Market Caviar

Original, independent and outside the box thinking.

Index Investors Beware of the Sucker Punch

By Sam Hassan | May 09, 2018


Market Caviar: First Edition

My name is Sam Hassan. I recently joined Capital Wealth Advisors as Managing Director of Investment Management. Thank you for reading the first edition of Market Caviar.  The goal of Market Caviar is to bring to light some of the things we consider important when making capital allocation decisions.  

Original, independent and outside the box thinking is the goal.   I hope after reading these pages and future editions, you walk away with a different or new perspective.  In this week’s edition, I’ll share some observations on index investing and bring to light an area that I believe is misunderstood and overlooked. 

I’ve always been fascinated with boxing.  Two highly trained people get into a ring and duke it out until someone gets knocked out.  On any given day, anyone can win.  In boxing, like the markets, it is often the punch you don’t see coming that puts you on your back.  The most skilled knockout artists aren’t the hardest punchers, rather they are the ones that lure their opponents into complacency then hit them with a punch they do not see coming.  I worry that index investors have been lulled to sleep and could awaken flat on their backs to a very different reality from what was originally expected. 

Muhammad AliMuhammad Ali after first-round knockout of Sonny Liston. May 1965

Index investors claimed a victory in 2017 with handsome returns following a decent year in 2016.    Not all that shines is solid gold.  Underneath these numbers you will find that a mere 5 stocks contributed around 20% of the overall return.  They call them the “FAANG” stocks represented by Facebook, Amazon, Apple, Netflix and Google.  In my opinion, these companies siphoned lots of excess return from the market and disrupted several large industries along the way. 

Underneath these numbers you will find that a mere 5 stocks contributed around 20% of the overall return.  
By owning the index, investors had ample exposure to these names and the end result was a handsome return.  These publicly traded FAANG stocks post their results quarterly, telegraph their execution plans and announce to the world how they intend to continue to deliver for their shareholders.  These companies’ gains likely came at the expense of another.  As of May 4th, these companies accounted for 27% of the Nasdaq’s market capitalization!
In September 2003, Forbes posted an article comparing to Barnes & Noble.  In conclusion the article noted, “Barnes & Noble has the best of both worlds since it also owns"  For those keeping score, Amazon shares went from approximately $47 to $1,600 while Barnes & Noble went from approximately $12 to $5 from the time of publication.  In the end, the overall index did fine because gains in one more than offset losses in the other. I believe Amazon’s beginnings as a disruptor are very similar to the new crop of companies in the background, however I also believe the major difference is that today’s batch remain privately held. 
I believe that going forward, the index is not going to benefit from today’s disruptors because they are not publicly traded and may remain private for longer than in previous cycles.  This new crop has been training hard and does not publicly post financials, updates, annual reports, business plans, milestones, successes or failures.  Worst of all, so long as they remain private, the index will not benefit from their successes in the public market but index investors will still be exposed to the companies that get disrupted.  I believe this new generation is bigger and bolder than it’s FAANG grandparents. Staying private may give them the advantage of surprise.    

Worst of all, so long as they remain private, the index will not benefit from their successes in the public market but index investors will still be exposed to the companies that get disrupted.
Recently these private companies were given the nickname “Unicorns.”  I find the name ironic as my daughter loves to draw unicorns and thinks they are so innocent and cute.  A unicorn is defined as a private company with a market capitalization of $1bn or more.  In terms of numbers, there are currently approximately 170 unicorns up from about 45 in 2014.  Do not let the name fool you, as these companies are not start-ups!  They boast private market capitalizations ranging between $1- $70 bn compared to Amazon’s IPO market capitalization of less than $500m or Netflix which went public closer to $300m.  
You may have heard of these companies and maybe even used some of their products.  Uber, Lyft, Airbnb, SpaceX and Pinterest are just a few.  These companies are well capitalized, and their ambitions appear to be way beyond delivering books to your home.  I had the opportunity to meet with many many Unicorns while working for a large Sovereign Wealth Fund in the United Arab Emirates.  I believe these Unicorns have ambitions bigger than their market caps. They say things like “we want to make car ownership obsolete” or “people don’t need central bank currency anymore.”  Think about all of the industries and companies that are represented in the index here that could be negatively impacted.  Fewer cars on the road means less auto loans, insurance premiums, parts, components and on and on.  This is just one example.    
My biggest concern is that the longer they remain private, the greater the likelihood they detract from the performance of publicly traded companies in the index.  Amazon went public with a market capitalization of under $500m.  Yet Uber, in the private market, is valued at around $70bn.  Today, Amazon’s market cap is $775bn!  That’s over 1,500 times its original size.  All of those gains were captured by the public market which I believe more than offset the losses on companies disrupted along the way.  How much value creation and return will be extracted before these companies go public?  Based on current valuations relative to Amazon, the returns generated in Uber from $500m to $70bn are already gone.  In Spotify’s case, their direct listing started at close to $30bn where I believe most of the easy money was already made. 
When we look back 5-10 years from now, some of these Unicorns will likely have changed capital markets permanently.  It is my belief that they have remained in the private markets for longer already and may yet remain private for longer still.  Capital is still flowing into the private market with alternative investors providing fresh dry powder to support these companies.  Spotify’s recent listing is an example of how these unicorns are even changing the process of debuting shares on the market.  Rather than issue new shares through an Initial Public Offering (IPO), the company chose to do a direct listing where shares were sold by private market owners.  In this process, there was no lockup placed on the owners and there was no underwriter. 

Capital is still flowing into the private market with alternative investors providing fresh dry powder to support these companies.
These are some of the reasons we own individual stocks and bonds when constructing portfolios.  We strive to have eyes wide open and act when there is enough cushion to protect against what we can see and what we can’t see.   Investors who choose to get their market exposure through an index should also be aware of the changing capital market structure that they might not see. 
Remember this Index investors: when you step into the ring, keep an eye on the left!  Focus, the left is coming, do you see it?  DING! DING!  What happened? What round is it?  Is it over?  Yes, it’s over…straight right.  Did you see it coming? •


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CWA Asset Management Group, LLC is an SEC-registered investment adviser, doing business as Capital Wealth Advisors and as blueharbor wealth advisors.  Fundamental Global Investors, LLC is a SEC-registered investment adviser that is affiliated with CWA Asset Management Group, LLC. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and unless otherwise stated, are not guaranteed. Nothing herein should be interpreted as investment advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Specific companies or securities described in this report are meant to be illustrative of investment style. Such case studies are not meant to be, and may not be, representative of any portfolio or holdings of CWA Asset Management Group, LLC, or Fundamental Global Investors, LLC.

Please note that past performance is not indicative of future results.
This material is solely for informational purposes and is intended only for the named recipient. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.
Sam Hassan
Managing Director - Investment Management

Author of Market Caviar. 

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