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Living in a bubble world
Equity value today has nothing to do with current or future profits but is being driven by a company’s ability to be disruptive

David Einhorn

The market remains very challenging for value investing strategies, as growth stocks have continued to outperform value stocks. The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy. The knee-jerk instinct is to respond that when a proven strategy is so exceedingly out of favor that its viability is questioned, the cycle must be about to turn around. Unfortunately, we lack such clarity. After years of running into the wind, we are left with no sense stronger than, “it will turn when it turns.”

For a moment, let’s consider the alternative. Might the cycle never turn? Our strategy relies on the assumption that the equity value of a company equals the market’s best assessment of the current and future profits discounted at the company’s cost of capital. Our ability to outperform often comes from our skill in finding opportunities where the market has misestimated current or future profitability or miscalculated the cost of capital by over- or underestimating the risks.

Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value. What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss? It’s clear that a number of companies provide products and services to customers that come with a subsidy from equity holders. And yet, on a mark-to-market basis, the equity holders are doing just fine.

When we consider the business performance of our three most well-known “bubble” shorts, we wonder if this alternative paradigm is in play. Last quarter, we noted’s earnings estimates had fallen over the prior few quarters. This quarter, Amazon revealed a much lower level of long-term structural profitability, causing consensus estimates for the next five years to drop by 40%, 22%, 18%, 14% and 8%, respectively. Ordinarily, stocks trading at nosebleed multiples fall sharply when such a dramatic reassessment happens. Instead, Amazon fell less than 1% during the quarter. Our view is that just because Amazon can disrupt somebody else’s profit stream, it doesn’t mean that Amazon earns that profit stream. For the moment, the market doesn’t agree. Perhaps, simply being disruptive is enough.

Tesla had an awful quarter both in its current results and future prospects. In response, its shares fell almost 6%. We believe it deserved much worse. So, much went wrong for Tesla in the quarter that it is hard to only provide a brief summary. The main near-term problems are poor demand for its legacy vehicles and manufacturing challenges for the new Model 3. Notably, Tesla dramatically reduced its gross margin assumption for the September quarter and publicly blamed ramp-up costs for the new Model 3 sedan. More quietly, the company used the lower gross margin hurdle to offer incentives and to lower the cost of options on the Model S and Model X vehicles, and even offered significant markdowns on showroom models. Given the depth of the price cuts, we were surprised that demand for the Model S and Model X only improved modestly.

Meanwhile, it is becoming clear that scale manufacturing is actually a skill. While the CEO makes bold claims about Tesla’ssuperior prowess, continued production shortfalls, defects and product recalls disprove him. Tesla faces competition from established OEMs that have decades of scale manufacturing experience. Some of Tesla’s presumed market lead in areas like autonomous driving may more likely reflect on its willingness to put inadequately tested and dangerous products on the road rather than a true technological advantage.

Finally, there is Netflix, where the quarterly results beat expectations and the shares advanced 21%. Competition is heating up and media companies such as Disney will be removing their content from Netflix to compete directly (bulls used to believe that Disney would pull a Time Warner/AOL and pay-up for the highly promoted but profitless business). Netflix continues to accelerate its cash burn as it desperately tries to compensate for its inability to rely longer-term on licensed content. On the second quarter conference call, the CEO stated, “In some senses the negative free cash flow will be an indicator of enormous success.” To us, all it indicates is that Netflix is capable of dramatically changing the economics of stand-up comedy in favour of the comedians. Perhaps, there really is a new paradigm for valuing equities and the joke is on us. Time will tell.

This is an edited extract from the October quarterly newsletter of Greenlight Capital

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