DIS and DAT - Unicorns and Zombies - December 2017

Dear Friends:

            As the year winds down with above average returns for some of the stock indices, it reminds me just how difficult separating the dancing prices from the reality of business can be. Ted Seides gave a talk at the University of Virginia on November 10, where he said, “The markets have a tendency to make it so if you’re doing well, you think you are much smarter than you are.” Ted is known as the hedge fund manager who bet Warren Buffett in 2007 that a basket of hedge funds chosen by him would beat the sp500. He lost the bet. But without context, Ted could be speaking about today’s market.

From reading and talking with others about investments, we know the crowd currently has two areas in which they are feeling very “smart.”  The first is FANG (Facebook, Amazon, Netflix, Google) stocks; the second area, closely related, is “index funds.” I won’t spend much time on the index mania because we have previously, but Professor Shiller gave his caution this month:

"It's kind of pseudoscience to think these indexes are perfect, and all I need is some kind of computer model instead of thinking about business," Shiller said. https://www.cnbc.com/2017/11/14/robert-shiller-passive-investing-is-a-dangerous-chaotic-system.html

AVOIDANCE AS A WAY TOWARD IMPROVEMENT

            Another quote, this one from Benjamin Graham in The Intelligent Investor, will help me drive my point home further: “Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time.  Remarkably few, also, of the larger companies suffer ultimate extinction.  For most, their history is one of vicissitudes of ups and downs of change in their relative standing.” (Page 204 of The Intelligent Investor)

I have come to label two activities that I wish to avoid. The first unique situation described by Graham — those companies which “Show a high rate of uninterrupted growth” — I have dubbed the Unicorns, and I have named those which “ Suffer ultimate extinction” the Zombies. (I suppose Pooh Bear’s “Heffalumps and Wuzzles” could have worked just as well, but here we are.) Therefore my avoidance would be in chasing Unicorns, and running from Zombies, as they are near mythical investment creatures. Instead, the activity of preparing for the more common event of cyclical market prices and business conditions would be beneficial.

            Netflix is a great example of a current Unicorn. Recently, Netflix sold another $6.1 billion in “Junk Bonds” to the public. According to an article on MarketWatch, the rating agencies did not downgrade their bond status. Two CreditSights analysts contributed to the article, which quoted them below as writing in a CreditSights commentary the previous week.  http://news.morningstar.com/all/printNews.aspx?article=/MW/TDJNMW20171023434_univ.xml

“We expect the company will take leverage back up with new debt to finance original content creation, but we are comfortable with that risk in the context of the company’s 90 times EV/EBITDA multiple,” they wrote in commentary last week. (emphasis mine)

            They are comfortable with the company issuing more debt because the stock valuation is so crazy high! That’s okay for some, but that’s not the way we want to invest.           

IMMEDIATE VERSUS DELAYED GRATIFICATION

            Some scholars have found that our brain is not wired to make great investment decisions automatically. In a new book entitled, “The Hacking of the American Mind,” by Doctor Lustig; he discusses the difference between pleasure and happiness. He did an interview which I watched where he makes a distinction that pleasure brings addiction while happiness brings contentment.

I relate the differences between immediate pleasure and delayed happiness to the trials and tribulations of investing one’s wealth. You see, constantly judging your investments against your neighbors’ investments, against yesterday’s and yesteryear’s prices only provides pleasure and brings addiction. You get instant feedback, good or bad, as each dancing price change mesmerizes.  This behavior can lead an “investor” to trade to frequently. But happiness may come from the long-term performance of the business, which is quite slow. We strive to have our investments bring long-term happiness.

Kermit the Frog describes the differences between pleasure and happiness in his famous quote, “It’s not easy being green,” and the poem that follows:

It's not that easy being green;
Having to spend each day the color of the leaves.
When I think it could be nicer being red, or yellow or gold
or something much more colorful like that.

It's not easy being green.
It seems you blend in with so many other ordinary things.
And people tend to pass you over 'cause you're not standing out like flashy sparkles in the water-
or stars in the sky.

But green's the color of Spring.
And green can be cool and friendly-like.
And green can be big like the ocean, or important like a mountain, or tall like a tree.

When green is all there is to be
It could make you wonder why, but why wonder? Why Wonder, I am green and it'll do fine, it's beautiful!
And I think it's what I want to be.

            So in some ways, the “hot trends” make your life more difficult; in one very important way it makes it easier.  Bruce Greenwald is a professor from Columbia, and he supplies us with the thought that as most people try to buy their lottery ticket in the stock market by chasing hot themes such as FANG stocks, it leaves a void in other areas.  We will continue to look for bargains in those avoided areas. At times this process may have us thinking as Kermit: “I am green and it’ll do fine….I think it’s what I want to be.”

See you next time.

James Pope

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