The Ingham Analytics Weekly Letter on Sunday - 31 January 2021

Sunday, 31 January 2021

Welcome to our Ingham Analytics Weekly Letter on Sunday where we take a step back to see wood for trees, in South Africa and around the world - not too seriously, there is enough of that about. 

Cabin fever is the theme for us this Sunday. That is, when it comes to the psychosis that is stock market behaviour in the US. Markets in America have come to resemble gigantic casinos, with crazed addicts at the poker tables. 

With cinemas closed (which is why AMC and Regal are on life support), shelter-in-place in an on-and-off mode for months, stimulus cheques burning a hole in pockets, and maybe boredom setting in with streaming services, having binged through the repertoire of titles, many thousands of punters seem to find equity markets a perfect distraction. The ubiquity and, often, anonymity of social media feeds this. 

This stock market environment is unfathomable to those schooled on "The Intelligent Investor" and "Security Analysis" by Benjamin Graham but if you have dipped in to "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay and "Liar's Poker" by Michael Lewis you'll get the drift. 

What is interesting about the book by Mr Mackay is that it was published in 1841, making the author a contemporary of Charles Dickens, but human psychology hasn't changed one jot despite our pretensions as a species to be evolved and rational. 

Universities, business schools and professional associations have any number of tomes and scholarly lectures on how to value something. Professors make careers out of it. Investment banks, fund management firms and family offices employ only the best and brightest to be analysts, poring over financial statements, modelling scenarios, assessing management of companies, doing peer comparisons, and so forth. 

All this science and logic often gets trampled in the herd with the emotions of fear and greed triumphing. In a Letter on Sunday dated 4 October last year we concluded that a medical qualification in psychiatry may probably be better suited to running funds and trading securities than a degree in finance, with the advantage of being able to go back to private practice if the sheer madness finally gets to you.

Speculation is at fever pitch in certain quarters and certain stocks. What was hilarious for us this week was how popular the World Wide Robin Hood Society based in Sherwood, Nottingham had become. On Thursday it had 400 Twitter followers, by Friday it was 40,000 followers. Meantime, the other Robinhood (in one word with no surname) which is a controversial online trading platform for trading in shares, often highly leveraged, had to tap into credit lines as it was unable to meet deposit requirements. 

By the end of this week short sellers on US shares had lost a combined $70bn this year according to data firm Ortex. There are already rumblings of systemic risks, closures or bankruptcies. This week hedge fund Melvin Capital needed a $2.75 billion cash infusion. 

This truly is a gamma squeeze and short sellers with (literally) short memories because they haven't been around the block a few times are having a painful tuition, this isn't a one-way street to profits on troubled or overvalued securities. 

The above situation is exemplified in a tale of polar opposites and how fundamentals sometimes don't get a look in. 

Several months ago, we assessed a company called Activision Blizzard, a video gaming company based in California whose roots go back to 1979. For the year ended December 2020 we estimate Activision Blizzard will make $7.7bn in revenue, a decent margin, generate free cash flow (operating cash less capex), and have net cash on its balance sheet of $4bn. It therefore makes real money and has a strong balance sheet. The stock price has had its ups and downs but today can be bought on a reasonable multiple. It even paid a dividend last year. 

A small games business called GameStop, based in Texas, came across our radar when assessing Activision Blizzard. GameStop isn't without prospects, but it did not take us long to conclude - stay away. Declining footprint and sales, losses, negative free cash flow and shareholder equity that had fallen to $600m from over $2bn and which as of 31 October 2020 had declined further to $332m, which is $5 per share. As recently as 11 January GameStop reported a sales decline of 3% for the nine-week period ended 2 January, despite a rise in e-commerce sales. 

Now, you'd have thought Exhibit A would be the one getting rational investors attention and even putting the folding stuff into it. Not a bit of it. Exhibit B is all the rage. 

Off a shareholder equity base of around $300m and falling by the quarter, a nine-month loss of $296m (it was a loss of $492m for the comparative period in 2019) GameStop at one point this week had a market capitalisation of $24bn. That means punters were paying 72x NAV of $5 per share for a lossmaking business with declining sales. 

Activision Blizzard has a market cap of $70bn, for which you're getting a profitable, cash flush and growing business that has stood the test of time for 4.8x net asset value per share of $18.70. The company helpfully puts an Excel financial model on the investor relations section of their website so geek analysts can access a detailed financial statement history with segment disclosure and use that as a basis to then make their own forward-looking assumptions. 

Exhibit A has a mere 1.1% of shares outstanding that are shorted. That is also an indication that short sellers see little to profit from in Activision Blizzard. Tesla, a short seller favourite for years, at one point had over 20% of its stock outstanding on loan and we thought that was rather high. The figure has since dwindled to 7.5% as short sellers have lost a ton of money on the bet. GameStop this week had an insane 140% of its shares shorted. 

Another metric we keep tabs on is how often, based on daily volume of shares traded, does a company cycle its share register. 

For Activision Blizzard, average daily trade is such that the company turns over its share register every 112 days, not an unreasonable figure. The same figure for Tesla is 20 days, which is high but then Tesla attracts adherents and detractors in equal measure. Apple as an example turns its register over every 150 days and for Berkshire Hathaway B shares it is 250 days. 

Volumes of shares traded in GameStop are now so frenzied that the public float of shares turns over in less than two days. That is unheard of and abnormal. 

The takeaway for us is that punters probably aren't fussed about business fundamentals and they aren't necessarily in GameStop for how many games its going to sell or because they reckon it's got good management. They are in it as a temporary, volatile play that is also given a temporary lift from short sellers forced to short cover. This is an extreme speculative trade and that doesn't necessarily make it wrong or indeed that it should be outlawed by regulators. But that is exactly what it is, speculation and not investing; it creates no value and probably even detracts from value. It can also lead to outsized losses in what is ultimately a zero-sum game. 

This week we issued an Equity and Credit Markets note entitled "Elevator to the stratosphere?" which gives further colour on what is happening in US markets. A fun fact is that the market value of US stocks is now 185% of GDP, a record high which means the value of stocks exceeds GDP by a whopping $18 trillion. The ratio of total market value to after-tax profits is at multi-year highs. 

In the note we say that investors seem to be betting on is a brisk recovery in earnings of US listed companies. The question is will this happen? 

Markets are forward looking but have no particular prescience as they reflect the collective view of thousands of participants who individually cannot predict the future but have a view. With earnings season underway in the US there are encouraging signs. General Electric and Microsoft, at different ends of the business spectrum, are two examples. Yet with COVID-19 a daily reality one must temper exuberance. Vaccines too aren't a magic bullet to normality. 

We also point out that short-term, out-of-the-money call options have been soaring with puts lagging well behind calls. This has been largely driven by retail punters although as we've seen in 2020 hedge funds and other institutional investors haven't been above slurping at the punch bowl. There are implications here right through the chain. Warning signs are flashing all over and our discussion in this Letter points to that. 

To end off with, seasoned trader Andrew Kinsey will shortly be bringing an eLearning offering to the platform. This will be through interactive seminars and through video modules. For a fee, investors will be able to access practical tools to assist them making better judgement calls. 

Andrew has few equals in his field, and you won't find a better teacher. His expertise is sought globally, including by central banks and commercial banks. He has traded foreign exchange, fixed income and equities and is experienced too in derivatives and risk. Andrew is an expert in financial derivatives and the evolving regulatory architecture. 

Robbing from the rich to give to the poor, Robin Hood is our newsworthy deal of the week.