Invest in What You Know: What does democratization of equity investing mean for valuations & performance?
Peter Lynch, the former manager of Fidelity’s Magellan Fund, is perhaps best known for preaching “invest in what you know.” While Lynch ran the Magellan fund for 13 years, compounding at ~29.2% per year, and overseeing an increase in AuM from $18mn to $14.0bn (at one point with “one of every hundred Americans” invested in the fund), it’s this line that defines his legacy & investment philosophy. While the nuance is often lost on most, (Lynch stressed using this as a starting point for investment diligence, and that if you don’t do this professionally either allocate to an active manager, or look to index); the saying today, coupled with increased global access to US equities could help explain current & future stock price performance.
Online broker firms have seen record interest in new accounts & trading activity YTD as the move to zero-commission trading, the market volatility, government shut downs, and lack of sports / other gambling ventures have led to the perfect storm for retail trading. This has resulted in an explosion of brokerage accounts for legacy players & FinTech challengers alike. Based on public reporting & self-disclosed #s / press reports “new-age” FinTech firms have ~1/3 of the total accounts of legacy brokers & if you exclude Fidelity / Vanguard (which have a significant number of retirement accounts) they start to look equal to their predecessors such as Ameritrade, E*Trade, Interactive Brokers, and Schwab.
This explosion in new accounts, coupled with existing trends towards passive management / quant funds, has started to change market microstructure, flow of funds, and likely led to distortions of valuations vs. historical precedents. The combination of the above factors has led to a significant inflow of capital into names that “people know” which include global brands / companies such as Apple, Amazon, Disney, Facebook, Google, Microsoft, Netflix, Nike, and yes even Tesla. For those fans of history, the references of “FANG” or “FANG + M,” offers flashbacks to the “Nifty Fifty” of the 1960s/1970s which were fifty popular large-cap stocks that started to materially re-rate higher from a valuation perspective vs. the broader market; with P/E ratios in excess of 50–60.0x common. At the peak of the Nifty Fifty “bubble” you had companies like McDonald’s trading with >85.0x P/E ratio, with the S&P at a comparable ~19.2x ratio (data via Brooklyn Investor):
As you can see this list included companies like Anheuser-Busch, Avon Products, Bristol-Myers, Coca-Cola, Dow Chemical, Eastman Kodak, Eli Lilly, General Electric, IBM, Johnson & Johnson, McDonald’s, Merck, PepsiCo, Pfizer, Philip Morris, Polaroid, Procter & Gamble, Revlon, Sears, The Walt Disney Company, Walmart, and Xerox. Some of these names performed just fine over the subsequent decades, while many fell out of favor. Just because a company is popular today, with a “global brand” doesn’t mean it will be tomorrow, which is why “investing in what you know” remains an important adage. This allows people to identify stocks such as AAPL, AMZN, LULU, NKE, SBUX, and SHOP sooner than other market participants, or traditional metrics would suggest, while identifying the demise of firms like GPS, JCP, M, and YHOO earlier than most.
When we see portfolio companies launch US equity trading in Emerging Markets (or domestically for that matter) these “global brand” stocks are often the most frequently traded. When you look at reporting from companies such as Robinhood, Square, and eToro these stocks are almost always in the Top 10–25 of most frequently traded & most widely owned. This has led to significant outperformance in many of these names, and more often than not a valuation re-rating from where the stocks traded just 2–3 years ago (outpacing that of the broader indices), but still significantly below the premiums seen within the Nifty Fifty as show below:
We’re not making a call on short-term equity moves, and view some of the recent price action as too far too fast. However, in the intermediate to longer term it is our view, that as there’s greater access to the US equity markets, coupled with less dollars held by active fund managers, this scarcity “premium” may continue to be awarded to globally recognized firms. Even if we’re wrong, at the very least this is a phenomenon worth watching as international markets continue to open up, and retail brokerage accounts increase towards historic highs domestically.
