Alphabet (GOOG), the parent of Google, missed Wall Street expectations on revenue and earnings for the first quarter yesterday, April 21, after the market close. Revenue at $20.26 billion was $120 million less than the Wall Street consensus. (By the way that’s a miss of 0.5%.) Earnings per share were $7.50 (after excluding some items) versus the $7.96 a share that Wall Street expected.
On the news today, Friday April 22, Alphabet’s shares fell $40.37 or 5.3%, to $718.77. (Alphabet is a member of my long-term 50 Stocks portfolio.)
Okay, maybe the results aren’t enough to set your heart a-flutter. But a surprise? No way. The problem, if there was one, with Alphabet’s quarter is that it was remarkably like past quarters. The problems that Alphabet has been struggling with for a long time now were exactly what damaged this quarter.
For example, the tough transition from a desktop world with its higher ad prices to a mobile world with its lower ad prices continued. Aggregate ad revenue per click continued to fall–as it has done in every year of the transition from PC to mobile ads. The drop this quarter was 9% from the first quarter of 2015. I think you can make a case that Alphabet continues to work its way through the problem caused by this transition in the platforms that people use to access the Internet, but the transition still isn’t over.
Or, for to take another long-standing Alphabet problem, the company still doesn’t have good controls on its hiring, compensation, and spending. For example, the company issued so many shares as compensation to employees that share count reached 699.3 million for the quarter. That’s an increase of 9.8 million shares from the first quarter of 2015–and comes in spite of the company spending $2.3 billion to buy back shares during the quarter. (There’s also the issue of why the company didn’t do a better job of making sure that analysts had an accurate share count when they did their calculations of earnings per share.)
Alphabet has split off what it calls its Other Bets businesses from its core businesses of search, Youtube, and advertising in an effort to give investors more transparency into its business. And the company brought in a new CFO, Ruth Porat, from Morgan Stanley, to assure investors that, in the words of more than one analyst, “an adult was in charge of the cash flow.” That didn’t have much effect this quarter as the operating loss in the Other Bets business grew to $802 million this quarter from $633 million in the first quarter of 2015.
I’d note, however, that in the “not a surprise” category on the plus side investors should also put the extraordinary performance of YouTube. On the mobile version of the platform alone, YouTube reaches more 18- to 34-year-olds than another broadcast or cable network.
What should be of special interest to long-term investors is the company’s announced intention to spend some of its $75 billion in cash (up from $65 billion in the first quarter of 2015) on blasting its way into contention in the cloud computing sector. Amazon (AMZN) and its AWS cloud computing unit is far and away the leader in the sector. but Alphabet isn’t #2 (that’s Microsoft (MSFT) and it may have recently fallen from #3 to #4 (behind IBM (IBM).) Alphabet hasn’t offered any specifics on how much it will spend, but given its recent hire of Diane Greene, founder and CEO of VMware from 1998 to 2008, to head up its cloud business, I’d say Alphabet is very serious. I’ve heard analyst estimates of capital spending on the cloud business of $3 billion over the next few years. That will be a big drag on cash flow, since the cloud unit showed revenue of less than $500 million in 2015 and will need time to gain share from tough competitors such as Amazon, Microsoft, and IBM. But given the size of Alphabet’s cash hoard and the company’s ability to generate cash by the truckload, investing in cloud computing seems a good use cash. Nobody in the sector matches Amazon’s operating margins but at 35% or so the margins at Amazon for this business are clearly worth chasing.
As you can guess for the tone of this post, I’m keeping Alphabet in my long-term 50 stocks portfolio. A 5% dip isn’t a huge buying opportunity, but I’d use it and any other near-term weakness to buy shares. On my Timeliness Scale I’d rate this time to accumulate.
To celebrate the publication tomorrow of my book on volatility, Juggling with Knives, and to bring the existing long-term picks portfolio into line with what I learned in writing that book and my best new ideas on how to invest for the long-term in a period of high volatility, I’m completely overhauling the existing 50 Picks portfolio. (You can buy Juggling with Knives at http://www.amazon.com/Juggling-Knives-Investing-Coming-Volatility-ebook/dp/B016TX4ETY/ref=sr_1_1?s=books&ie=UTF8&qid=1453757542&sr=1-1&keywords=juggling+with+knives
This will happen in stages with the two stages taking place today.
