right, that's a good thing. It doesn't lead you to believe that their profits will permanently decline by 40%. They're likely to be pretty steady. And so we're seeing good strength in margins going forward in the underlying business when you take out these unusual gains, right? The bear concerns are mostly priced in. They just had the big settlement that was dealt with in the Department of Justice, you know, all the costs related to the most recent recall. Look at what happened— what's happened with Volkswagen. Like, this could happen to anybody, right? And the fact that GM, you know, has already been under the scrutiny of the regulators, it's unlikely they're going to uncover any other smoking guns at GM. They got bigger fish to fry— Volkswagen, maybe other firms. So, you know, GM has kind of taken their lumps early, potentially here. Even if they haven't, the likelihood of cash flows declining by 40% or more Seems pretty low, right? And we go into more detail, but you get the idea. We're about risk-reward. Risk-reward, at the end of the day, is what the market's going to care about almost all the time. Now, there are situations where our risk-reward is wrong. You know, I remember a long time ago, we first started a hedge fund, Blockbuster came out as attractive in our system. We said, whoa. Well, it's because they were harvesting the balance sheet, so cash flows were abnormally strong for one period because they were basically selling off the business. And that's where a human overlay should be involved. If we had the crystal ball that could predict the future of every stock price's performance, I probably wouldn't be doing this webinar right now. Or if I would— if I was doing it, I'd be doing it on the beach of Bermuda. Not actually here on the beach here in Florida. Just kidding. I'm not on the beach. But you get the idea, right? If I had the perfect stock picking engine, I probably wouldn't be talking about it. But we do have the best risk-reward analysis in the business. And I think the difference today versus the difference over like the last 10 or 15 years is that risk-reward is starting to matter again. Risk-reward is starting to matter again. Markets aren't gonna keep going up forever. What do we have today? Another down 30, 35 basis points. How many days in a row, trading days in a row, have we seen the market been going down? Trends are not good. Hype is not mattering as much anymore. Technical trades are crowded. And if you still want to focus on technical, why not marry that with some fundamental? Right? Here's a great idea: GM. Technicals have been terrible. Stock's been getting crushed. We think it's going to turn around. About another example of where technicals look good for a long time and then the stock got crushed, crushed, and we pointed it out a long time ago: Demandware. Great story. Right? Alan Jackson, one of our new guys, helped figure this idea idea out, and it joins a lot of companies that are getting blown up. Cloud-based companies that don't make money. The hype can only last for so long. So we pointed out back in early June, mid-June, mid-June, June 23rd, that Demandware was kind of a fake. Costs growing faster than revenues, return on capital was going from -16% to -23%. You know, I mean, this is not a good business. and they face fierce competition, right? The only places where they do make any— have any business are the parts of the business that, you know what, the profitable companies don't care about because those parts of the business are not profitable. Providing e-commerce services for super small merchants who don't want to build it on their own and are willing to pay what ultimately becomes an exorbitant fee relative to sales is not a winning business model. And guess what? Our analysis pointed it out early on and still points it out. Still gets a dangerous rating even though the stock is down a huge amount recently. So let's look at what, you know, bad risk-reward looks like. Here, Splunk, Demandware, Twitter— these are 3 stocks we put in the danger zone fairly recently, right? All of which are down 16, you know, 16, 22. I'm sorry, this screen's awfully small. Google will not let me in. There we go. You can see stocks down a lot more than the market, right? These are all stocks from the danger zone recently, and you want to avoid them. Stocks that have good risk-reward are going to get— are going to— are going to do better in markets when the markets go down. I'm not here to tell you that the market— that they're going to do awesome, that we're going to have Good performance no matter what's going on. GM might suffer in a market downturn too. A lot of stocks are going to suffer. But you know what? At least you want to be in those that will rise from the ashes because guys with fake business models pretty much like Splunk, Demandware, and Twitter, they're going to get blown up. If you want to figure out where to find more good ideas from new constructs, where to get this, look at our Stock Pick of the Week, long ideas. Good Good risk-reward. Verizon, another great call. Kyle pointed this out, right? These guys are the only business I think in telecom that are going to make money. I don't think