Democratization of Equity Investing
Firms like Robinhood, eToro, Acorns, Stash, and Square Cash have all in some way shape or form sought to democratize access to US equity markets. This has been part of a slow evolution from the mid-1970s to where now the majority of Americans who want to have access to US equities can do so in both a fractional and “zero-commission” world. Robinhood was founded in April of 2013, with a mission to enable “Investing for Everyone” by bringing a zero-commission brokerage account to market. They pioneered the first real innovation in brokerage since firms like eTrade offered their services online in the early 1990s, and prior to that the SEC allowed for negotiated commission rates in 1975 which led the birth of the original discount brokers like Charles Schwab, and First Omaha Securities (later Ameritrade), This led to the next iteration of innovation which enabled fractional equity investing initially at firms like Stash, at first domestically, and now internationally. You have firms like APEX, Alpaca, and DriveWealth which are now powering this phenomenon for FinTech companies in the US & abroad, which enable “anyone” to offer clients exposure to fractional US equities.
What does this mean for valuations? As these FinTech firms & legacy brokers exhibit record user growth (above), the question is what are they investing in? Robintrack offers a view into the number of Robinhood accounts that hold a given security. It’s not surprising that names like DIS, APPL, MSFT, TSLA, AMZN are all in the Top 15 with names like SNAP, UBER, FB, TWTR, NFLX, SBUX, KO, F, all in the top 50. These are all companies and brands people know and interact with on a daily basis.
DIS (#4)- DIS is the 4th most popular holding on Robinhood.
AAPL (#6)- AAPL is the 6th most popular holding on Robinhood
MSFT (#7)- MSFT is the 7th most popular holding on Robinhood
TSLA (#9)- TSLA is the 9th most popular holding on Robinhood
AMZN (#13)- AMZN is the 13th most popular holding on Robinhood.
It’s interesting to highlight the difference in activity amongst some of these popular names for those firms that enable fractional equity trading / put that front & center and those that don’t. When it’s a core part of the product offering trading volume in names such as AMZN, TSLA, and GOOGL tends to be higher as they view this as “less expensive.” However, when fractional equity investing isn’t enabled you see more activity in names like SNAP, UBER, TWTR, with “lower notional dollar requirements.” While there has been a plethora of academic research to suggest stock splits shouldn’t have an impact on price, real world results have varied based on a number of key criteria. We think companies like AMZN, GOOGL, and TSLA will shortly have bankers pitching them splits, as the next “leg” of price appreciation.
Square Cash prominently displays the “Most Traded” Monthly stocks where the Top 10 over the trailing 30 days (and very representative of the Top 10 since they launched the product) include those same names such as TSLA, AMZN, AAPL, BA, MSFT, FB, NVDA, BABA, NFLX, & GOOGL.
Payment for Order Flow (“PFOF”):
There was a big stink when Robinhood recently filed a “Rule 606A & 607 Disclosure Report which is the- Held NMS Stocks & Options Order Routing Public Report, aka “Payment for Order Flow” report. This showed that in 1Q20 the firm earned $90.9mn thru selling order flow to firms like Citadel, Two Sigma, Virtu, and Wolverine Securities, across S&P 500 Stocks, Non-S&P 500 Stocks, and Options.
When firms went to a zero commission model one of the key ways to monetize retail trading was through Payment for Order Flow. There was a Quartz article published late last month, that detailed retail trading’s impact on the stock market & highlighted this trend in the below chart (we note that despite the title this looks to exclude option volume):
What does this mean practically? As retail investors continue to transact in the aforementioned stocks these high frequency trading firms are often on the other side of that trade. This means they have developed market making strategies around these tickers as they sit in between retail investors on one side & institutional participants on the other. All of this leads to elevated volume which has implications for a variety of factor investing, momentum, and other quant strategies. Retail investors tend to be much more price agnostic than institutional investors, with some of these platforms (E.g., Square Cash) quoting a “fixed price” which is often times penny’s above the offer. That leaves significant room for HFT firms to monetize this flow. Based on the Robinhood data you can see a real explosion in March in payment for option flow which was more than all PFOF in February. The options market has even more inefficiency, which leads to greater arbitrage opportunities for these HFT firms, and as a result they are willing to pay up for it.
