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I remain of the view that the “consensus” opinion is that equity markets will retest the March lows. That consensus opinion is also confirmed by record cash levels.
To be very clear, there is a tonne of cash sitting on the sidelines, waiting for a better buying opportunity. The chart below shows US money market assets are now the highest ever.
No doubt, there were a multitude of reasons in February and March for investors to rush out of risk assets and into cash, yet as we get closer each day to the removal of some restrictions, the economy is expected to see cash come back into risk asset from the sidelines.
Central banks and governments have also taken unprecedented action in unprecedented time. Yes, COVID 19 is an unprecedented problem but we now have the fiscal spending response and central banks are fully deployed, using tools they didn’t even deploy in the GFC.
These massive asset purchase programs (QE) are now larger in terms of demand than what is expected to be issued by sovereigns, mortgages and credit in 2019. In other words, fixed interest markets in aggregate will shrink as central banks soak up supply. This will almost certainly mean that bond yields stay at record lows, or even lower, and that will support long duration equity valuations. It will also further drive demand for equity dividend yield from those who require income to live.
With stability and fixed income markets, a bounce in equities and the worst of COVID 19 lockdown related economic interruption behind us, my view is to look to 2H 2019 and where you want to be invested.
Interestingly, that is a contrarian view as the majority of equity market investors are running large cash positions and in the case of the hedge fund community, very cautious net exposure.
A variety of measures suggest continued investor caution. This is understandable, given 2Q20 will be one of the worst quarters for growth in economic history. But it also suggests that the bar for ‘good’ news may be low, much lower than it would otherwise be. When positioning is this cautious news flow only needs to get “less worse”…That is clearly happening right now.
Hedge Fund net leverage is low, especially in the US.
I find this such a bullish set up: record low interest rates, record central bank asset purchases, record fiscal spending, record cash levels and very cautious investors.
Of course, however, we currently have a record rise in unemployment and record economic disruption. We also have sharp falls in corporate profitability.
However, are the falls in corporate profitability, particularly in large cap US technology stocks, over-estimated?
I believe they are and Alphabet (GOOGL), parent company of Google and YouTube, confirmed that on Tuesday night, with earnings that were significantly better than lowered analyst expectations.
The question that has to be asked is if big cap US tech companies are the new “defensives”? It’s starting to appear so and this week we will get more earnings evidence from Amazon, Microsoft and Facebook to name a few key ones.
All I know is in a post COVID-19 world, these major US technology businesses are even more important in our day to day lives. It’s also worth remembering they have the best balance sheets on the planet and won’t be coming to investors seeking new equity. If anything, they continue on with their massive share buyback programs.
In terms of a world leading company, you want to own coming out the other side of COVID 19, Alphabet (GOOG.US) is a clear standout.
To put GOOG’s balance sheet in context, they have US $117B in cash. That is A$180b Australian Dollars, more than A$50b more than the Australian Government just spent on the Job keeper initiative!
They are also buying back SU$8.5B of stock per quarter, funded broadly from free cash flow.
I thought I’d provide you with a high-level summary of GOOG’s results to remind you what an amazing business this is. This is why you need to have some overseas investments. GOOG is my 2nd largest investment.
Here are 4 main points from the Alphabet result & management call:
1. Revenue growth for the quarter was better than expected: we hit the numbers hard from mid-February. In reality, the real slowdown only came from the first week of March and accelerated into the final weeks. Reported revenue growth came in at 13.3%, with FX roughly a 2% headwind. To be a bit more granular:
a) Search revenue was up by 8.7%, but exited March being down ‘mid-teens’. That implies revenues were growing about 20% YoY in January and February – in line with the long-term trend and our expectation. More importantly (and you can time the spike in the A/H trading to when this comment was made at 40 minutes): “…based on our estimates from the end of March through last week for Search, we haven’t seen further deterioration in the percentage of year-on-year revenue declines.” Basically, if down mid-teens is as bad as it gets, everyone was far too bearish on the collapse in demand. Management guided against extrapolating this too much, but I saw 1Q20 numbers as low as -30%; we were -20%. I have adjusted our 2Q expectation up strongly (now -20% – still implying some deterioration – vs. previously -28%), but it does not change much to the present value of the firm in the long run.
