It’s an understatement to say that the Great Financial Crisis of 2008/2009 has not easily been forgotten by US equity investors. It looms large in peoples’ psyche even today - eleven years later and well into the second longest economic expansion in US history. Investors and market pundits are extremely busy predicting the arrival of the next US recession. We’ve written previously about the dangers of ‘market timing’ - the belief that investors can time stock investments correctly to avoid sell offs (without actually doing more damage to longer run returns), however it’s worth reviewing at least one popular recession ‘predictor’ that is currently getting a lot of attention in addition to sharing our current views on stocks.
Recently, there’s been a lot of talk about the ‘inversion’ or flattening of the yield curve for US Treasury bonds. Said another way, a flat or inverted yield curve is when investors can currently be paid as much or slightly more in ‘yield’ to own short duration bonds like a 90-day T Bill than they can to hold 10-yr US Treasuries. That is not the way bond investments are supposed to work. If you own something with a longer wait to get your money back - you’re supposed to collect more interest to compensate for the risk of inflation or potential loss. A ‘normal’ yield curve of 90-day T-bills and 10-year maturities for US Treasuries typically shows a positive, upward ‘slope’. You wait longer, you get paid more. Why do people care about any of this? Because the last 7 recessions were preceded by a ‘flattening’ or inverted yield curve. Figure 1 shows the difference between the yield on a 10-yr US Treasury and a 90- day T Bill. In a ‘normal’ yield curve, the 10-yr yield is higher, and thus the ‘10-yr yield minus 90-day yield’ is positive. In an ‘inverted’ yield curve, the 10-yr yield is lower, and thus the ‘10-yr yield minus 90-day yield’ is negative. As shown, the last seven recessions (shaded in green) were preceded by an inverted or flattened yield curve.
Historically, yield curve inversions occur because the Federal Reserve raises short term interest rates too far/ too fast in response to inflation concerns or tight labor market conditions. While that appears to be the case again this time, there are reasons why there should not be a panic with respect to stocks. The market is a discounting mechanism. What does it already know?
First, we know that economic growth is slowing - not just in the US but also recently in readings out of the European Union as well as China. We also know US corporations will have lapped the annual benefit of the Tax Reform Act of 2018 in this current quarter, so year over year earnings growth vs. 2018 will be more difficult. Second, we know that the last 3 US yield curve inversions have been followed by an average 17 month lag before a recession arrives. Returns for stocks in the 2 years before recessions have been positive 80% of the time (Figure 2), so fleeing to cash or fixed income prematurely is not a winning strategy. We also know that 2018 saw net negative outflows from equities that have continued into 2019. Last, we know that US hedge fund positioning and investor sentiment has been near multi-year lows. People are nervous. This is the kind of bearish sentiment we like to see as contrarians. It is no guarantee of positive returns, but nothing troubles us more than complacency with respect to both valuations and the outlook for stocks.
We believe concerns about economic growth and the subsequent dovish pivot in central bank monetary policy, not just in the US but overseas, has helped to drive global interest rates lower recently. This is typically constructive in the short term for flows back into stocks as ‘risk assets’ become more appealing in relation to diminishing returns available in bonds. The year to date recovery in stocks has in part been driven by a surprisingly dovish turn on interest rate policy by the US Federal Reserve as well as progress on bilateral trade talks with China. However, if the yield inversion data from the past is any guide, the risk of a recession appearing 15-24 months from now is rising. Should you do anything about it? We’d caution clients and investors against trying to reposition portfolios to attempt to anticipate a slowdown well ahead of time. Asset allocation and positioning over the long term should be much more a function of individuals’ or clients’ cash flow needs, risk profile and investment horizon.
Assuming a recession does arrive in the next year or two, what does it mean for stocks? We looked at stock behavior in the last 11 US recessions (Figure 2). It was surprising to note, that while some losses are to be anticipated in the months immediately preceding a recession, the actual return of stocks from the inception to the conclusion of recessions is approximately 0.0% - and this average includes the extreme outlier of the 2008/2009 crisis (-37%) in which the US financial system was brought to the brink of collapse - a scenario we do not see repeating in the near future.
This history suggests that if you are selling stocks into a multi-week or multi-month panic that’s well underway, the chances are you are already closer to a bottom than a top. Time is usually the investors’ friend. We expect annualized total returns over the next few years to be below the +9.5% average over the past century. This reflects our expectation that earnings growth will slow and that valuations on stocks have little room to expand following a +13% return during the first quarter of the year.
Historical data suggests yield curve inversions are worth paying attention to as an indicator of recessions/ growth slowdowns, but they’re typically less useful as an indicator of near-term stock weakness. Moreover, stock losses on average have been close to nil assuming one holds on from inception to conclusion of an actual recession.
Lyft, Uber, Excitement
Lyft and Uber are among the large and widely known private companies that have or plan to have an Initial Public Offering (IPO) in 2019. See Figure 3. Lyft and Uber, in addition to Airbnb, are part of the new “sharing” economy. This new economy is exciting, and these companies offer a way to invest in this potential long-term growth opportunity.
Lyft and Uber offer a particularly compelling story - they are a duopoly in the ridesharing market. Lyft’s S-1 (SEC filing for companies planning to go public) calls this Transportation-as-a-Service, or TaaS. In addition, the filing points to the fact that while we spend more money on transportation than any other household expenditure, except for housing, the average car is only used 5% of the time. The other 95% of the time, the car sits parked at your house, office or some other parking lot.
