The stock market is not the economy

The Coronavirus rally continues, though has perhaps started to show signs of slowing down over the past few weeks. I’m still feeling bearish overall but my perspective on how the stock market might behave is slowly becoming more nuanced. 

I’ve tried to explain previously why I believe that share prices are driven more by the indeterminate, strategic process of investors trying to second-guess the market (each other), rather than by judgments of whether valuations are correct. The more immediate goal of investing is not to be objectively ‘correct’ about valuations, but rather to second guess how other investors are going to behave. Because of this, many investors care less about the levels share prices are at and more about the direction they are going in. While fundamentals obviously matter to some extent, the valuations implied by share prices can remain arbitrary for a long time. This is especially the case during periods of high uncertainty, when objectively assessing valuations is even harder.

This means that the stock market has some counter-intuitive properties. Prices can have feedback effects. Falling prices create fear and rising prices lead to fear of missing out. This can overwhelm the tendency of prices to ‘discover the equilibrium’, especially at times of stress. This means extended bubbles or severe panics are not only possible but likely. In this context liquidity can make a big difference. Temporary illiquidity causes prices to plummet in a panic. The injections of liquidity we are now seeing from central banks have created an imbalance the other way, leading to a sustained, self-fulfilling rise.

The point I take away is not to have too much conviction in a view based on macro fundamentals. Market timing is hard. The stock market can easily take off in either direction and you shouldn’t be too surprised. While I am still bearish and think the negative economic impacts of extended lockdowns are not yet fully appreciated by the market, this doesn’t mean the market is going to crash imminently. It just means, if I am correct, that the risk is high.

The other nuance that’s easy to overlook is that the stock market is not a single entity. It’s made up of lots of different businesses. Often the share prices of these businesses are highly correlated and it makes sense to talk about market movements. But this simplification misses a key point right now.  The stock market has bifurcated into a low quality, cyclical half, for whom share prices have been hammered, and a high quality, technology-oriented half, which after an initial fall is now in rude health.

This has accelerated a trend that was already there. The spread in valuations between the cheapest and most expensive stocks has been rising for years. AQR have recently published an interesting paper showing that the value spread is now at levels not seen since the dot.com bubble. The paper shows that this isn’t just driven by differences across sectors or the tech giants, but has happened within sectors too. 

Has this trend gone too far? This is difficult to say. My perspective is that the value spread has tended to be far too narrow most of the time in the past. Investors have tended to undervalue great businesses by under-appreciating the extent they were likely to grow relative to their mediocre rivals. This idea is the cornerstone of my strategy and I’m pretty confident it has been true in general. It’s also clear that the current crisis justifies a widening of the spread. Low quality cyclicals are going to be hit disproportionately hard. But I’m also wary that things can go too far at the extremes, such as the dot.com bubble. 

When I look at individual stocks right now, I feel ambivalent about valuations at both ends of the spectrum. Businesses in many sectors more directly affected by lockdowns, including retail, travel and the financial sector look cheap. However, they face a very uncertain future and could well get cheaper. My bearishness about the economy in general is most relevant to these businesses. How far they ultimately fall probably has less to do with how badly they are affected and more to do with how quickly uncertainty is resolved and investors start to look through to the other side. There still seems plenty of uncertainty at the moment. It is notable that Buffett has been selling his airline and banking stocks rather than buying more recently, despite Berkshire’s huge war chest full of cash.

Most of the businesses in my portfolio and watchlist are either defensive or IT related. They have performed relatively well and many are at new highs. Most of these businesses don’t actually seem obviously overpriced to me, but are more expensive than they have been at a time when the risks have risen. I really struggle with the valuation of some, like Shopify for example. Highly valued technology shares could be hit hard if and when it becomes apparent that they are not immune to the secondary effects of lockdowns on the economy after all. On the other hand, prices for these businesses might continue to be inflated by the enormous injections of liquidity by central banks. I really don’t know how long this can continue, but an extended bubble in high quality doesn’t seem beyond the realms of possibility, especially if the longer term effects of the recession are not as bad as feared. In the short term at least, this is what seems to be happening.

A rotation away from quality towards cheaper cyclical businesses seems likely at some point, but the question is when. My guess is that the more tech-oriented sectors will probably continue to outperform for some time before the bubble bursts.

So what does this mean for my strategy? I’m still heavily weighted to high quality as I think the current trend probably has some way to go. However, I’m anticipating rotating towards cheaper stuff soon.

I’ve been steadily reinvesting the cash from my failed house purchase (if only I had done this more quickly!) I bought back a few familiar faces: Euronext, LSE, ServiceNow and Burford, and a new position in Adyen.

I’ve now reached 60% invested and may take this a little higher. But I’m going to keep a reasonably high cash balance for the time being as the risks of further falls seems high.

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Adyen

Adyen is a payments processor, similar to PayPal. It is a large, £30bn market cap, business and is listed on the Dutch stock exchange.

Adyen provides the full suite of payment processing to merchants, allowing them to integrate payments across multiple channels and operations. It integrates with the card networks and other technologies, such as CRM. It makes a small commission for each payment processed. It is predominantly focused on larger international businesses and has global reach itself.

Quality

  • Business economics: the business economics are excellent. The business model is inherently very capital light, highly profitable and scaleable with new sales to a large extent dropping straight through to the bottom line. Adyen has an operating margin of around 10% and returns on capital consistently above 25%
  • Track record: Adyen is a youthful business, starting in 2010. In this short timeframe it has been extremely successful and has grown revenues at a phenomenal rate.
  • Competitive advantage: payment processing has historically been fairly fragmented with a few large businesses such as PayPal, Wirecard and Stripe and a large number of smaller regional players. Adyen seems to have a strong competitive advantage over its rivals. It is growing faster, has almost no customer churn and many high profile international tech businesses as its clients, including Netflix and EBay (a high profile win from PayPal a couple of years ago). Its scale, geographic reach and the quality of its technology allows it to offer a higher quality, more efficient, cheaper platform, particularly suited for larger customers with complex international operations. Most of its rivals are focused on the smaller end of the market and provide more add-on services.
  • Growth prospects: the growth prospects are excellent. The overall market for payment processing has huge growth potential. Adyen grows either by its customers growing or by adding more customers. Both of these are growing strongly and the runway looks huge.

Price

Momentum is great. I bought as the price was breaking out to new highs and it has continued to motor on since. The last results were impressive and the near-term outlook is relatively positive in spite of Covid. The valuation is superficially high but I think is warranted by the quality.

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