Edgepoint Edgepoint2

Inside Edge is dedicated to providing a collection of investment-related charts, articles and musings that have hit our desks or inboxes. Once in a while we will post materials we’ve created and glimpses of EdgePointers’ lives.

Big 5 stocks dominate markets

Over the past year, the 5 largest S&P 500 companies (AAPL, MSFT, AMZN, GOOGL, FB) returned 58% vs. 1% for the rest of the market.

At $6.2 trillion, the combined market cap of Apple, Amazon, Microsoft and Google is now greater than the GDP of every country in the world with the exception of the US and China.

In his latest memo, Howard Marks dissects the impact of the COVID-19, Fed policy, and the long-term implications of low-interest rates in equity markets.

Marks concludes with some thoughts on today's extreme valuations and the current market darlings:

On one hand, we have the surprisingly rapid recovery of the stock and credit markets to roughly their all-time highs, despite the fact that the spread of Covid-19 hasn't been halted, and that it will take a good number of months for the economy to merely return to its 2019 level (and even longer for it to give rise to the earnings that were anticipated at the time those market highs were first reached). Thus p/e ratios are unusually high today and debt yields are at unprecedented lows. Extreme valuations like these are usually justified with protests that "this time it's different," four words that tend to get investors into trouble.

On the other hand, John Templeton allowed that when people say things are different, 20% of the time they're right. And in a memo on this subject in June of last year, I wrote, "in areas like technology and digital business models, I'd bet things will be different more than the 20% of the time Templeton cited." It certainly can be argued that the tech champions of today are smarter and stronger and enjoy bigger leads than the big companies of the past, and that they have created virtuous circles for themselves that will bring rapid growth for decades, justifying valuations well above past norms. Today's ultra-low interest rates further justify unusually high valuations, and they're unlikely to rise anytime soon.

But on the third hand, even the best companies' stocks can become overpriced, and in fact they're often the stocks most likely to do so. When I first entered the business in 1968, the companies of the Nifty Fifty - deploying modern wonders like computing (IBM) and dry copying (Xerox) - were likewise expected to outgrow the rest and prove impervious to competition and economic cycles, and thus were awarded unprecedented multiples. In the next five years, their stockholders lost almost all their money.

We reach our conclusions, limited by the inadequacy of our foresight and influenced by our optimistic or pessimistic biases. And we learn from experience how hard it is to get the answer right. That leads me to end with a great bit of wisdom from Charlie Munger concerning the process of unlocking the mysteries of the markets: "It's not supposed to be easy. Anyone who finds it easy is stupid."

Seth Klarman on the Fed

Seth Klarman said the Federal Reserve is treating investors like children and is helping create bizarre market conditions that are unsupported by economic data. "Surreal doesn't even begin to describe this moment," Investor "psychology is surprisingly ebullient even though business fundamentals are often dreadful". "Investors are being infantilized by the relentless Federal Reserve activity. "It's as if the Fed considers them foolish children, unable to rationally set the prices of securities so it must intervene. When the market has a tantrum, the benevolent Fed has a soothing yet enabling response."

Taking the the best managers over the past 10 years in Canadian equities. These are the ones that have crushed it over a decade of measurement and are in the top position among their peers. But, during that same 10-year period, almost all of them spent a three-year period or longer with below average results. (chart 2) Half spend at least a three-year period in the bottom quartile. If you are prone to chasing performance, you would likely have bailed on these managers when they were underperforming

Alternatively, we looked at Canadian equity funds that were in the top quartile in June 2014 based on their three-year trailing performance (June 2011-June 2014). Some 69% of these funds were not positioned in the top quartile in the next three year period (June 2014-June 2017) - 44 % were actually below average. Similarly, 65% of the top-quartile funds in June 2017 were not top quartile during the next three-year period (2017-2020). See Chart 3.

A narrow group of companies or business models is perceived to be so valuable that any company that is seen as belonging to this group is valued at extraordinary levels.

