Investor Essentials Daily

Today’s fund uses a seventy-year-old theory to unlock value for investors

August 7, 2020

Modern Portfolio Theory has shaped understanding of asset allocation, due to its division of risk into idiosyncratic and systematic buckets. Through diversification, idiosyncratic risk and variance can be reduced.

However, some investors look to take advantage of systemic risk within individual market sectors to beat average market returns. Today’s fund leverages the properties of one market sector to produce impressive returns.

In addition to examining the portfolio, we’re including a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.

Investor Essentials Daily:
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“All of life is the management of risk, not its elimination” —Walter Wriston

One of the base concepts any finance student will learn is the idea of portfolio theory. Modern Portfolio Theory was pioneered by Harry Markowitz, who published his ideas in 1952. These ideas later won him a Nobel Prize. Despite being almost seventy years old, Modern Portfolio Theory informs how most investors think about diversification and risk.

The staying power of the Modern Portfolio Theory revolves around how Markowitz addressed minimizing risk through the stock selection process. The key is understanding the difference between idiosyncratic risk and market risk, which have vastly different implications for investors.

Idiosyncratic, or unsystematic risk, is the inherent variance in investing into any one individual investment. For example, the BP oil spill in 2010 had a huge impact on British Petroleum. And yet, this event did not impact other oil stocks in the long term.

Meanwhile, market risk, or systematic risk, is the possibility of a market-wide event depressing valuations. An example of systematic risk in the oil industry would be how this year, the price of oil has plummeted, negatively impacting the entire industry.

Many amateur investors think only about idiosyncratic risk and neglect to consider market risk. By focusing on what stocks they should buy on an individual basis, they will neglect how to best choose a level of variance they are comfortable with. Modern Portfolio Theory shows the power of combining stocks to work together.

We’ve heard many people say different numbers to fully diversify idiosyncratic portfolio risk. The people we most respect tend to think it’s somewhere between thirty and fifty names. However, this diversification does not eliminate any market risk, which accounts for more than 20% of any individual stock’s performance. By understanding the difference between these two risks, investors can make intelligent decisions with how to leverage their funds.

By thinking about stock selection as a piece of a larger portfolio, variance can be reduced by eliminating idiosyncratic risk. Furthermore, by investing in stocks across different industries, variance in sector performance can also be eliminated, improving an investors risk adjusted return.

However, what if a fund was looking not to eliminate variance, but embrace it?

Some investors are looking to take advantage of different sectors’ performance to beat average returns. While this increases a portfolio’s variance, if an investor believes a particular sector will do better than average, greater exposure to this industry will lead to greater returns, as a large amount of a stock’s return is tied to its sector.

For example, real estate investors love to find the cheapest home in an up-and-coming neighborhood. As the neighborhood becomes renovated and improved, overall property values rise. This home will go up in value due to its surroundings.

For a fund which embraces sector variance, managers need to worry less about choosing individual stocks to outperform the market. Rather, a rising tide can lift all ships within the correctly identified sector.

This week, we have identified a fund who has leveraged Modern Portfolio Theory to maximize its variance, rather than eliminate it.

This fund has seen impressive performance over the past few years because it has correctly focused on the tech sector, a segment of the market which has historically overperformed.

This fund, Altimeter Capital Management, has no affiliation with our individual investor offerings at Altimetry. However, it is crucial to use Uniform Accounting when analyzing this fund’s current holdings.

Using only as-reported metrics, it would appear Altimeter Capital Management is taking on excess variance to attempt to beat market returns. In reality, these names are significant players in their booming industries.

See for yourself below.

Using as-reported accounting, investors would think Altimeter Capital is arbitrarily picking stocks within the tech sector.

On an as-reported basis, many of these companies are poor performers with returns at 0% or below, with the average as-reported return on assets (ROA) right around -0.2%.

In reality, the average company in the index displays an impressive average Uniform ROA at 42%.

Once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see the underlying strength of Altimeter Capital’s picks within the tech industry.

Once the distortions from as-reported accounting are removed, we can see that salesforce.com (CRM) does not have negligible return of 1%, but a sizable ROA of 21%.

