I’m a big fan of George Soros and his theory of reflexivity. I thought it would be interesting to explore some of the themes within it and, expand upon them in order to see how it might manifest itself into specific investments. Before engaging in this, here's a quick primer on what my take is on Soros’ reflexivity theory and, a key issue within it.
Essentially, Soros’ idea is that positive feedback loops are created between prices and fundamentals which ultimately then lead to a collapse whereby negative loops are created the other way. Whilst all of this is well known, it does contain one critical element in the process, which many investors find counter intuitive and hard to digest. In fact it is such an unpalatable idea that it is frequently forgotten in the discussion. I speak of the fact that prices change the fundamentals. This sounds reasonable, so why am I arguing that many investors find this idea contentious and uncomfortable?
The problem is that when prices start surging in an industry, as in say housing, it attracts interest and investment, which then creates earnings, which feeds back into price rises, etc. The key thing here to understand is that whilst this bubble is forming, the price to earnings ratio may in fact be stable or even in decline. In other words, the fundamentals are starting to look better at precisely the moment when there is a collapse about to burst. It is the classic cyclical value trap.
This should be fine as long as investors understand what is and isn’t cyclical. Unfortunately, I am becoming increasingly convinced that the term ‘cyclical’ is one that should be used very loosely and with great flexibility. Especially, when that ‘cyclicality’ is actually referring to the ebb and flow of sentiment, which is then exacerbated by the feedback loops expressed in the reflexivity theory.
The conclusion of all of this -which I accept will make many investors feel uncomfortable- is that relying heavily on a fundamental evaluation such as the PE ratio or dividend yield, isn’t a universal panacea. On the contrary, on occasion, it can be rather dangerous. I would take the argument further and argue that the earnings multiple expansions and contractions are also guided by sentiment rather than purely fundamentals.
It’s time for a few examples.
General Electric, a GDP+ Play or a Financial Services Company?
For years and, particularly under Jack Welch, General Electric $GE was seen as the archetypal global GDP+ type stock. Its mix of long and short cycle industries was seen as a proxy for global growth. In fact, GE is so big that its revenue used to equate to 1% of US GDP. Moreover, its prospects were usually gauged in terms of how much more than GDP could it generate income growth? Its management were judged by their ability to achieve this. In terms of evaluation, an investor needed look at GDP growth and, then pencil in earnings estimates based on that.
Of course, it didn’t quite work out like that in recent years! Here is the reality of GE’s last five years.
In actuality, it is GE Capital that has guided the share price and, arguably, it is trading more like a financial services stock. The industrial segment has been pretty steady over the last five years and, last year’s industrial revenues were higher than in 2007.
The point here is that just looking at GE’s PE ratio would not have told you much about future prospects. What did matter was predicting the bust in the financial services industry. An altogether harder enterprise.
Cisco Systems and Goldman Sachs, When Investors Fall In and Out of Love
Consider Cisco Systems $CSCO. This stock was the former darling of the ‘dotcom’ boom. Telcos and ISPs flocked to invest in next generation networks. This caused earnings to rise for companies like Cisco. The spike in earnings and interest in the sector caused more investment and, then ultimately the inevitable bust came.
A classic example being the vast sums paid for 3G licenses at the start of the ‘naughties’ decade. Huge capital investments were made in networks and infrastructure without sufficient consideration as to the fact that the technology behind the terminals (mobile phones, laptops etc) was nowhere near ready to encourage the requisite broadband capacity utilization. However, Cisco was a key beneficiary of the boom and, investors loved the stock. Indeed, its 100+ PE ratios are now the stuff of legend.
Cut forward to 2005 and, now, investor sentiment is badly damaged with Cisco. No one wants to hear about internet stocks anymore. Cisco enters 2005 on a PE in the mid twenties. It leaves 2007 on a very similar evaluation. Investors are not attaching a premium to Cisco anymore. However, in that time Cisco’s stock price went up 47% and, was 79% higher at one point. The point is that, at this time, Cisco did not see PE multiple expansion because sentiment remained against the sector.
However, whilst technology was out of favor in the aftermath of the dotcom bust, another sector was all the rage. I’m speaking of housing and financial services. The Federal Reserve lowered interest rates and the US embarked on a housing boom accompanied with the reckless expansion of investment banks balance sheets via structured investment vehicles. The consequences of which are plain to see today.
Goldman Sachs $GS share price soared, in fact, it more than doubled from 2004-07. The company’s activities should be well known by now, but I want to focus on the fact that throughout 2007, its earnings multiple fell. The stock had a wild ride that year. The fact was that the housing bust had already happened and investors were shying away from financials. The multiple and current earnings didn’t matter so much, as did its positioning within the boom and bust.
What Next for this Analysis?
Of course, all of this hindsight analysis is wonderful, but it’s always interesting to get opinions on what might work in future. Frankly, I like some housing related stocks.
Despite the strong rise in the price over the last six months, I look at Home Depot $HD and, see a stock trading on 20x current earnings and a free cash flow yield of over 7%. Analysts have EPS expansions of 17% and 12.8% for the next two years respectively and, this is with housing affordability being at historic lows. Similarly, Lowe’s Companies $LOW trades on similar current multiples to Home Depot. In addition, it offers 12% and 22% earnings growth, if analyst forecasts turn out to be correct.
Whilst I appreciate that ,there are still significant numbers of foreclosed properties in the system, the fact is that new housing construction has not kept pace with new household formulation over the last two years. So despite, sentiment being negative towards housing, if the best that Home Depot or Lowes’s can do is retain their respective multiples and ‘do their earnings’ then we are set for mid teens returns for the next few years. That would be fine with me!
US Housing has had its boom and bust, and I doubt it will come back again for a while. In my opinion, the future fundamentals will be affected by the underlying supply and demand and, not the result of speculative fervor. No matter, the earnings growth for these two companies could allow for some decent gains in the next few years.
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