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Excessive unproductive liquidity causes irrational speculation in stock markets

Asia Analytica
Asia Analytica • 8 min read
Excessive unproductive liquidity causes irrational speculation in stock markets
The reality is that, while earnings and cash flow determine stock prices in the long run, short-term prices are driven by demand and supply.
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(July 17): This market rally is, without a doubt, driven by massive amounts of liquidity, created by major central banks of the world in an effort to limit the fallout from the Covid-19 pandemic. To many, the strong global stock market recovery from the lows in March and subsequent resilience appear disconnected from the dismal economic data and corporate earnings. After all, the price of a stock is supposed to reflect its underlying intrinsic value, which is the discounted future cashflow stream, plus a layer of premium for risks and liquidity. By this measure, many of the best-performing stocks are trading at irrational valuations.

The reality is that, while earnings and cash flow determine stock prices in the long run, short-term prices are driven by demand and supply. Investor demand is, in turn, driven by prevailing storylines.

In other words, the seemingly irrational stock prices we see today reflect the chase for the hottest trends — be it fad, hype, buzz or, yes, even blind faith — rather than staid old business models, sustainable competitive advantage, balance sheets and profit margins.

There is no better example than Tesla’s epic rally over the past one year, where its share price rose nearly sixfold. The electric carmaker reported delivery numbers for 1H2020 that beat market estimates, further spurring optimism on already very lofty expectations.

Tesla’s market capitalisation surged to more than US$280 billion ($390 billion) (at the point of writing), making it the world’s most valuable automaker by far — overtaking Toyota Motor Corp, whose market cap stands at less than US$177 billion (excluding treasury shares).

This is a company that has yet to report a full-year profit, though it was profitable in the last three straight quarters. Tesla delivered 88,400 and 90,650 vehicles in 1Q2020 and 2Q2020 respectively, and a total of 367,500 cars in 2019. The company has two factories, in California and Shanghai, with total production capacity of about 750,000.

By comparison, Toyota sold 10½ million vehicles in 2019 and 3.4 million in the first five months of 2020. It is consistently profitable, reporting net profit of more than US$19 billion in the latest financial year ended March 2020, and has an established network of factories-dealerships worldwide.

Yes, electric vehicles will dominate the future car market. And Tesla cars are highly sought after by tech enthusiasts and arguably the most popular brand of electric car today. Nevertheless, Tesla is still very much a niche producer with a string of execution problems in the past. It remains to be seen whether the company can scale up to cater to mass-market demand.

Do investors truly believe that it can challenge, let alone overtake, Toyota’s global market share in the foreseeable future? Or are investors just that enamoured of the hype surrounding its charismatic, and controversial, CEO? Incidentally, Elon Musk has 36.7 million followers on Twitter.

Even with first-mover advantage — a head start on software technology, data amassed from its artificial intelligence (AI)-assisted driving system and a Supercharger network that currently has 1,971 stations, mostly in the US — and no legacy (internal combustion engines) burden, competition from all carmakers in the electric vehicles space will be fierce. Case in point: An unprecedented number of models are slated for launch over the coming year.

Some have argued that Tesla is really a tech stock, not an automaker. Tech players are disruptors of industries and will win market share from the incumbents in a future digital economy. They should, therefore, as the argument goes, not be measured using stringent, traditional investing metrics. The result is a yawning valuation gap between these perceived tech-driven new economy disruptors and existing industry giants.

We have our doubts. Tesla’s competitive advantage may not be an enduring one. Its marginal cost is certainly not going to zero, though the business does have some network effects. But Tesla, at least, is already selling cars commercially.

Nikola Corp, which designs fuel cell and battery electric trucks, is yet another hot stock in the electric vehicle space that has created waves in the stock market. It has unveiled big plans but manufactured exactly zero vehicles so far. That has not stopped its market cap from surging to as high as US$34 billion since its debut on Nasdaq in June. For perspective, Ford Motor Co, which produced the world’s first mass affordable car, the Model T, in 1908, currently has a market cap of just about US$25 billion.

Nikola’s share price is being driven purely by a compelling story — the promise of clean technology and a greener future.

Perhaps the market is simply enamoured of the “shiny, new thing”. That said, while irrational valuations are most prevalent in the tech sector, they are not exclusively so.

Malaysia’s glove maker stocks are one such example. With the Covid-19 pandemic still raging through many parts of the world, demand for gloves has soared. Not surprisingly, so have valuations for glove makers. The three largest glove makers, Top Glove Corp, Hartalega Holdings and Supermax Corp, are currently trading at between 97 and 144 times trailing 12-month earnings.

Yes, their price-to-earnings multiples will drop in the next one, maybe even two, years as profits expand strongly. For instance, Top Glove reported a threefold increase in profits quarter-on-quarter, on the back of higher sales volume and selling prices, for its latest quarter ended May.

But it is highly unlikely that such abnormal profit margins can persist for long in any competitive free-market environment. Already, there is a list of new and existing players — including Chinese and Thai manufacturers — announcing major capacity expansions, slated to come onstream over the next two to three years.

Additional supply will chip away at the abnormal margins. In fact, with a successful vaccine and receding pandemic, we might very well end up in an excess supply environment. Supply gluts happen fairly regularly in the sector, as recently as in 2019.

Look no further than the price of disposable face masks. In the initial stages of the pandemic in Malaysia, prices soared as demand well exceeded supply, before the government capped the ceiling price at RM1.50 (49 cents) apiece. Supply responded very quickly, though. A search at one online e-commerce platform last week turned up multiple sellers at only 30 sen apiece.

We will wager the same will happen with the selling prices of gloves, probably sooner than the market currently expects. Gloves are commodity-like and the industry has relatively low barriers to entry.

What happens when hype ends and reality sets in?

With so much liquidity, including from loan moratoriums and new credit facilities, and at a time when loan demand is soft and business opportunities lacking, some of these funds are being diverted to stock markets — causing excessive speculation.

Two very good examples are the recently listed structured put warrants for Top Glove and Supermax. Based on the terms and current prices, they are practically useless as hedging instruments — unless one believes the stock prices for Top Glove and Supermax will crash below RM4 (from RM23.50) and RM1.60 (from RM15.70) respectively, within the next six months.

Otherwise, these warrants have no value — which will be zero upon expiry on Feb 26, 2021 — save for the in-demand names of their underlying mother shares and huge trad - ing volumes (liquidity).

These kinds of irrational valuations exist on the belief that there is always someone else willing to pay a higher price, regardless of the intrinsic values. It is called the greater fool theory. Tesla, for one, has proven many bears and sceptics wrong. The thing is, bubbles eventually burst.

Excessive speculation will end in tears, especially for the newer retail investors. Even worse, some of these funds are not excess savings but deferrals on loan repayments and so on.

While the renewed interest is driving up market volume and stock prices, generating positive sentiment, we need to be mindful that it does not create more pain later.

It is time for reasonable voices of caution to be heard. Retail amateurs take heed of this warning — only speculate with money you can afford to lose and do not use borrowed money!

The Global Portfolio gained 2.3% for the week ended July 16, boosting total portfolio returns to 24.5% since inception. This portfolio continues to outperform the benchmark index, which is up 14.8% over the same period.

The majority of stocks in our portfolio ended the week with gains, though we did see some profit-taking on tech stocks. The top gainer was Builders FirstSource, up 11%. Other notable gainers were BMC Stock Holdings, Alibaba Group Holding, Home Depot and Johnson & Johnson. The three losing stocks were Vertex Pharmaceuticals, Adobe and Microsoft Corp.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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