Those stages will be
1. Explaining the rationale for these changes and the new rules of the road for this portfolio
2. Cutting down the deadwood–which means the immediate drop of 12 stocks in the portfolio
3. Adding five short-side ETFs to use in hedging volatility in extraordinarily risky markets
4. Adding seven new long-term picks to the portfolio (in addition to the 5 ETFs)
5. Updating all the existing write-ups on the 38 carry-over picks and giving them a new timing rating and a clearer indication of what silo in the portfolio they belong to so the reader will understand what long-term trend I think is behind each stock and why each stock is in the portfolio.
Ok, so let’s start with steps one and two today.
When I started this long-term portfolio, based on my 2008 book The Jubak Picks. my goal was simple. I wanted to create a portfolio for a long-term investor of 50 stocks backed by long-term trends (10 of them in fact) that were strong enough, global enough, and long-lasting enough to give anyone who invested in them a good chance of beating the stock market averages.
The portfolio would be largely passive with changes limited to 5 potential drops and 5 potential adds just once a year.
That worked fairly well for the first four years of the portfolio. In its first year, 2009, The Jubak Picks 50 portfolio gained 57.8% versus a gain of 28.3% for the S&P 500. Year two, 2010, the portfolio gained 20.1% versus 15.01% for the S&P 500. Then in 2011, the portfolio lost 18.6% versus a 2.1% gain for the S&P 500. Year four, 2012, the portfolio gained 6.6% versus 16% for the S&P 500. Total for four years came to a gain of 64.4% for the Jubak Picks 50 portfolio versus 72.3% for the S&P 500.
But I could already see a problem. This long-term portfolio had a lot of fundamentally solid stocks that would do well when the global economy was in a growth mode and when global stock markets were in an uptrend. (2010 is a good example of this. I discount 2009′s really great performance as a timing artifact since I started the portfolio close to the post-global financial crisis bottom.)
But in a volatile down market, this portfolio could take a deep hit. Part of that underperformance was a result of the fact that when investors get scared by a correction or bear they tend to sell their most liquid positions first and also tend to take profits in their winners. Part of it was a result of the rigidity I built into the portfolio in an effort to make it a long-term portfolio. When a sector tanked, as energy has done twice recently, the once-a-year limit on changes to the portfolio meant there was no way to respond. And partly it was a result of the way that this rigidity influenced my own stock picking: When it came time to add new stocks for the once in a year overhaul, I tended to pick stocks in trends that had done/were doing well recently. In retrospect I wound up doing that even though I recognized that this was a real danger that I should avoid. Knowing what to do doesn’t always mean that you actually do it. One result of this bias is that I went into 2015 with way, way too much exposure to energy and mining and the portfolio has paid the price in 2015 and into 2016.
As I looked at the portfolio, though, I also began to notice a missed opportunity. Being a long-term investor and having a long-term time horizon gives that investor some key advantages in a volatile market. You can buy fundamentally superlative companies at a reasonable price when they’re out of favor. You can pick up an entire sector or trend when most investors hate it. If you want to take a somewhat more active role, although something still far short of trading, a long-term investor should be able to sell at some market tops (or sector or trend tops) and buy at some sector or trend bottoms.
In the last few years I’ve made unsatisfactory stabs at adding that perspective to the portfolio. The most recent was an effort to designate some stocks each year as most timely and least timely for purchase. I haven’t found that especially productive since market volatility hasn’t been willing to cooperate with my once-a-year schedule.
In the process of writing Juggling with Knives, I’ve become convinced that I needed to 1) junk my once-a-year rigidity so I can buy and sell whenever, 2) add short-side ETFs to the portfolio to keep the need to rejigger the entire portfolio during a period of downside volatility to a relative minimum, 3) get rid of about a dozen stocks that no longer fit the best in the world paradigm either because of changes in trends or because of changes at an individual company, 4) add an explicit indicator of what trend owning this stock put you in a position of following, and 5) add explicit timing advice so a reader could tell whether this stock was, in my opinion, a bargain now, something to avoid now, or a potential bargain for another day (and a limited number of stocks would get a designation as “core” meaning I recommend holding them through just about any volatility.)
Today–although I may take another day for these changes to show up in the portfolio, I’m removing 12 stocks from this list. They are
in energy Apache (APA), and Ultra Petroleum (UPL)
in mining and commodities Fortescue Metals (FSUMF), Goldcorp (GG), Impala Platinum (IMPUY), Lynas (LYSDY), Thompson Creek Metals (TC)
in banks HSBC (HSBC) and Standard Chartered (SCBFF)
and in emerging markets GOL (GOL), Home Inns and Hotels (HMIN), and Yingli Green Energy (YGE)
Why these drops?