Quant Funds vs. Passive vs. Active:
Post the Global Financial Crisis public markets have been bifurcated into two main camps: Passive & Quant, with little room for long-term active management. The L/S HF industry has been decimated with underperformance post GFC as QE Infinity & Beyond has dampened volatility and market breadth has narrowed; if you weren’t in the top 10 names you underperformed.
There have been significant outflows in active management into Passive over the last 10+ years. Ark Invest highlights this in their case for innovation noting that innovation investors have largely crowded into the private markets. Their data from 2008–2018 (based on Morningstar & Preqin) showed $6.8bn of withdrawals from active over that time, with $3.5 Trillion of inflows into Passive vehicles. While this data is slightly dated as we sit here in 3Q20 the trend has only accelerated with prominent funds continuing to shut down & return outside capital (e.g. Appaloosa, Omega, Moore Capital, and Paulson).
As more money flows into passive funds, and within active management quant funds and away from L/S managers the process of price discovery in the short-to-intermediate term becomes slightly more complex. There are a variety of factor strategies, and quant strategies that take advantage of price movement, momentum, volume, recent return data, etc… all of which are being impacted on the margin by retail activity. As a variety of passive funds are market-cap driven this results in a virtuous cycle where retail investors trade stocks, the flow is paid for both HFT firms, who create even more volume, leading to activity from quant funds, outperformance and up weights in passive indices, and the cycle continues.
In our recent piece Emerging Market FinTech, we highlighted Brokerage Functionality as a key area of interest for us. We pointed to companies such as Flink in Mexico, Toro in Brazil, Bamboo in Nigeria, and more recently GoTrade (formerly TradeID) in SE Asia, while noting global players such as eToro. As international market participants open up access to US equities they immediately gravitate to these same names that they “know” such as Facebook, Amazon, Apple, Netflix, Google, Microsoft, and still yes, Tesla.
Interestingly enough nearly everything we’ve discussed above could be viewed in the lens of “momentum investing.” We could say that retail investors are in fact momentum traders, and this is one big correlation not causation event. The reason why these stocks are the most commonly traded on brokerage platforms is by & large they’ve been some of the top performing and retail investors chase performance. We feel this EM data is particularly relevant here, to support the thesis that retail investors are “investing in what they know.”
The Quartz Article cited above quotes DriveWealth’s CEO Bob Cortright. DriveWealth powers trading for companies like Square Cash, Monzo, and Revolut so Bob is definitely a subject-matter expert. He notes that this retail trend has been building up for the better part of a decade.
“For Cortright, one of the keys to the retail trading bonanza is the proliferation of more than 2.5 billion smartphones around the globe. That, combined with the rise of electronic markets and growing wealth in emerging economies, means an even bigger wave of retail trading could be building up. As digital wallets like INDmoney in India or Australian brokerage app Stake become popular, Cortright thinks “globalized investing” is taking root.
The US stock market will benefit from this overseas investment money. American brands are well known around the world, and the US equity market is the deepest and most liquid in the world. Cortright said his company is adding around 100,000 new brokerage accounts each week, and about 45% of those are outside the US.
He also thinks the advent of “fractional trading” has been underestimated. Thanks to fractional trading, you don’t need to buy an entire share of Google, which costs about $1,400. Instead you can buy a tiny sliver of the stock, making it much more affordable for new investors to get started. “We’re in the early innings,” he said. “It’s going to continue to grow rapidly over the next five years.”
If we truly are in the early innings of this trend, which will see significant growth over the next 5+ years, what stocks are the 1.2 billion people in Africa, 650 million people in SE Asia, or 640 million people in LatAM going to buy? Will they search for “value” stocks such as Tobacco, Regional Financials, or Energy? Or will they invest in “what they know” including “FANG + M,” DIS, NKE, TSLA, etc….
Valuation of Assets:
If we look at P/E expansion of some of these “global brands” this tells part of the story of increased ownership:
MSFT: P/E went from <10 when Robinhood launched to 35.5x today. That coincided with Sataya Nadella taking over for Steve Ballmer as CEO in 2014 and Azure going from $1.0bn run-rate business in 2015 to $20.0bn+ today. While part of this is driven by growth in cloud, and broader business mix / shift (e.g., MSFT Teams), even the mention of “FANG + M” now suggests broader ownership is partially responsible for this multiple expansion, particularly YTD.
