The hosting business is a prime beneficiary of this phenomena as well. All the companies in these conceptual stage use hosting. As an example, Netflix (NFLX) is one of the largest hosting service users in the world. Netflix, however, is losing billions of free cash flow every year. The first quarter of 2019 was no different. How do they make up for this shortfall of free cash flow? Borrowing in the junk bond market! Investors who believe they are taking good risks are willing to put up billions for this debt instrument. It was just announced today that another $2 billion will be raised in their next debt sale. It is fine if they can issue billions every year for the next 10 years. If the sentiment of the capital markets changes, they could lose access to capital. Who would this hurt? The high margin hosting businesses of Microsoft, Amazon and Google. Grantham’s corporate profit margin mean reversion becomes more real in this way.
“The sense of responsibility in the financial community for the community as a whole is not small. It is nearly nil.” – John Kenneth Galbraith
Over the last 50 years there are other examples of the capital markets getting outside the realm of providing capital to sustainable individuals and entities. In the process, profit margins become distorted at the time. The last example was in 2007, when the investment markets became euphoric over the idea that homes never go down in value. Investors, both institutional and individual investors, supplied large amounts of capital to nooks and crannies of the debt market, providing credit to willing borrowers. Banks showed illusory underwriting profits in mortgages and other debt instruments. The flow of capital was too easy.
The banks’ profitability was not sustainable if the supply of capital dried up. Individuals didn’t need to prove they could pay back the money. They could get credit on the conceptual belief that there could never be trouble in residential real estate. They could all see the pathway for these borrowers to succeed in the end. Washington Mutual looked very attractive and even Jamie Dimon considered buying it at lofty prices. This was all for naught. Capital markets changed, margins at the banks got crushed, investors dried up and conceptual borrowers became bad bets for the real economy.
This was a credit problem, in comparison to today’s profit margin distortion from easy access to funding via public and private equity. Though low rates have affected all asset classes, the real economy is being affected by capital raising success in equities (public and private) and the junk bond market. These are some of the riskiest spheres of investing. We are fearful of the activities being practiced by investors currently. The self-funding nature of the kinds of companies identified by our eight criteria appear more valuable than ever.
As compared to a company like Google with the capital market distortion as a tailwind, we like companies such as Walgreens (WBA) and Discovery (DISCA). Going forward, they can create their own capital from their profitable and free cash flow generating business operations. Walgreens’ and Discovery’s problems are well-known and perceived by nearly every analyst on the street. They can tell you what would greatly impact these businesses, but we pay very low prices for these future risks. We highlight today’s profit margins distortions that we believe could prove to be far more painful for equity investors. No one on the street can see problems for big-cap tech other than regulation. The profit margin distortions of housing in 2007 were hard to see also.
Warm regards,
Cole Smead, CFA
Shiller Barclays CAPE® U.S. Sector Index Sector Selection Rules
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