In the 1920s it was the radio stocks. In the 1960s it was the conglomerates and the Nifty Fifty. In the 1990s it was the Internet stocks. Now it's "platform companies".

Company "stories" become more impactful than financial results.

Many of the current market darlings don't have amazing financials to lean on. What they do have is stories, and perhaps some period of revenue growth which is yet to translate into substantial profits. So which do you think will help them promote their stock: the stories or the numbers?

Securities are purchased based on belief rather than thorough analysis.

This sign refers to which part of the brain investors are using to make decisions: the part they use to figure out which refrigerator offers the best value for the money, or the one that makes some of their heads turn when a really attractive sports car drives by.

Doubters have been wrong for a long time and are largely disregarded as people who "just don't get it".

When a group of people have been warning about danger for a prolonged period of time, a certain fatigue sets it. Kind of like the story about the boy who cried wolf.

Ironically, in stock market as prices rise higher and higher without the fundamentals to support that increase, the longer the warnings have been sounded and ignored, the more relevant they become. Only they do not appear so. These naysayers become largely discredited and ignored. Usually just as what they have been warning about is on the cusp of wiping out a large chunk of investors' portfolios…

The specifics change, but the general pattern reoccurs throughout investing history. The most expensive words in investing are "this time is different." Yet investors think and say these words every few decades. In large part, they do this because every time is different. The details change. What doesn't change is that in the long-term, stock prices are determined by weighing the cash flow streams of the underlying companies, not by stories or by popularity of these companies for a period of time with investors.

We are looking at one share of Berkshire B relative to one share of Apple. Three years ago, one share of BRK was enough to buy 1.2 shares of Apple, whereas today, one share of BRK would be sufficient to buy less than half a share of Apple.

Meanwhile, Berkshire owns 250 million shares of Apple, which have a market value approaching $100 billion. So, while the number of shares of Apple that one share of Berkshire can buy has been steadily falling, BRK's stake in AAPL (which should positively impact BRK's stock price) has been steadily rising.

Berkshire is also renowned for its large cash hoard.

What does one get in the Buffett Stub? Essentially, it would be all the insurance assets, Burlington Norther Santa Fe (BNSF) and all the other investments public and private that Berkshire has made ex-Apple.

If we strip out AAPL, the cash and BNSF, the rest of Berkshire - mainly insurance and the remaining public and private investments essentially have a negative value.

You are essentially getting much of the company for free.

*BRK is a holding in EdgePoint and Cymbria portfolios.

Given the high number of consumers working from home, especially those with school age children, it should come as no surprise that one-in-three Americans signed up for a new subscription service in the first few weeks of the shelter-in-place lockdown in the U.S.

Nearly 60% of parents with children under the age of 18 signed up for a new subscription of some kind in the first few weeks of the national emergency.

Baby Boomers stood out as the least likely group to sign up for new services, with just 10% of those surveyed saying they had signed up recently.

By May, a new trend was becoming evident in the subscription industry - subscriber fatigue. In Deloitte's Digital Media Trends Survey, it was apparent that churn was becoming a major factor as companies were rapidly onboarding and offboarding customers at an alarming rate.

Almost a third of consumers had added a new streaming video service or added one while canceling another since mid-March. Further, when looking at cancellations since mid-March, 14% had either cancelled a service outright with no replacement or cancelled a service and picked up a competitor's service instead. All-on-all, almost four-in-ten U.S. consumers had made a change to a video streaming service in the first two months of the pandemic.

Will Berkshire step up now to buy businesses on the same scale?

"Well, I would say basically we're like the captain of a ship when the worst typhoon that's ever happened comes," Mr. Munger told me. "We just want to get through the typhoon, and we'd rather come out of it with a whole lot of liquidity. We're not playing, 'Oh goody, goody, everything's going to hell, let's plunge 100% of the reserves [into buying businesses].'"

On the airlines:

"They've never seen anything like it. Their playbook does not have this as a possibility."