the content creators are going to make money because content's going to become a commodity, just like what we're seeing at Netflix, right? Content's commodity. The people are going to be paying a toll for the bandwidth. That's where Verizon is. That's why they're doing this work. They got the best— they got the best network already as it is. But this focus on live feeds, DVR-proof content, that's the ticket, folks. That's the only thing you can't commoditize is live content because it's only live once. You know, another great example, Verizon, highest ROIC in telecom by almost 2 times as much as the next best guy. Its valuation implies its profits will permanently decline by 30%. That's good risk-reward, my friends. Good risk-reward. So let's look at— let's take a look at another danger zone candidate. I like the one from this week. That's a really good one. We might go back a little farther. Lance Snyder or Snyder's Lance, right? The idea that a basically a gas station food, right? I mean, how often do you see Lance's stuff in any place other than a gas station? You don't see it in Whole Foods, but yet they're going to go make a bunch of money in organic despite the fact that they've not really ever made any money? They've got the lowest return on capital in the peer group, right? And they've got lots of competitors everywhere and more profitable. Healthy eating trend doesn't make a healthy business, right? And let's see what the valuation implies here. Stock is up 20% over the past year. Shares have reached levels unjustified To justify its current price of $35, they got to grow profits at 15% compounded annually for almost 20 years. Are you willing to make a bet on that? What do you think is going to happen to that valuation when markets continue to be turbulent? You know, I do a Danger Zone call every week with Chuck Jaffe, radio show, and he always asks me, David, all this stuff makes great sense. What's the catalyst? And I say to Chuck all the time, like I say to you here, If I had the crystal ball to tell you exactly when this was going to happen, I would probably be doing the show from my yacht. And that's the nature of the market, right? Warren Buffett has said, markets can be irrational for longer than we can be solvent. I've had clients say market irrationality is potentially limitless. But all that's just a bunch of talk. You've got to think about your portfolio. You've got to think about your clients. And whether or not your risk appetite is limitless, because that's what the technical game is playing. It's musical chairs, and we don't know when the markets are going to finally turn. And I think most people agree that we're closer to the end of the bull market than the beginning of the bull market. So it's like the— how the music starts to play faster and faster as you get close to the end of musical chairs. I think that's what's happening, folks. Better to be safe than sorry right now. Make sure you find safe harbors, safe harbors to put your money in, for clients to put their trust in, for you to put your trust in, for you to have peace of mind. I'm going to take a few questions here since we're about halfway in. What sector do we think is most overvalued? I can answer that question. We have sector ratings. Focus on that specifically. That's our recap. So these are analysis of all the sectors and the sector ratings. Most recent right here. Energy looks the worst. You know, a lot of that's because of a big drop in in in prices. So prices. You know, it depends on what your long-term call on a commodity is. If your long-term call on the commodity is that oil is going to skyrocket back up, energy is probably not that risky. But I'm not going to be in the business of forecasting commodity prices because I don't really think I can. In fact, I know I can't. I don't think too many people in the world can. And if they are, they're not talking to me. I don't know anyone. And in that situation, Recognize your limitations. I like to say recognizing my limitations is very important, right? Being stupid is not so bad. Being stupid about being stupid, then that's not so cool, right? So if we're gonna talk about where the risk-reward is the worst, you know, that's where it's the worst. Now you may be able to find reasons around that, then more power to you. But at least understand that when you begin, when you come to the table, For making an investment in the energy sector, energy sector funds in particular, understand where you're starting from. The thesis needs to be strong. How are bubbles started? Good question. You know, I think these days it's different all the time, right? I mean, the tech bubble— all these things look so obvious in retrospect, right? Like the tech bubble. I remember when I was on Wall Street and golly, I mean, the prices were just going crazy and a lot of people were like getting short. And then all those folks lost their shirts. And I remember talking to some really smart people on the trading floor at Credit Suisse, smart people that I've worked with who understand— understood the work I was doing with Value Dynamics Framework and return on invested capital and cash flows. And they turned, they're like, oh