DIS: DIS saw its P/E ratio increase from ~13.5x to 40.0x. This is in part due to the market “looking through” 2020E / early 2021E and potential COVID-19 disruptions. But even prior to the pandemic you saw an expansion by ~5–10 turns. The launch of DIS+ and recurring revenue associated with it, drove this in part, but DIS is particularly interesting as it pertains to retail ownership due to the relative underperformance vs. the broader market.
GOOGL: GOOGL has seen its P/E ratio expand from 16–32.0x; over that time Google Cloud has gone from a $200mn run-rate business to a $7.0bn run-rate business +35x, including +80% YoY.
Lack of Alternatives:
In our piece entitled This Time It’s Different: Maybe? we note that you cannot look at equity valuation multiples in a vacuum without considering interest rates. If you take a look at the equity risk premium (“ERP”) the 2010s had the highest ERP on record due to artificially low interest rates. This lowers the discount rate used by investor (higher discounted PV of future cash flows) which is immediately worth a few turns of multiple expansion itself. We also discuss the deflationary nature of technology & corresponding margin expansion that has resulted. All of this supports higher valuations for these assets but also boils down the sheer lack of alternatives for capital allocators.
There are few companies that have the financial performance, balance sheet strength, and visibility that these firms have. Given the equity performance they have the ability to create “bullet-proof” balance sheets, invest heavily in R&D, and have the benefit of ignoring quarterly results as the market continues to reward them.
Sports as a “Scare Asset” Parallel
In the 1st Century BC, Publilius Syrus wrote: “Something is only worth what someone is willing to pay for it”. Over thousands of years with advancements in accounting, technology, creation of valuation ratios, and multiples, at its core this simple principle holds more true than any other investment philosophy; perhaps there is no greater embodiment of this than professional sport teams.
As of the last “Forbes Valuation” the “Big 4” Sports Leagues have an aggregate $220.2 billion of value. There are less than 450 people in the world that have direct ownership of a professional sports franchise (excluding those that are publicly traded).
When these assets are sold there is an often a change of control premium in excess of 25–35% versus the prior year’s “Forbes estimate,” with the magnitude of the premium dictated by team history, MSA, Media Rights, Stadium Ownership, and somewhere down towards the bottom of the checklist quality of the team.
The Mets are the most recent team on the bidding block, and their sale marks the first time a New York Franchise in the Big 3 will have a complete auction since the 1980s. They lose ~$100mn/year today but the purchase price is expected to fetch upwards of $2.0bn. Why is it that people are now paying billions of dollars for professional sports teams that have at most a few hundred million in revenue, many of which struggle to break-even? There’s a significant scarcity premium as there are only 92 teams in the Big 3 (NFL, NBA, MLB) and 123 teams in the Big 4 (31 in the NHL until Seattle comes next season). With a finite number of buyers, and an even more finite number of teams, some of the wealthiest people on the planet have viewed this as an attractive area to deploy billions of dollars despite the illiquid nature of the investment.
Whether it’s a professional sport team, or the first time 650mn people in SE Asia can access any global equity market without exorbitant fees or high minimums, there is “scarcity value” associated with certain assets. Those assets that have a global appeal may in fact trade at a higher valuation vs. historical precedents and vs. the market at large. As these trends look to accelerate over the next couple of years, breadth ownership, trading volume, and multiple re-ratings will all be important to watch. This is not to say these stocks are infallible and are buy & holds forever; before we know it, GPT-3 could create the next great search engine usurping GOOGL (we doubt this happens anytime soon and believe quantum computing will be required given computational paradigm more than actual power). However, if you’re following these companies in your day-to-day life the inflection points are usually pretty evident, at least before it’s too late and the “passive” funds figure it out.
As we think about holistic portfolio construction we’ve made the case to own “Central Nervous System” Cloud Stocks & believe these “Global Brands” also deserve an allocation as they can start to look like the modern day Buffett “moat” business, due to their competitive advantage as it pertains to capital allocation and investing in R&D, as the stock market continues to reward them regardless of quarterly results.