Posts tagged ‘losses’
New Year, New Clean Slate
Stock and bond market returns in 2022 were disappointing, but we now get to start 2023 with a clean slate. Before we turned the page on another annual chapter, Santa Claus chose to finish last year by placing a lump of coal in investor stockings, as evidenced by the S&P 500 index decline of -5.9% during December.
Good News & Bad News
There is some good news and bad news as it relates to this year’s underwhelming stock market results (-19.4%). The bad news is last year turned out to be the 4th worst year in the stock market since World War II (1945) and also marked the worst year since 2008. Here’s a summary of the S&P 500’s worst years over the last eight decades:
2008: -38.5%
1974: -29.7%
2002: -23.4%
2022: -19.4%
Source: CNBC (Bob Pisani)
The good news is that the stock market is up 81% of the time in subsequent years following down years. The average increase in bounce-back years is +14%. In another study of down years, the analysis showed that after the stock market has fallen -20% or more, stock prices were higher on average by +15% one year later, +26% two years later, and +29% three years later. Nothing is guaranteed in life, but as Mark Twain famously stated, “History does not repeat itself, but it often rhymes.”
2022: The Year of No Shock Absorbers (Worst Bond Market Ever)
The stock market receives most of the media glory and reporting, however the bond market is the Rodney Dangerfield of asset classes, it “gets no respect.” Typically, during weak stock markets (i.e., “bear markets”), the bond or fixed income investments in a diversified portfolio act as shock absorbers to cushion the blow of volatile stock prices. More specifically, in a typical bear market, the economy generally slows down causing demand to decelerate, and interest rates to decline, which causes the values of bonds to increase. Therefore, as stock prices decline, the gains from bonds in your portfolio usually help offset stock losses. Unfortunately, this scenario didn’t happen in 2022, but rather investors experienced a double negative whammy. Not only did stocks experience one of its worst years in decades, the bond market also suffered what many pundits are describing as the “Worst Bond Market Ever” – see chart below.
Why in particular did bonds perform so poorly this year, when they commonly outperform in slow or recessionary economic conditions? For starters, interest rates spent most of 2022 increasing at the fastest pace in more than four decades (see chart below). An unanticipated rise in inflation was the main culprit, which was caused by spiking energy prices from Russia’s invasion of Ukraine; COVID-related supply chain disruptions; unprecedented fiscal stimulus (trillions of dollars in infrastructure spending and incentives); record monetary stimulus (QE – Quantitative Easing); and extended years of ZIRP (Zero Interest Rate Policy). For these reasons, and others, bonds collapsed in sympathy with deteriorating stock prices.
Room for Optimism in 2023
Last year was challenging, however, not all is lost. The Federal Reserve, inflation, interest rates, Ukraine, and cryptocurrency volatility (e.g., Bitcoin down -64% in 2022) dominated headlines this year, but many of these headwinds could abate or reverse in 2023. For example, there are numerous indicators pointing to peaking and/or declining inflation, which, if true, could create a tailwind for investors this year. Bolstering this argument are the current weakening trends we are witnessing in the housing market, which should ripple through the economy to cool inflation (see chart below).
And if it’s not declining home prices, lower energy prices have also filtered through the global economy to lower transportation and shipping costs (e.g., freight rates from China to West Coast are down -90%). What’s more, a stronger dollar has contributed to declining commodity prices as well.
Although inflation still has a long way to go before reaching the Federal Reserve’s 2% target rate, broad inflation measures, such as the GDP Deflator, are showing a significant decrease in inflation (see chart below). By analyzing the various disinflationary tea leave markers, we can gain some confidence regarding future interest rates. Observing the fastest rate hike cycle by the Fed in decades informs us that we are likely closer to an end of rate hikes (i.e., pause or cut), rather than the beginning. If correct, tamer inflation means 2023 could prove to be a better environment for both stock and bond investors.
In summary, last year was painful across the board, but investors are starting this year with a clean slate and signs are pointing to a potential reversal in inflation and interest rate headwinds. With the change of the calendar, a messy 2022 could turn into a spick-and-span 2023.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (Jan. 3, 2023). Subscribe on the right side of the page for the complete text.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Netflix: Burn It and They Will Come
In the successful, but fictional movie, Fields of Dreams, an Iowa farmer played by actor Kevin Costner is told by voices to build a field for baseball playing ghosts. After the baseball diamond is completed, the team of Chicago White Sox ghosts, including Shoeless Joe Jackson, come to play.
Well, in the case of the internet streaming giant Netflix Inc (NFLX), instead of chasing ghosts, the company continues to chase the ghosts of profitability. Netflix’s share price has already soared +63% this year as the company continues to burn hundreds of millions in cash, while aggressively building out its international streaming footprint. Unlike Kevin Costner, Netflix investors are likely to eventually get spooked by the by the stratospheric valuation and bleeding cash.
At Sidoxia, we may be a dying breed, but our primary focus is on finding market leading franchises that are growing cash flows at reasonable valuations. In sticking with my nostalgic movie quoting, I believe as Cuba Gooding Jr. does in the classic movie, Jerry Maguire, “Show me the money!” Unfortunately for Netflix, right now the only money to be shown is the money getting burned.