yeah, I'm buying some of these stocks. I'm like, are you kidding me? What's wrong with you? They said, David, It's the Greater Fool theory. What? I don't understand. Well, as long as somebody else is willing to pay more for it than I have, I'm going to play the game. These guys got tired of going to cocktail parties and hearing about their more reckless trading friends making so much money by trading in these tech stocks. And so— and this relates to another great question. How does market psychology play a role? It plays a huge role. It plays a huge role because market psychology ignores these signals in your portfolios. It ignores risk-reward. It goes straight to the day-to-day psychology, the day-to-day trends in stocks. It goes back to our friend, right? Don't talk to me about market psychology. Kramer will tell you all you need to know. And by the way, it's going to be different, like, from oftentimes from one day to the next, certainly from one week to the next, sometimes from one hour to the next. So yeah, it's a lot about psychology. Looks like we have some other questions. I'm trying to see if there are any— did anyone— if you've asked a question, put it back in because I'm not seeing it in the system right now. I thought I saw something, then it went away. Here's another one. Is volatility good or bad for your value investor? That's a terrific question. The answer to that question is very simple. It depends on what kind of value investor you are. If you're a true value investor, And you care about risk-reward, and you actually do your homework and do that kind of work, and you're not just a value investor in name only— by the way, I don't mean to be accusatory. I've just had a lot of meetings over the last 15 years with people who claim to be value investors, and they're not really. The very few that I meet with— these are guys who run billions of bucks, portfolio manager clients. The few that I meet with, the ones that I know are really value investors, You know what they say to me? David, I'm not going to subscribe to New Constructs because you know what? I don't want you to be successful. I said, what? They said, we don't want you to be successful because you're taking away my competitive advantage. I said, well, wait a second. You don't understand. What New Constructs is doing is what eventually is going to be done for all stocks. And it's going to be a part of the dialogue for everything. Because why in the world would anyone in their right mind want to ignore risk-reward? I'm not saying it's the only thing that drives your investment decision-making. You've heard me admit it's not a crystal ball. But it's kind of a necessary component to factor in if you really want to be a value investor, if you really want to be a diligent investor, if you really want to be a safe investor, if you really want to be anything besides a purely speculative technical trader. And I said, listen, our technology— it's not an if, it's a when. Eventually, this technology is going to be created. Right? If you're a millennial listening to me now, you're probably dumbfounded by the fact that it hasn't been created before, that everybody isn't using it. Why, why would people not actually have technology or some kind of system to go in and shine a light, a light in the dark corners of all these filings and bring out the truth? Why would you not want to know that? If you're a millennial, you're probably thinking, I'm going to talk to my advisor right now. If he isn't doing something like this, I might need to find a new advisor. Just makes no sense except for the fact that the prevailing dialogue has overlooked it because the prevailing dialogue has been driven mostly by Wall Street. And as I've said many times, Wall Street's not always in their best interest to be completely truthful. There are too many loopholes that allow them to do IPOs and stocks and sell stock that they should not. Right. Here's a list of— this is a report we did We put IPOs in the danger zone. Beware of these 3 letters. Great example: GoPro, Zulily, Wayfair, Box. I think all these guys have blown up. GoDaddy. These are all IPOs, businesses that really weren't sound, weren't really generating cash flow, that have since blown up. A couple of new questions here. How can I protect myself against purchasing overvalued stocks? Great question. The answer is go in and run it through our screen, right? Make sure you're not putting your money in something that is going to get a dangerous rating. Are some sectors tougher to value than others? You know, that's a good one too, right? You know, so when I first started doing this kind of work, they said it couldn't be done for financial services. And then I wrote a report with Mike Mayo, the number one bank analyst at the time, on how to apply this methodology. It was called EVA for Banks. We put it out, I think, in '97 or 1998, Mike Mayo and I. It can be done. Some stocks, some sectors don't trade as much on cash flows though. Right. And financials is one in particular, especially banks, because the bank sector and the performance of banks has been driven by really macro factors for, for a long time now. For a long time. Think about for how