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2024-11-20 07:00 by Karl Denninger
in Market Musings , 288 references
[Comments enabled]  

SMCI, specifically, Supermicro.

I know this firm's products quite well and have used them personally since the mid 2000s.  They are a motherboard manufacturer and have some very nice kit with features that make them particularly suitable for server machines (not so much for desktop computers simply because the extra cost doesn't bring you much except in very-specific circumstances.)

Specifically, most have "out of band" management so you can not only do things like toggle the power, check fan and temperature status, reset the box and such but in addition they have a "virtual console" capability using what is called "IPMI"  over a dedicated network interface (preferred for security reasons since that interface never leaves your data center "raw") and their boards typically support ECC memory, which is very important in larger server configurations with processors that also support it (specifically the Intel Xeon series) since random memory errors (e.g. cosmic ray hits, which can happen although they're very rare) could otherwise cause either undetected data corruption or even crashes.

But in the last couple of years they've been on a tear because they uttered the words "AI" and were buying quite a lot of Nvidia chips.

Just recently their auditor quit with a rather-amusing letter to the SEC (which of course is public) and drew a number of snickers, implying that they didn't like what they saw in the firm's financials.  The stock crashed, and is now trading around $30 (after trading as low as $17) -- off a fairly recent high of around $140!

This has brought many people out thinking its a screaming buy -- provided, of course, the books are not entirely-fraudulent.

As recently as mid 2022 the stock was trading at a split-adjusted $4.00/share!

So exactly what has changed in the company's forward prospects selling server boards that leads someone to believe that it is was ever worth thirty times what it was worth in 2022 (note -- this was not a "startup" that just started making money!) and why is it worth seven times what it was in 2022 right now?

Again -- this is a company that makes motherboards, a commodity product that has decent operating margins and it is an established player in that space.  Note that it was a strong player in the space the entire time "cloud" was taking over the world and while they made a nice amount of money and have excellent products how did the market turn around and revalue them up by thirty TIMES in the first place when their essential product is a commodity item in the computing space?

Does anyone really think we will be putting thirty times as many servers in datacenters over the next few years?

Just contemplate that in the market as a whole folks -- look at basically everything and you will find this sort of pricing in what equities go for these days.  How is that defensible?

I argue it is not.

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2024-11-13 07:45 by Karl Denninger
in Market Musings , 75 references
[Comments enabled]  

Remember "a permanently high plateau"?

Of course you don't; you weren't alive when it was spoken.

I've recently written on the yield curve.  What most people commenting in that thread failed to recognize (and our various folks in the investing and money business, including Powell) is that these swings are a Kondratiev cycle and there is no nation in recorded history that has managed to evade them.

Tamper with them, try to get around them, make excuses for them, yes.

Actually change them?  No.

As I pen this the market has been on an absolute tear since election day.  The irony is that many of Trump's policy pronouncements, such as removing EV mandates from carmakers (whether explicitly or by setting fuel standards to a level impossible to attain under the laws of thermodynamics any other way, as the Biden path in fact did) means Tesla no longer has a government-driven sales quota.

Now that's not to say that people won't want to buy Tesla vehicles standing on their own in a field of vehicle choices.  The obviously have but Tesla has benefited mightily in cash flow from those "credits" that others have had to buy (from Tesla) for the last several years which has been reflected in both the price of Tesla vehicles (downward) and Tesla's P&L statement (upward.).  That cash flow, if the mandates are removed, will disappear and the cost of them in the price of fuel-powered vehicles will also disappear while at the same time the subsidy in favor Tesla car prices will also go away.  In other words all other things being equal Tesla vehicles become more expensive and fuel-powered vehicles becomes less expensive because the forced payment from other companies to Tesla disappears.

How will all this balance out?  I have no idea but it is flat-out nuts to believe that it will be accretive to Tesla's earnings and thus should be reasonably-reflected in a higher stock price.  Yet that is exactly what has happened.

