The Economist Bears Will High-Five at the Bottom
An article in today’s WSJ notes that nearly 2/3 of professional economists predict recession in 2023. This has basically never happened before. Usually, according to the historical track record, economists only predict recession well after the recession is already underway. In this sense, economists are like the opposite of weather forecasters. The weather forecasters are always jumping up and down about the next giant storm coming, and then sanguinely sweep it under the rug when instead there is only clouds and drizzle. Economists always predict growth, and then blame recessions on a “confluence of unpredictable external shocks” or something along those lines. However, one factor explains both weather forecasters and professional economists. It’s how the groups are incentivized. Weather forecasters need viewers, so they are biased to say the most outrageous things possible. Professional economists mostly work for investment banks, and their outlooks are used by the sales departments to justify all manner of financial products and transactions, which is how the banks make money. So why are the banking economists breaking with tradition and raining on the parade this time? Here’s my guess: The stock market (which did dramatically worse last year than nearly all published predictions) is telling them that investors believe a recession is coming. Therefore, from a saving-your-job perspective, there is now more risk to predict the usual good things, than to make the “tough” call that a recession is coming. Will this sad groupthink help you with your investments? Maybe you can leave the umbrella at home.
The Snobbish Seduction of Negativity, The U.S. Stands Alone, and The Invisible Hand
I used to really enjoy Alan Abelson’s weekly Barron’s column. Mr. Abelson wrote for Barron’s starting in 1956, with his column launched in 1966. He passed away in 2013. (Here’s his obit in the NY Times.) His weekly column was typically the introductory page of the periodical and contained a combination wisdom on markets, the economy, individual stock ideas, criticism of the industry and individuals, especially in the government and all delivered with an entertaining tone and employing a vocabulary that frequently sent me to the dictionary. I just fault him for one thing. Every week during the crisis, Abelson would skewer the regulators, professional investors, banks and the real estate industry, describing the mess in lurid detail. He, and his favorite economist, David Rosenberg, were backed up so far into their bear caves that they could not see any light even as the crisis peaked and started to be resolved. Consuming this negativity influenced me and helped me to distrust and miss the start of last decade’s bull market. I eventually had to stop reading Barron’s to spare myself. As far as I know Mr. Rosenberg (who launched his own firm in 2020, according to Google) never turned bullish.
I prefer Warren Buffett’s naïve sunny optimism. The U.S. markets attract a lot of criticism for their treacherous nature, especially for individual investors. However, one observation we made from a year of traveling and observing in 2022 is that there is no other country that has the U.S.’s combination of innovative companies, favorable demographics, rule of law, stable currency, and liquid capital markets that are ready to fund both start-ups and growth plans for established firms. And this is not to mention its geographic position, natural resources or the stabilizing power (sorry) of its military. There are plenty of flaws in the markets, and bad actors, fraudsters, and human psychology gone wild, but the bottom-line is the reasons to be optimistic about the future (even with climate change, social media and Gen Z’ers) are still pretty compelling, in our opinion.
The invisible hand. The market’s action over 2020-2022 demonstrates the outsized impact that fiscal and monetary policy can have on both the economy and equity valuations. Furthermore, the impact of the Fed’s 2022 actions will surely be felt in 2023. It will not be helpful to the economy. Will we be in a recession? It seems likely. Will it precipitate calamity and crisis? Possibly, but probably not. More importantly from our perspective: what will happen to stock prices when this highly anticipated recession rolls around? We don’t know, but we do believe stock prices are “forward-looking” and will start to anticipate a recovery as soon or even before it is underway.
Selection from our Client Portfolio Airbnb (ABNB) *
Airbnb has possibly the single best business model I have ever seen.
ABNB was a 2021 IPO. Like nearly everything else that went public in the rush of liquidity following the Covid panic, it was offered at a crazy price and started trading at an even crazier price. Airbnb hit a market capitalization greater than $125B in February 2021 and again in November 2021. Considering 2021 revenues were just $6B, this was a big balloon. Fortunately, the magic of the 2022 market correction came along and deflated the stock price, which closed Friday at $100 down from a peak north of $200. The company’s enterprise value (EV), which is the market capitalization adjusted for $7B of net cash on the balance sheet, has contracted to roughly $61B. Meanwhile, the business has been growing very quickly with 2023 revenues now estimated at $9.4B.