b) Network revenues – a much smaller component than core Search – was up by 4%, exiting March with a ‘low double digit’ decline in YoY revenues. Again, backing out the math, it would seem to imply a run rate of +10% to +12% in Jan/Feb – an acceleration from FY19 levels to closer to FY17/FY18 run-rates, which is heartening.
c) YouTube revenues grew by 33.5%. To quote from the call directly: “…significant YouTube revenue growth persisted until late in the first quarter, with different performance trajectories for the brand and direct response components. Direct response (DR) continued to have substantial year-on-year growth throughout the entire quarter. Brand advertising growth accelerated in the first two months of the quarter but began to experience a headwind in mid-March. As a result, by the end of March, total YouTube ads revenue growth had decelerated to a year-on-year growth rate in the high single digits.” DR ads are critical right now. Many advertisers have clearly cut brand advertising, but the ability to convert a marginal buyer at present is extremely powerful, which is where DR thrives. (Bodes well for FB as well, though more SMB exposure).
d) Google Cloud grew revenues by 52.2%, with GCP outgrowing the division by ‘meaningfully.’ G-Suite is seeing increased engagement, now with 6mn users. Meet (Zoom equivalent video conferencing) is adding 3mn users per day – over 100mn daily Meet participants. Up 30x over Jan figure. G Suite experienced both growth in seat count (volume) and average revenue per seat (price) due to users adding more functionality.
e) Other Revenues were up 23%, benefiting from increased Google Play app store revenue and YouTube subs. March saw a 30% month-on-month increase in app downloads.
f) Other Bets revenues were $135mn – essentially generated only by Google Fibre and Verily (the health sciences business).
2. On the cost side:
a) Traffic acquisition costs (TAC) only increased by 8.6% compared to total search revenue growth of 10.4%, indicating the variable nature of this line item. TAC as a percentage of search revenue declined very modestly (to 22.1% from 22.4%) as a result of more search activity shifting to Google-owned channels (YouTube, Google.com, etc.)
b) Other COGS (cost of goods sold) grew by 26%. This relates largely to D&A (depreciation and amortisation) relating to new data centres, other direct data centre operating costs, and content acquisition costs for YouTube (advertising-supported content, YouTube TV, YouTube Music and YouTube Premium). These costs are not as variable in nature as TAC.
c) Overall, COGS grew by 19%, meaning gross margins compressed to 53.9% (from 54.4% in 4Q19 and 55.9% in 1Q19). Gross profit grew by 9.1% (compared to the 13% revenue growth rate).
d) has OpEx grew by 18%. This would have been closer to 15% excluding a provision raised for ‘credit deterioration’ – essentially, bad debt from small businesses hitting the wall, one would assume. This was not quantified but will be in the 10Q out today.
3. Regarding the outlook for the rest of the year on spending:
a) Management are “taking steps to enhance efficiency, including slowing the pace of hiring and some categories of marketing spend as well as further enhancing infrastructure utilization.”
b) Specifically, the pace of new hiring is now expected to be lower than the 20% headcount growth seen in FY19; this will be more material in 3Q/4Q (when new hires join out of university). Given that Google I/O (their big developer event in SF every May) is cancelled, there will also be a substantial saving in marketing spend, though this will likely be re-allocated towards areas they consider to be strategic (and will thus keep spending on.) They did say that they believe there is more cost that can be taken out on a permanent basis than simply slowing hiring this year.
c) In January, they guided capex to increase from its FY19 run rate ~$25bn, which itself was a near doubling from FY18. They now guide for a ‘modest decrease’ in Capex for FY20, with the delta coming from office facility investment (and some related to delayed data centre spend, as the crews physically cannot be on site to build).
4. Management were at pains to point out that:
I am of the view GOOG is worth significantly more in the long-term than its current share price around US$1,300. This was an excellent result in trying times and sets the company up well for the future as the economy comes back on line.
So in summary today, I remain of the view that the so called “pain trade” for professional investors in equity markets is higher and companies like Alphabet (GOOG) are where investors should be putting cash to work. As each day passes it appears to me that retesting the March equity market lows is increasingly unlikely. This week’s large cap US tech results will play are large role in overall equity market sentiment.