Energy: The collapse of oil prices and the rise of supply from oil shales makes Apache’s expertise in late-stage recovery less valuable. With Ultra Petroleum I feel that Chesapeake Energy (CHK) is a better long-term option on natural gas prices and I’d prefer not to hold two options.
Mining: We’re looking at long-term supply surpluses, tight capital market and stressed balance sheet for a long time
Banks: I think the model of the global bank is less valuable for the next decade
Emerging markets: The growth cycle has changed, becoming a lot less predictable, and while the story of the rise of a big new middle class in developing economies is still powerful, it has more uncertainty than earlier.
Tomorrow I’ll add a few stocks to the portfolio and a short ETF or two plus update at least two existing entries with my timing suggestions.
Why do I want to own Itau Unibanco (ITUB)? The company is a growing regional super bank in Latin America, picking up business as the biggest global banks shed assets. It is also likely to pick up asset market share in Brazil as the country’s big state-owned banks pull back in the current financial and economic crisis. Itau Unibanco owns two of the biggest credit card brands, Hipercard and Itaucard, in Latin America with 58 million accounts in Brazil in a region likely to show above average growth in consumer credit after the turn in Latin American economies. And as the largest private bank in Brazil, I think it is likely to pick up market share as state-affiliated banks cut back in and after this crisis.
Why don’t I want to buy these New York traded ADRS quite yet? Itau Unibanco has a great record in recent years of sticking with high quality assets and that has kept bad debt ratios from climbing even in the current economic plunge, but I don’t care how good your credit controls are a recession or a potential depression just isn’t good for a bank’s balance sheet.
I’m going to keep Itau Unibanco in my 50 Stocks long term portfolio as a long term play on the expansion of credit among a growing middle class in Latin America and on my read on the way that superregional banks like Itau are picking up market share as the biggest global banks sell off assets to meet tougher capital requirements from regulators. (I’d put this in a long-term silo labeled “Rise of global middle class.) But on my new 50 Stocks timing scale I’m going to rate this “Cheap but not cheap enough—Hold. (For more on where the bottom might be in Brazil see my subscription only JubakAM.com post from December 1 http://jubakam.com/2015/12/brazil-could-be-headed-for-an-honest-to-goodness-depression/ On November 13 I wrote that I’d like to buy this around the then bottom of the ADR’s Bollinger Band at $6.46. That means something like another 10% down from the December 1 close at $7.14. That still seems like a good entry to me.
As of November 16, 2015, I’m keeping Vale (VALE) in my long-term 50 Picks portfolio. If you hold the shares of this Brazilian iron ore producer, I’d continue to hold. If you were thinking of buying because the shares look so cheap at $3.93 today, I’d say “Not yet.” I’d look to buy the New York traded ADRs (American Depositary Receipts) at $3.30 or so—about 15% below the 52-week low. (Vale was a member of my 12-18 month Jubak’s Picks portfolio until October 13, 2014. I sold it on that date at $11.47.)
Two reasons to buy (or hold onto) Vale at these prices. First, the iron ore cycle will turn someday as growth in the global economy picks up and as demand/supply come back into balance. Second, Vale is expanding production at its Carajas mine, a project with one of the richest iron ore bodies in the world. Because the iron ore at Carajas is so rich it sells for a premium on world markets and it helps make Vale the low cost iron ore producer in the world. Add in cost reductions, the efficiency of the new truckless operations at Carajas, and China’s recent willingness to accept the extremely big ore carriers that Vale increasingly uses, and Vale has been able to reduce its cost by 15% in the most recent quarter to $34 a metric ton delivered in China. When the market for iron ore does finally turn Vale will be one of the big winners.
But the reasons to hold off on buying are more numerous.
First, the momentum in Brazil’s financial market is still thoroughly lower. ETF iShares MSCI Brazil Capped (EWZ) was down 35.07% year to date for 2015 as of November 13. Vale itself is down 33.6% year to date. Brazilian service and consumer sector leaders Kroton Educacional (KROT3.BZ in Sao Paulo) and Natural Cosmeticos (NATU3.BZ), respectively, are down 56.15% and 42.86% for the year. In the currency market the Brazilian real is the world’s worst performing currency, down 31% in 2015 to date. The country’s debt has been downgraded 4 times since 2014 by Standard & Poor’s, most recently to junk in September.