You may be thinking, that’s a really nice haircut, but ABNB is still valued at a multiple of 6.5x revenues. How could that possibly be interesting? This is where our claim that ABNB may be the single best business model we’ve ever seen comes into play. As you probably know, ABNB runs a website that primarily facilitates peer-to-peer rentals of homes and apartments. ABNB does not own the homes, nor does it operate the properties, it only connects renters to owners, collecting a fee for its (minimal) efforts. Thus, ABNB’s business has few expenses from an operational perspective (it basically runs a website and does some marketing) and, more importantly, from a capital perspective (it has nothing invested in the properties and is not on the hook for maintenance or capital improvements in the future). These advantages show up in the company’s profit margins (its gross margins are near 82% and operating margin (EBIT) is near 33%) but also in its conversion of revenues to free cash flow. This conversion ratio measures how much of each revenue dollar is left for shareholders after subtracting all expenses to run the business, taxes for Uncle Sam, and capital investments needed to grow the business. For ABNB, this ratio in 2022 was 39%. Is this good? Very good. To put this figure in context, I produced the below table by cherry picking a selection of extremely profitable businesses (mainly software companies and franchisors) and as you can see, ABNB is among the best we can find using this metric.
It should be clear from this consideration that a dollar of revenue for ABNB should not be valued the same as a dollar of revenue for most other businesses. But 6.5x? Here’s an alternative way to look at the valuation using only cash flow. ABNB is expected to grow revenues about 13% over the next year. If this growth rate is sustainable and the cash conversion ratio remains the same, over 10 years ABNB will generate cumulative free cash flow of $67B, exceeding the current market value. Normally, if you can buy an asset, and get back 100% of the purchase price over 10 years and still own the asset, it is a sign the price is attractive. But how likely is this simplified cash flow forecast? If I had to guess, I suspect the company’s capex is too low and needs to increase, but I also think revenues can grow faster than 13% annually and that margins will rise, rather than contract. I promise to check back in 10 years from now and let you know what the actual figure was. Lastly, I will just mention the biggest risk I can see, which is increased regulation, which could lead to both slower growth and increased expenses.
*This discussion is not a recommendation for any security. Speak to your financial advisor for advice that is tailored to your financial profile, risk tolerance and investment horizon.
John Zolidis
President & Founder
Quo Vadis Capital, Inc.
Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017. He started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford. He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients. He also managed money in a buy-side role at a long-short equity fund over 2013-2014. He was named in the Wall Street Journal’s Best on the Street list in 2005. Mr. Zolidis and works from New York, NY and Paris, France or wherever he has his laptop.
Travel update: Holding close to home in January but kicking off the first week of February with the ValueX Klosters conference in Klosters, Switzerland. I skipped the annual January ICR investment conference in Orlando this year. I tuned in via webcast to company presentations (and found a stock I want to buy) but missed out on the chance to meet management teams and catch up with friends, not to mention grabbing some Florida sunshine between meetings. Instead, the first trip of 2023 will be to Klosters, Switzerland (next to Davos, about two hours by train from Zurich). In Klosters, I will be attending the ValueX conference for the fourth time. ValueX is an idea-sharing conference, in which participants are tasked with finding and presenting “an idea worth sharing”. Most choose an investment idea, but other topics have included lifestyle, health, medicine, risk management (outside of finance) and topical cultural issues. When not in meetings talking about serious stuff, participants are expected to socialize during grueling activities such as downhill skiing, snowshoeing or enduring extremely long lunches. Sometimes we are even forced to convene at the bar late at night. Here’s the link for the conference in case you’re curious. Last year, I gave a presentation on Luckin Coffee (LKNCY), which gained well over 100% last year in 2022, beating every single stock in the S&P500 and which was my best idea in years. You can check out an extended version of the slides from my investment deck here. I have some plans for my talk for this year, but I can’t reveal them here. ?
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The author of this write up has a long position in shares of Airbnb (ABNB)
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