Pods, Passive Flows, and Punters

I’ve banged on about the market being a voting machine in the short term for years. I’ve tried considering about how long that short term actually is, and how it isn’t necessarily as short as many of us would like.

Part of the explanation may be the continued rise of two factors that tend to impact that definition of “the short term.” One big one is the trend toward indexing. I mean, I get it. I get why my RIA buddies all recommend owning diversified indices that minimize expense ratios and maximize diversification. I get why they recommend “owning the market” and eschew individual stock-picking. However, and I don’t think they would argue this point, inclusion in the right index at the right time can actually impact how much a stock is worth (at least temporarily) – and as funds continue flowing out of more active strategies into more passive ones – this can extend “the short term” from a few hours to a few days, weeks, months, or (potentially) even longer periods.

Many of us probably remember when it was announced that Tesla was entering the S&P 500. Rumors started circulating in September of 2020, with the stock as low as $110. By the time the announcement was made on November 17, the stock was trading at $136. And when it was actually included in the index on December 21, it had surged to $231, and it continued up to $300 by the end of January.

Now, sure, there were other dynamics affecting the stock, and other dynamics that affect all stocks. We will discuss some of them below. But there is no doubt that inclusion in the S&P 500 Index mattered for Tesla. It mattered so much that my former professor Merton Miller is probably rolling in his grave.

And the next question is how long we have to wait for that price pressure (in either direction) to subside. This one can be a real rabbit hole, and I want to stay practical with this article, but if you have any curiosity in the history of the academics and empiricists trying to answer this question, you’ll find this linked article interesting too.

Anyway, the other factor that I believe has contributed to the market’s focus on the short term (and concomitant volatility) is the change in market structure. That factor is the rise of the pods.

If you don’t know what a pod is, think of Millennium, Point 72, or Balyasny. These pod shops attract some of the best stock picking and/or trading talent in the world, and a few of the teams have incredible track records. A few don't. Those that don't meet the criteria are shut down. They are all a little different, but all somewhat similar too. The bottom line is that there are rules in place that force their PMs to reduce exposures in losing positions. Of course they aren’t stupid about it, but in he aggregate I believe this exacerbates volatility.

And that brings us to the impact of the retail investor. The punter.  And, more specifically, what the impact of social media means for price discovery.

I haven’t done any empirical work at all, but suspect that companies where retail investors are more prevalent, either in ownership or in the percentage of daily trade flows, also have an impact on volatility. And, more specifically, an impact on our definition of “the short term.”

We of course all saw that with the meme stock frenzy during COVID, from the behavior of stocks like Peloton and Carvana to the surreal craze that surrounded Gamestop and AMC. There may even be cases where the meme-stock impact on the valuation of a stock has not yet subsided. And when you combine this with the passive nature of the non-retail investors with forced exits (or indeed avoidance) of certain investments, price discovery suffers, and that short-term ends up being more than short.

But I am as convinced as ever that, eventually, it is the fundamentals that matter. Eventually, the market is a weighing machine. If you want some evidence – even from some of the most iconic, well-followed, index-heavy, retail-engaged, pod-owned, successful companies, it is still, eventually, about the fundies.

Let’s take some of the winners as an example. And by winners, I mean game-changing, world-dominating winners.

You’ve surely noticed what has happen to Nvidia lately. We used to just call these winners FANGs, and then FAANGs and then FAMANGs, but Nvidia has insisted on joining the league table. It now has a $1.7 trillion market cap. And in the last five years, the stock is up about 1,700%. Guess what else is up about 1,700%?

Nvidia’s earnings estimates.

How about Facebook, aka Meta, which goes through periods of hatred and love with equal vigor? Well, over the past seven years it has bounced around a lot but still has generated nearly 260% returns. And forward earnings projections? They’re up 280%.

We can stretch things further back, and look at Google over the past 14 years (earnings up 885%, stock up 980%); or Amazon during the same period (earnings up nearly 2,500%, stock up about 2,800%).

Or we can go waaay back and analyze Microsoft over the past 22 years. Forward earnings projections have increased from $0.93 in February of 2002 to $11.57 today. That’s nearly 1,150%. The stock is up just over 1,200%.

And finally, from one of my favorite former-CEOs Reed Hastings, we have good old Netflix. About 18 years ago, analysts were forecasting that Netflix would generate 11 cents of earnings in the coming 2006 year. Here in 2024, they are forecasting a whopping $17 of earnings in the coming year. That is a whopping EPS increase of 14,889%.

And how about the stock? We’ll it is up a whopping 14,882%.

Fundamentals matter, sports fans. Fundamentals matter.

Admittedly, some of these examples above are very long-term, but even when we self-select with some of the biggest, most exciting, long-term winners out there, and ignore the losers (of which there are many), it is still clearly apparent that it is the fundamentals that matter most.

So basically, it probably isn’t terrible advice to ignore the rest of it. Ignore the noise. Ignore the talking heads on CNBC. Ignore prognostications of meme-stock sith lords. Ignore the volatility. Embrace it, actually. And just focus on the fundamentals. Get those right, and you will likely win.

Can you take advantage of it? Can you take advantage of the noise? Well, that is what we try to do at Albert Bridge, but if you and your team of analysts don’t want to work 90 hour weeks, banging your head against the wall and getting things wrong at least 35% of the time, then I suggest you just ignore it.

But, admittedly, that is the exciting part…