long interest rates have been sort of an issue. And then also think about with these banks how much merger— mergers and changes in regulation have been an issue. Right. And so really cash flows around banks have been really kind of murky and hard to understand. And they've been involved in some major cycles that mean that, you know, existing cash flows are not as representative of future cash flows. So there've been a lot of changes. It's been very lumpy for banks. And so it's tougher. But I think at the end, you know, at the end of the day, what you want to be able to focus on, and anytime you're investing in anything that isn't getting green flags here, is to understand What the model or what the stock price implies. And that's where I like to show my— how our models work, right? These models— I love every opportunity I can to talk about our models because they're amazing. And really what you see in our model is you get an opportunity to look at what kind of future cash flows are required to justify the stock price, right? So we look at Demandware. We see, you know, if you put in consensus estimates, which is the default scenario, we can't get to a DCF much above $10 or $15, right? And it's trading at $55, right? So to justify $55 a share, you got to see 21.2% compounded annual growth in revenues over 14 years, right? And if we look in the discounted cash flow model, Behind this. You look at the NOPAT CAGR. Oh, we can't even do a NOPAT CAGR because our NOPAT's negative now, right? Anyway, look, if you really like a story, do yourself a favor and test exactly what expectations mean. And when you see what $55 implies for Demandware, then you have to ask yourself the question, do I believe the company can do better than that? Because if you believe they can just do that well, then you shouldn't buy the stock because Everything about the performance of the stock that you believe to be happening or will happen is already priced in. You have to believe they're going to do materially better to justify owning the stock, right? You got to believe that it's going to go to $65. Okay, what is $65? Well, it just means 15 years of growth at that point. Yeah, because it's growing so fast, it gets kind of crazy. So That's what I recommend you do. Biotech question. Biotech's crazy. I don't know what to say about biotech. Biotech is kind of unrelated to fundamentals, right? I mean, one thing that's cool about biotech— whoever asked the biotech question, throw in a ticker you want me to look at, because this would be an interesting use of the model, right? The biotech ratings are tough, right? Because, you know, if the drug hits— well, shoot, I can look up some biotech here. This is our dynamic screener, so I can drill down, get some biotech tickers. I don't know any off the top of my head. All right, so let's just take— let's take the rating on all these. And let's take a number 5. Let's look at the model, Alexion. All right, so what's interesting about our model is it'll tell you how much of the drug hitting is already baked into the stock price, right? So let's just— let's run a scenario here. For fun, we'll just say neutral. Um, you know, these are consensus numbers for revenues. So let's just say— 5. We're going to go— we're going to just say 20% out for the next 25 years. Let's say margins get to be the best they've ever been, which is the most recent fiscal year. Let's say they're even better than that, right? Say that— by the way, if you want to download any of our models, right, into CSV file, all you got to do is click that button. So for example, if we wanted to look at— so let's just look at the valuation here. So we put in some pretty sick numbers for Alexion's future, right? And they got to do it to justify $160. They got to do that kind of growth and profit level for the next 11 years. So a lot of what's priced in To the stock, or what's a lot of what the best possible future of the stock of the company could be is already priced into the stock. Sorry, I stumbled over that a little bit. And I don't really know Alexion better to know what their pipeline looks like. They could be doing 50% revenue growth for 10 years if the drug hits, in which case maybe it's cheap. But the point is, this is a tool for you to measure that, to test that. So yeah, the models are really powerful. There's now a new download CSV feature, so You click on this and you want to see the DCF model in Excel, here you have it in one second. This is all the data. And you're an institutional client, have access to this stuff, you can have a pretty awesome model at your fingertips. Same is true for the rest of the model. If you want to get the financials and metrics, you can download that CSV. If you want to see our NOPAT statements, see how that works, download that into a CSV. So that's pretty much it. I appreciate everybody being with us today. Remember, it's all about risk-reward. It's all about risk-reward when the markets get volatile. That's how you find a safe harbor. Go to somebody you can trust, and before you try to trust anybody, make sure they're independent, make sure they're not conflicted. Thank you for attending, and please fill out our survey at the end.