Second, the country’s economy is a mess. The economy is in recession and the Banco Central Do Brasil projects that GDP will fall by 2.7% in 2015 and by 2.2% for the four quarters ending with the second quarter of 2012. The bank projects inflation of 9.5% for 2015, way above the central bank’s inflation target of 4.5% give or take two percentage points. That forecast is built on the assumption that the Selic benchmark interest rate will be 14.25% during the period.
Third, the country’s politics are so convoluted with President Dilma Rousseff facing six (at last count) impeachment resolutions, that it is unlikely that the Brazilian legislature will tackle the country’s big problems (budget deficit, corruption, a bloated state sector, etc.) anytime soon.
And fourth, although iron ore prices will turn someday, they are still falling and it looks like supply won’t come into balance with demand until 2017 or 2018.
On balance this earns Vale a place in this long-term portfolio on the company’s potential. And a current rating of HOLD CHEAP BUT NOT CHEAP ENOUGH as of November 16, 2015. I’d put Vale in my cyclical commodity, and developing economy silos for its long-term trends.
Why this emerging market crisis might be different–less like a heart attack and more like heart disease
The current meltdown in emerging financial markets and in emerging market economies isn’t like the 1997 Asian financial crisis that smashed economies and stock markets from Indonesia to Thailand to China to Korea, according to Australia’s Macquarie Group, a global investment bank that’s a big commodity and infrastructure investor in developing economies.
Whew! No one wants to relive that period. In that crisis the Thai baht lost 50% of its value and
Thai stocks fell by 75%. Indonesia lost 14% of its GDP.
Unfortunately, according to Macquarie, the fact that the current crisis won’t duplicate the character of the 1997 crisis is the end of the good news. If 1997 was a sharp heart attack, Macquarie notes, today’s crisis is chronic heart disease with a limited chance at a cure and with an extended period of disease punctuated by significant and recurring flare-ups that end short of an actual heart attack. There is, again according to Macquarie, a chance, however, that an escalation of the crisis in one country could turn into a freeze for the entire emerging markets sector.
Some good news, eh?
The problem this time isn’t a lack of reserves to back currencies, as it was in 1997, or unsupported trade deficits. All the Asian countries involved in the 1997 crisis—and other emerging markets such as Brazil—have far larger foreign exchange reserves than they had in 1997.
This time the problems include long-term structural deflation and depressed commodity prices, over-leverage in the private debt market by consumers and companies, massive overcapacity in sector after sector, and a surging dollar. For the countries most burdened by a combination of external debt, current account deficits, structural inefficiencies in markets and financial markets, and exposure to global deflation, the recovery is likely to be much, much slower than from the 1997 crisis. Emerging markets don’t have the option of using leverage to goose growth by consumers. Consumers in the global economy in general and in developing economies in particular are already leveraged and the world’s central banks have already flooded financial markets with cash. That flood of cash, in fact, is one cause of the current crisis and of global deflation.
Macquarie has put together a list of countries least and most affected by this chronic disease—so far. Among the least affected so far, according to Macquarie, are the Philippines, China, Russia, Korea, Taiwan, and Brazil. That list is subject to revision, Macquarie points out with Russia and Brazil, for example, extremely vulnerable to continued low commodity prices. Countries facing the biggest negative impact include India, Indonesia, Mexico, Poland, South Africa, Turkey, and Malaysia.
Now you might differ with Macquarie’s country calls. For my part I think the analysis underplays the political strengths of Mexico and the political chaos of Brazil and Russia (and potentially Turkey.)
But I think the overall point deserves serious thought. We’re used to emerging market crises that are deep but short and that are followed by relatively rapid returns to economic growth rates that far exceed those in the developed world.
I think the case for arguing that the current crisis is different is convincing. I think there is a very good chance that we’re looking at an extended period of under-performance—by historical standards—of developing economies and emerging markets.
How extended might that period be? That’s the wild card here. Nobody knows and any forecast is made doubly difficult by China’s need to radically transform its economy if the country is to escape the classic middle income trap that yawns ahead of developing economies that have climbed out of the ranks of the poor—on a per capita basis—but that haven’t yet joined the ranks of the much wealthier developed economies of the world.
China’s GDP may now be larger than that of the United States (on a purchasing power parity calculation) but China’s per capita GDP was just $7,594 in 2014 while that of the United States was $54,630. Narrowing that gap is going to take serious structure change in the Chinese economy that is likely to be extended and disruptive, if it is possible at all.
This time, this emerging markets crisis, looks like it could indeed be different
And I’m going to use this perspective to begin my revision of my long-term Jubak Picks 50 portfolio tomorrow.