Burn It and They Will Come
In a little over three years, Netflix has burned over -$350 million in cash, added $2 billion in debt, and spent approximately -$11 billion on streaming content (about -$4.6 billion alone in the last 12 months). As the hemorrhaging of cash accelerates (-$163 million in the recent quarter), investors with valuation dementia have bid up Netflix shares to a head-scratching 350x’s estimated earnings this year and a still mind-boggling valuation of 158x’s 2016 Wall Street earnings estimates of $3.53 per share. Of course the questionable valuation built on accounting smoke and mirrors looks even more absurd, if you base it on free cash flow…because Netflix has none. What makes the Netflix story even scarier is that on top of the rising $2.4 billion in debt anchored on their balance sheet, Netflix also has commitments to purchase an additional $9.8 billion in streaming content in the coming years.
For the time being, investors are enamored with Netflix’s growing revenues and subscribers. I’ve seen this movie before (no pun intended), in the late 1990s when investors would buy growth with reckless neglect of valuation. For those of you who missed it, the ending wasn’t pretty. What’s causing the financial stress at Netflix? It’s fairly simple. Beyond the spending like drunken sailors on U.S. television and movie content (third party and original), the company is expanding aggressively internationally.
The open check book writing began in 2010 when Netflix started their international expansion in Canada. Since then, the company has launched their service in Latin America, the United Kingdom, Ireland, Finland, Denmark, Sweden Norway, Netherlands, Germany, Austria, Switzerland, France, Belgium, Luxembourg, Australia, and New Zealand.
With all this international expansion behind Netflix, investors should surely be able to breathe a sigh of relief by now…right? Wrong. David Wells, Netflix’s CFO had this to say in the company’s recent investor conference call. Not only have international losses worsened by 86% in the recent quarter, “You should expect those losses to trend upward and into 2016.” Excellent, so the horrific losses should only deteriorate for another year or so…yay.
While Netflix is burning hundreds of millions in cash, the well documented streaming competition is only getting worse. This begs the question, what is Netflix’s real competitive advantage? I certainly don’t believe it is the company’s ability to borrow billions of dollars and write billions in content checks – we are seeing plenty of competitors repeating the same activity. Here is a partial list of the ever-expanding streaming and cord-cutting competitive offerings:
- Amazon Prime Instant Video (AMZN)
- Apple TV (AAPL)
- Hulu
- Sony Vue
- HBO Now
- Sling TV (through Dish Network – DISH)
- CBS Streaming
- YouTube (GOOG)
- Nickelodeon Streaming
Sadly for Netflix, this more challenging competitive environment is creating a content bidding war, which is squeezing Netflix’s margins. But wait, say the Netflix bulls. I should focus my attention on the company’s expanding domestic streaming margins. This is true, if you carelessly ignore the accounting gimmicks that Netflix CFO David Wells freely acknowledges. On the recent investor call, here is Wells’s description of the company’s expense diversion trickery by geography:
“So by growing faster internationally, and putting that [content expense] allocation more towards international, it’s going to provide some relief to those global originals, and the global projects that we do have, that are allocated to the U.S.”
In other words, Wells admits shoving a lot of domestic content costs into the international segment to make domestic profit margins look better (higher). Longer term, perhaps this allocation could make some sense, but for now I’m not convinced viewers in Luxembourg are watching Orange is the New Black and House of Cards like they are in the U.S.
Technology: Amazon Doing the Heavy Lifting
If check writing and accounting diversions aren’t a competitive advantage, does Netflix have a technology advantage? That’s tough to believe when Netflix effectively outsources all their distribution technology to Amazon.com Inc (AMZN).
Here’s how Netflix describes their technology relationship with Amazon:
“We run the vast majority of our computing on [Amazon Web Services] AWS. Given this, along with the fact that we cannot easily switch our AWS operations to another cloud provider, any disruption of or interference with our use of AWS would impact our operations and our business would be adversely impacted. While the retail side of Amazon competes with us, we do not believe that Amazon will use the AWS operation in such a manner as to gain competitive advantage against our service.”
Call me naïve, but something tells me Amazon could be stealing some secret pointers and best practices from Netflix’s operations and applying them to their Amazon Prime Instant Video offering. Nah, probably not. Like Netflix said, Amazon wouldn’t steal anything to gain a competitive advantage…never.
Regardless, the real question surrounding Netflix should focus on whether a $35 billion valuation should be awarded to a money losing content portal that distributes content through Amazon? For comparison purposes, Netflix is currently valued at 20% more than Viacom Inc (VIA), the owner of valuable franchises and brands like Paramount Pictures, Nickelodeon, MTV, Comedy Central, BET, VH1, Spike, and more. Viacom, which was spun off from CBS 44 years ago, actually generated about $2.5 billion in cash last year and paid out about a half billion dollars in dividends. Quite a stark contrast compared to a company accelerating its cash losses.
I openly admit Netflix is a wonderful service, and I have been a loyal, longtime subscriber myself. But a good service does not necessarily equate to a good stock. And despite being short the stock, Sidoxia is actually long the company’s bonds. It’s certainly possible (and likely) Netflix’s stock will underperform from today’s nosebleed valuation, but under almost any scenario I can imagine, I have a difficult time foreseeing an outcome in which Netflix would go bankrupt by 2021. Bond investors currently agree, which explains why my Netflix bonds are trading at a 5% premium to par.
Netflix stockholders, and crazy disciples like Mark Cuban, on the other hand, may have more to worry about in the coming quarters. CEO Reed Hastings is sticking to his “burn it and they will come” strategy at all costs, but if profits and cash don’t begin to pile up quickly, then Netflix’s “Field of Dreams” will turn into a “Field of Nightmares.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), AAPL, GOOGL, AMZN, long Netflix bond position, long Dish Corp bond, and a short position in NFLX, but at the time of publishing, SCM had no direct position in VIA, TWX, SNE, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
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