"Nobody in America's ever seen anything else like this. This thing is different. Everybody talks as if they know what's going to happen, and nobody knows what's going to happen."

Is another Great Depression possible?

"Of course we're having a recession,"

"The only question is how big it's going to be and how long it's going to last."

"I don't think we'll have a long-lasting Great Depression. I think government will be so active that we won't have one like that. But we may have a different kind of a mess. All this money-printing may start bothering us."

Photo contest: Winner!

In this quarter's EdgePoint photo contest, we chose the theme of "Home Life" to make sure our partners stayed safe while trying to find new ways to look at things they saw every day. The Committee had to look through some strong submissions, including family photos, restaurant-quality dishes and several artistic endeavours.

After some debate, this quarter's winner is Québec's very own Marc-Andre for his close-up of some latte art that showed us home truly is where the heart is.

Even though there are still travel restrictions, doesn't mean the Investment team's latest reading and listening recommendations can't help you escape some of the summer heat.

Bifurcated market

We guess this makes sense when Apple, Amazon, Microsoft and Google combined are now worth more than the entirety of the Japanese stock market.

"Can 'bad' things happen to an otherwise 'good' investment portfolio? To answer this question, I looked at the performance of a very large and well-known investment portfolio that has a long history of exceptional results. This particular portfolio provides a good 'test case' because its history goes back more than 50 years. Therefore, its success clearly cannot be attributed to mere luck."

Over its lengthy tenure the portfolio has widely outperformed its benchmark, adding significant value for investors over time. However, all sorts of bad things happened to this portfolio all along the way:

  • There were 11 calendar years over its tenure, where this 'good' portfolio would have lost you money. To add insult to injury, in seven of those negative years the portfolio also underperformed its benchmark.
  • There were 17 years in total where the portfolio underperformed its benchmark. That's almost 1/3rd of the time.
  • There were 21 years where this otherwise 'good' portfolio experienced a calendar year return that was negative and/ or worse than its benchmark.
  • There were 20 calendar years where the portfolio returned less than 10%.
  • And finally, it also experienced a couple of prolonged periods of particularly poor results. Throughout its history this portfolio experienced two separate periods of time where it had either a negative rate of return and/or underperformed its benchmark for four years in a row. In other words, if you had hired this particular portfolio manager at the start of either of these periods, and looked back at your results four years later, you would have experienced either negative or relative underperformance in each and every one of the previous four years.

    In either of these scenarios, many investors would have promptly pulled their money and fired the manager! The "portfolio" we've analyzed above is none other than that of Berkshire Hathaway, and the 'portfolio manager' you'd have fired would have been the world's greatest investor himself - Mr. Warren Buffett!

    Over the 54 year period from the beginning of 1965 to the end of 2018, Buffett/ Berkshire returned an average of 20.5% per year, more than doubling the S&P500 Index, returned 9.7% per year over the same period

    Truly bad things can only happen to good investment portfolios through our own behaviour; i.e. how we react to "bad" events such as temporary underperformance. If the portfolio itself is indeed a 'good' one by definition, it won't do bad things to you. Only you can do bad things with it.

    Retail sales

    Topline retail activity is now just -0.8% away from the pre-pandemic level.
    There is wide dispersion within the sectors and the "work-from-home" theme is clearly visible when we look at the fact that groceries are 11.5% above pre-Covid, e-tailing is sitting at 20.9% higher and now sporting goods etc. has ramped up to 23.1% above the pre-pandemic level.

    Household spending

    Although average spending fell for all households as the economy shut down at the start of the pandemic, unemployed households actually increased their spending beyond pre-unemployment levels once they began receiving benefits.

    Store openings and closures in the US

The central bank bought about $3 million of the company's bonds due 2024 at around 105 cents on the dollar, but they'll be redeemed at 101 cents on Tuesday. That will amount to a roughly $120,000 loss in principal on the debt purchased on June 23, according to the Fed's latest update to its secondary market facilities purchases.