These are valid points and make for a compelling investment thesis in the ridesharing market. The TaaS moniker is a little deceptive- taxis, shuttles and mass transit have been offering transportation services for decades. The 5% usage rate is not misleading but doesn’t necessarily mean 1 car can be shared with 20 people. Those 20 people might only need a car for a short time, but the overlap in that time among the 20 people is great. Chances are that most of the 20 people commute to work or school at the same time, and a good chunk of the time when they aren’t using the car they are sleeping. In general, most people keep similar sleeping hours.
Lyft and Uber are still growth stories. Lyft has increased revenue from $343M in 2016 to about $2.2B in 2018. It now reaches 95% of the US population and select Canadian cities. Each year, it has increased its wallet share with its users - in 2015, its users took 25 million rides. In 2018, those same users took 67 million rides almost tripling their usage of the service. In addition, it offers bike and scooter sharing services and has the potential to enter the food delivery market. Uber has the larger market share and a global presence. While there is no Uber in China or South East Asia, it has investments in the Chinese version of Uber (Didi) and the Grab, which operates in South East Asia. In addition, it operates Uber Eats and Uber Freight. Uber Eats has about 100,000 restaurant partners, which is more than Just Eat, Grubhub, and Delivery Hero.
The revenue growth potential for these companies is present. The ability to generate cash is still up for debate. Uber and Lyft battle for users as customers can download both apps and compare prices. This comparison-shopping limits the ability of either company to simply raise prices. They have been battling for market share, and in the US at least, Lyft has made large strides, claiming a 39% share in December 2018 vs 22% in December 2016. This shows Uber does not have an overwhelming first mover advantage, at least in the US.
Since drivers can drive for both services simultaneously, neither company can unilaterally cut fees and increase the “take rate”, or percent of bookings that the company secures. Insurance costs also eat into profits. Lyft provides $1 million in commercial liability coverage to drivers in addition to support in emergency situations and accidents. Lyft’s operating costs fell from 81% of sales in 2016 to 62% in 2017, and then declined only incrementally in 2018 to 58%. Sales and marketing expenses have fallen from 127% of sales in 2016 to 37% of sales in 2018. Even with those improvements, Lyft reported an operating margin of negative 45% in 2018 and burned through $349M in cash on $2.2B in revenue. Lyft and Uber both lose money and there are questions about the sustainability of the business model.
Uber and Lyft may not be profitable until autonomous driving becomes widespread. When software pilots their fleets, a major expense, e.g. the drivers, will disappear. While Uber and Lyft are investing in autonomous driving, neither controls the technology. Google’s Waymo appears to be the leader in this technology as it already has a commercial service operating in Phoenix, Arizona. General Motor’s Cruise Automation and Intel’s Mobileye divisions are also at the forefront of autonomous driving technology. Therefore, if Uber or Lyft do not leapfrog the current leaders, they will end up paying significant licensing fees to whichever company becomes dominant.
Uber and Lyft offer compelling stories, but the companies are not attractively valued since we believe that losses will persist longer than more bullish analysts. The “sharing” economy is a growth opportunity. The key to investing in these companies is finding which ones hold the intellectual property that is going to generate positive cash flows.
Fewer Choices in the United States
While it appears that the IPO market is robust given the recent surge in activity, the number of IPOs has decreased substantially over the past 25 years. In addition to lower levels of issuance, the overall number of companies listed on public stock exchanges has plummeted due to mergers and acquisitions. From 1995 until last year, the number of public companies decreased 42% from almost 8,000 to just over 4,000 (see Figure 4).
There are many explanations for the decrease in the number of public stocks. The private markets became much more efficient providing stable financing for early stage companies allowing them to remain private much longer. Venture Capital and Private Equity managers fund ongoing operations along with acquisitions of key technologies allowing private companies to continue developing without going public anywhere near as quickly as occurred during the 1990s. For example, Uber is now a mature company that s expected to garner a market capitalization of over $100 billion when it goes public. Regulation (specifically Sarbanes Oxley and Dodd Frank) has also played a role in decreasing the number of IPOs. Higher compliance costs have made the public option less attractive for many private operators. According to a study by the SEC five years ago, the average cost of an initial public offering was $2.5 million, and the ongoing costs were $1.5 million per year. Sarbanes Oxley and Dodd Frank increased disclosure and aided financial stability, but have raised the cost of entering the public markets.
Finally, the pace of mergers and acquisitions has remained very strong over the past two decades which has decreased the total number of public companies. Acquisitions allow companies to benefit from economies of scale and acquire new technology or business processes to fuel future growth. The ongoing trend to fewer and larger public companies has a few interesting investment implications. Since IPOs are delayed and more mature companies go public, the potential for extreme gains post-IPO are generally much more limited. For example, Microsoft’s stock price increased by 100 x from its IPO price over the first decade that it traded publicly after 1986. It would be unfathomable for any of today’s big IPOs such as Uber to experience this type of growth because the company is much more mature and the valuation is already substantial given the private market investment.
Another consequence of a more concentrated stock market involves investing in small capitalization stocks. Historically, small cap stocks outperformed larger capitalization issues (with more volatility). However, as of December 31, 2018, large capitalization stocks outperformed small capitalization stocks over 1, 3, 5 and 10-year periods. The gap over the past 5 years was 3.8% per year. We invest in a wide range of market capitalizations and do not believe a company’s size plays a material role in its performance as an investment. However, we do focus our research efforts on only those stocks that have a very strong market position within their business niches.
It will be interesting to see whether the trend to fewer public stocks continues. Internationally, the number of public companies has grown substantially, especially in Asia. In Japan, a very well-developed economy, the number of public companies has more than doubled since the mid-1990s. Regardless, there are plenty of stocks both here and abroad to create an infinite number of diversified portfolios with attractive investment characteristics.