Similarly, Alibaba Group’s (BABA) ROA is really 136%, not at 5%. While as-reported metrics are portraying the company as a business below cost of capital, Uniform Accounting shows the company’s truly robust operations.

Booking Holdings (BKNG) is another great example of as-reported metrics mis-representing the company’s profitability. Booking Holdings doesn’t have a 15% ROA, it is actually at 412%!

The list goes on from there, for names ranging from Microsoft (MSFT) and Peloton (PTON), to Facebook (FB), ServiceNow (NOW), and SkyWest (SKYW).

If investors were to only look at as-reported metrics, they would assume Altimeter Capital has simply thrown away Modern Portfolio Theory to embrace low-return businesses. Rather, the fund is making smart investments to compound returns.

Now, let us see how these firm’s returns can strengthen over time through EPS growth.

This chart shows three interesting data points:

  1. The 2-year Uniform EPS growth represents what Uniform earnings growth is forecast to be over the next two years. The EPS number used is the value of when we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework.
  2. The market expected Uniform EPS growth is what the market thinks Uniform earnings growth is going to be for the next two years. Here, we show by how much the company needs to grow Uniform earnings in the next 2 years to justify the current stock price of the company. If you’ve been reading our daily analyses and reports for a while, you’ll be familiar with the term embedded expectations. This is the market’s embedded expectations for Uniform earnings growth.
  3. The Uniform EPS growth spread is the spread between how much the company’s Uniform earnings could grow if the Uniform earnings estimates are right, and what the market expects Uniform earnings growth to be.

The average company in the US is forecast to have 5% annual Uniform Accounting earnings growth over the next 2 years. As a large number of these tech firms are large-cap stocks, it is no surprise Altimeter Capital’s estimated EPS growth at 4%, near market averages.

What is surprising however, is the market is pricing these companies for a huge EPS contraction, at -89% a year. This huge gap between market expectations and analyst predictions shows how Altimeter Capital looks to pick stocks with high EPS growth potential.

One example of a company with high growth potential is Okta (OKTA). While the market expects Okta to shrink by 399% over the next two years, analysts forecast the firm to see a 40% growth over the same period.

Another company with similar dislocations is MongoDB (MDB). The company is forecast for Uniform EPS to grow by 59% a year, and the market is expecting the company to in fact shrink by 306%.

Yet another example is Carvana (CVNA). The company is cheap, as it is priced for a 231% contraction in Uniform earnings, but the company is forecast to in fact grow their EPS by 71% in the next two years.

That being said, there are some companies that are forecast to have earnings growth less than market expectations. For these companies, like salesforce.com (CRM), Expedia Group (EXPE), and ServiceNow (NOW), the market has growth expectations in excess of analysts’ predictions.

In conclusion, investors often disregard the difference between idiosyncratic risk and market risk when constructing their portfolios. However, a firm grasp of Modern Portfolio Theory allows investors to control for variance. By maximizing its exposure to a strong sector, Altimeter Capital has managed to create value for investors with smart picks, seen with Uniform Accounting.

SUMMARY and Facebook, Inc. Tearsheet

As Altimeter Capital’s largest individual stock holding, we’re highlighting Facebook, Inc.’s tearsheet today.

As the Uniform Accounting tearsheet for Facebook highlights, the Uniform P/E trades at 30.7x, which is above corporate average valuation levels and its historical average valuations.

High P/Es require high EPS growth to sustain them. In the case of Facebook, the company has recently shown a 2% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Facebook’s Wall Street analyst-driven forecast is a 3% shrinkage into 2020, and a 20% growth into 2021.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Facebook’s $254 stock price. These are often referred to as market embedded expectations.

In order to justify current stock prices, the company would need to have Uniform earnings grow by 10% each year over the next three years. What Wall Street analysts expect for Facebook’s earnings growth is above what the current stock market valuation requires in 2021.

Furthermore, the company’s earning power is 6x the corporate average. Also, cash flows are 5x their total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low credit risk and dividend risk.

To conclude, Facebook’s Uniform earnings growth is above peer averages in 2020. Therefore, as is warranted, the company is trading above average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research