The transaction highlights the risks central banks take when they leave the safety of sovereign debt and venture out into niche corners of the bond market.

The surge in Indian internet subscriptions has been spectacular. A near threefold increase between 2014 and 2020. Google said Monday that it will set up a $10 billion fund to invest in India over the next five to seven years, including investments in other companies, to speed up the adoption of digital service.

India is a largely untapped market: It has 1.35 billion people and only about half of them are online. Digital services from e-commerce to online media are underdeveloped.

Net new retail accounts across major online brokers 
As you can see from the chart below, all the online retail brokers saw a huge swath of new users this year.

Dining in the hotspots heading lower

Gasoline consumption up on reopening as well as avoidance of mass transit
78% of the appreciation in S&P500 in last 5 years is attributable to tech and e-commerce

This quarter portfolio manager Tye Bousada looks at investors' path to point B and discusses why you need uncertainty and willingness to look wrong in the short term to get to point B.

Derek Skomorowski talks about risks in fixed-income investing and why it's important to fish where the best investment opportunities are.

The options market in the FAANGs - we're not sure what you call this, but we're pretty sure it's not called investing

July 6th call option volume on Amazon (AMZN) and Microsoft (MSFT).  Most of these are 4-day options!

Makeup and skincare trends
Beauty spending was already shifting from make-up to skincare, and this has accelerated during the shutdown:

The new and incremental buyer of online beauty products is older and wealthier - the highest percentage of first-time online buyers were over 55 and earned over $125k per year.

Robinhood's users buy and sell the riskiest financial products and do so more frequently than customers at other retail brokerage firms, but their inexperience can lead to staggering losses.

One of its users said he had been charmed by Robinhood's one-click trading, easy access to complex investment products, and features like falling confetti and emoji-filled phone notifications that made it feel like a game. 

Robinhood users traded nine times as many shares as E-Trade customers and 40 times as many shares as Charles Schwab customers, per dollar in the average customer account in the most recent quarter. They also bought and sold 88 times as many risky options contracts as Schwab customers, relative to the average account size, according to the analysis.

At the core of Robinhood's business is an incentive to encourage more trading.
It does not charge fees for trading, but it is still paid more if its
customers trade more.

It's time to start withdrawing the money you've accumulated - but making sure you know how much to withdraw is key. In this installment of EdgePoint's academy series on retirement, we discuss the importance of withdrawal rates, how inflation and investment returns impact them, and ways to make sure money you haven't withdrawn yet can keep growing.

Why is there a belief that Equities and Bonds must be negatively correlated?
It hasn't always been the case:
Based on death certificate data available on July 2, 2020, 5.9% of all deaths occurring during the week ending June 27, 2020 (week 26) were due to pneumonia, influenza or COVID-19 (PIC). This is the tenth consecutive week of a declining percentage of deaths due to PIC. The percentage is equal to the epidemic threshold of 5.9% for week 26.
An article that summarizes some of the problems with drawing conclusions from the increase in COVID-19 cases in the US.

Mega-cap growth vs the rest 
Mega-cap growth companies make up roughly 28% of the S&P 500. These are growth stocks with a market cap of more than $200 billion. These businesses have had a large impact on performance YTD.  Not surprisingly, the average number of retail investor accounts holding mega-cap growth companies has more than doubled.

Americans have really been embracing the can since the start of the quarantine 

And the 1 week Y/Y data is still strong indicating that this is not just a pantry loading phenomenon.

Vehicle miles driven (VMT) by destination
The pace of onshoring is picking up

A group of economists at Harvard have built a real-time, publicly available economic tracker. There are many good interactive charts here but below are a few interesting ones.

Consumer spending in the US is down 11.3% since January, but spending cuts by people in the top quartile account for more than half of the total aggregate decline in dollars. As of June 9th, spending by the top quartile was still down 16.8%, whereas spending by the bottom income quartile was only ~3% below where it was in January. 

Stimulus payments increased spending by low-income consumers, but didn't undo the initial most revenue:

By industry, in-person services were obviously the hardest hit, but the idea of the 'Roomba effect' was interesting. In a normal recession, households typically respond by cutting purchases of durable goods like cars, washing machines etc, and the policy response tries to counteract that (cash-for-clunkers, VAT cuts). In this recession, it's the opposite - people are substituting services for durable goods -buying a roomba instead of hiring a cleaning lady, which they think might have permanent implications for the economy because people are going for a capital solution instead of a labour solution.

Who actually likes uncertainty? For most people, it's pretty bothersome really, particularly when it concerns someone's hard-earned savings and investments. It's difficult for investors to understand how uncertainty could be a very good thing for their investments. Geoff MacDonald explains why investors need uncertainty in this excerpt from our 2020 Cymbria Investor Day Q&A session.

Nearly a third of investors ages 65 and up-sold all of their stocks at some point between February and May, compared with 18% of investors across all age groups.

U.S. stocks have managed a remarkable advance in the past several weeks as optimism outweighed concerns about the economic recovery and worsening COVID-19 cases. Has this been appropriate or irrational? Howard Marks thinks investors should ponder the following questions:
  • Are investors weighing both the positives and the negatives dispassionately?
  • What's the probability the positive factors driving the market will prove valid (or that the negatives will gain in strength instead)?
  • Are the positives fundamental (value-based) or largely technical, relating to inflows of liquidity (i.e., cash-driven)? If the latter, is their salutary influence likely to prove temporary or permanent?
  • Is the market being lifted by rampant optimism?
  • Is that optimism causing investors to ignore valid counter-arguments?
  • How do valuations based on things like earnings, sales and asset values stack up against historical norms?

Latest Charts

Technology stock valuations
Investors have come to believe in the sustainability of free cash flow, bringing down yields.

Shares of companies popular with individual investors have outperformed.

While it's not clear how much of the recent rally was driven by retail investors/traders, their increased presence in the market has been signaling a spike in speculative behavior.

Grocers charged into delivery to meet a surge in demand sparked by the coronavirus crisis, though many haven't figured out how to get food to customers' homes profitably and some wonder if they ever will. Retailers have modified their operations to manage the jump in delivery demand, hiring thousands of additional workers and devoting some stores to fulfilling online orders. That work is pushing up costs that eat into the margins on delivery sales.

What's your vintage year?

When did you become an EdgePoint partner? Let's take a walk down memory lane as we recall the major events and fun facts from your vintage year.

A few winners have generated big gains, fueling the misperception that losses have been minimal. The result is a market that isn't as irrationally exuberant as it might appear.

Year to date, Zoom Video is up 209%, Regeneron Pharmaceuticals Inc. 59% and Amazon.com is up 33%. But entire industries have been flattened. At the beginning of this last week, airlines were down an average of 52%; banks were down 33%; energy 32%; and autos was down 30%. It isn't unusual for the stock market to split into a few extreme winners and lots of losers. In 1973, a few darlings rose to near-record valuations while most stocks fell miserably. In 1999, technology shares shot up more than 80% even as many companies in the broader market languished and Warren Buffett's Berkshire Hathaway Inc. fell 20%.  Seldom, however, has the gap between the haves and the have-nots been as wide as it is now.

Charts and stats 

Unemployment hits lower-wage earners

According to the National Employment Law Project, higher-wage industries constituted 41% of job losses during GFC, whereas lower-wage industries constituted 22% of the job losses. On the other hand, according to the Federal Reserve, 39% of people under US$40,000 household incomes lost a job in March this year, compared with 19% of those earning US$40,000 to US$100,000 and 13% for those earning above US$100,000. 

Spike in savings
Big Growers trade at stratospheric valuations
The Big Growers* were turbo-charged through the pandemic and continue to trade at stratospheric valuations. 
*Big Growers are the top-half of the group based on trailing P/E ratio. Cheap P/E stocks are the lowest quintile of stocks from the entire large-cap universe based on trailing P/E ratio. Trailing P/E ratio is current price divided by trailing 12-month earnings.

Rush to safety

The market rushed towards safety in the pandemic and the slow growth, low beta stocks continue to trade at a huge relative premium.

Utilities valuations
Utilities are now trading at the highest ever historical premium relative to Financials.

Energy valuations

There are several industries with deep value characteristics that will benefit as the valuation spread compresses, but Energy stands out.

Online brokers are being flooded with new customers.

Dayanis Valdivieso is tapping an unlikely source of money for her first foray into stocks: the government's $1,200 stimulus check. Ms. Valdivieso, a 22-year-old in Louisville, Ky., used a portion of her check to trade stocks, using a Robinhood account. "It was basically free money, so, you know, I decided to play around with it," she said. "You might lose some, you might win some. It's like a gambling game."

That kind of enthusiasm has some market observers worried. In the late 1990s, small investors chased flimsy companies with .com attached to their names, buying that came after the Fed slashed interest rates in 1998 amid a financial crisis. In the spring of 2000, the Nasdaq market collapsed.

"The key parallel between 2000 and today is that retail investors are seeing the stock market as a can't-miss opportunity,".

Stats on re-opening
Only a handful of states have reopened bars and restaurants, and of those, most were in the past week. Montana was one of the earliest to reopen. The stay at home order in Montana was lifted on April 27th and bars and dine in restaurants reopened on May 4th at half capacity with social distancing measures. They move to 75% capacity tomorrow. Gyms reopened May 15th.

Buffett and Charlie Brown are due some relief
A resurgence of value implies an optimistic outlook for the economy. If growth returns, then cheap value stocks won't look so risky (because even their boats have been raised). Value tends to do well at the beginning of recovery - although note that the last great period of value outperformance, in the early '00s, came amid the onset of a recession and a bear market. As value stocks still include a lot of banks, a strong period for value also implies a steepening yield curve. This could be a dangerous bet to make when the Federal Reserve is discussing deliberately controlling the yield curve. And a second viral wave could change everything.

For now, the recovery of value would help to confirm that investor confidence, justified or otherwise, is really back.

There are many reasons to doubt that optimistic scenario. But the mere fact that advocating for value makes me feel like I might turn into Charlie Brown is perhaps the strongest reason for believing there is an opportunity here. One behavioral investor once told me that he adopted a "sharp intake of breath" test for potential investments. If a name provoked that reaction, the chances were that sentiment had moved too far and it was now too cheap. It is at this point that value investors can make a killing. Put differently, to quote Oaktree Capital Group's Howard Marks from an interview with me earlier this month, "every great investment begins in discomfort."

The week in charts 
Bubble behavior during a depression
The dot-com bubble made the stock market too tempting to pass up for aspiring day traders. This type of behavior makes sense during a mania. But what about during a depression?

This is one of the strangest economic crises in history. Stocks continue to surge higher in the face of the worst economic data of our lifetime. Housing demand has already surpassed pre-crisis levels. And even though the first quarter was the most volatile period since the Great Depression, people opened new brokerage accounts at a record pace. Major brokerages - Robinhood, Charles Schwab, TD Ameritrade, and Etrade - saw new accounts grow as much as 170% during the first quarter. 

Follow by email


Search Inside Edge


Book recommendations

  • Fixed income picks from Derek
  • Andrew's favourite biographies

Food for thought

The life of an EdgePointer



  • 2020
    • March 2020
    • February 2020
    • January 2020
  • 2019
    • December 2019
    • November 2019
    • October 2019
    • September 2019
    • August 2019
    • July 2019
    • June 2019
    • May 2019
    • April 2019
    • March 2019
    • February 2019
    • January 2019
  • 2018
    • December 2018
    • November 2018
    • October 2018