May I remind everyone that removing deficit spending by whatever means it occurs is good in the longer-term, particularly from an inflation standpoint (since all inflation is in fact caused by creation of credit) but a large part of the last several years' stock market price rise has been driven by that inflationary impulse.

Perhaps the market is telling us that despite all the bluster and claims nothing will be done about any of that and yet somehow we'll evade the march higher of interest rates over the next couple of decades, and evade the already-occurred turn in that cycle.  I've heard a couple of podcasts asserting that in fact rates will continue to come down from here, implying that we're headed back to a 2% long term bond.

No we're not.

Yes, there will be periods in the next twenty or thirty years when rates will fall but the general trend for the next two to four decades, with the median expectation of three decades of time, is upward.

The firms that will fare best in that world are the ones who have no operating leverage (that is, debt) on their balance sheets because you can't be involuntarily exposed to higher financing costs if you have no debt.  You don't have to deal with a ratchet job that isn't present and every firm is different in this regard in terms of its exposure.  A key element any investor in a firm should be looking at right now is the amount of debt on the firm's books compared with its free, unlevered cash flow -- that is, can the firm pay it off if necessary from operating income rather than roll it over or are they stuck with whatever rate environment they are presented when that time comes?  As an example Nvidia has an operating cash flow of about $49 billion with $10 billion out in debt.  Push comes to shove they could pay that off and survive.  It would hit their operating earnings severely but it could be done.

Now look at a firm such as Moderna.  You'd think they're mostly ok because the only have $1.3 billion in debt. The problem is that their operating cash flow is negative so they can't pay it off if necessary.  Whatever the market deals them in terms of a rollover rate they have no choice and must accept it.

How about Tesla?  Their gross operating cash flow is $14.5 billion but they have nearly $13 billion in debt.  While in theory they could pay all that off it would ruin their cash flow for that year.  Nonetheless they'd probably survive such a crunch, although not easily.

How about Amazon?  $112 billion in cash flow but $159 billion in outstanding debt.

Oh by the way this analysis has to extend to suppliers you can't replace easily too.  In the 1990s this was a huge problem as Internet access evolved; the DSL folks were all wildly levered and existing on Wall Street "another shovel of cash please" money, unable to generate free cash flow.

They all blew up when that dried up and if you were dependent on them you blew up too as your customers got cut off.

The usual answer to this sort of analysis is that the firm has plenty of time to figure it out and/or increase their operating cash flows before the debt must be either rolled or paid.  In a generally-declining rate environment this is almost-always true because tomorrow its cheaper to finance something that it is today, everyone knows this and therefore the odds of a dislocation and squeeze are small.

In a generally-rising environment the exact opposite is true: Everyone knows the price will be higher to roll over the debt tomorrow and thus the risk of a squeeze and bankruptcy rises vertically as the debt outstanding .vs. actual cash flow (not including leverage) goes up.

Read balance sheets and key financial statistics folks.  One of the greatest risks in a concentrated market like today's is that an utterly enormous amount of the index price (and thus ETF prices) is concentrated in just a handful of firms, and its very easy to just buy the ETF based on its current price change without looking at all at the concentration of risk or what those firms' balance sheets look like.

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2019-02-27 08:15 by Karl Denninger
in Market Musings , 291 references
[Comments enabled]  

The lie factory in the media continues with regard to the economy and markets -- and it's you who take it up the chute.

Lawmakers on both sides of the aisle have recently criticized stock buybacks, including Sen. Chuck Schumer, D-N.Y., and Sen. Bernie Sanders, I-Vt., in a New York Times op-ed and Sen. Marco Rubio, R-Fla., in a tweet storm about his plans to release legislation on the subject. As the Tampa Bay Times notes, this is something “you might expect from Bernie Sanders or Elizabeth Warren, but not necessarily the Florida Republican.”

These objections to stock buybacks are, in a word, misguided. Critics’ complaints rest on the premise that they maximize shareholder earnings to the detriment of workers and at the expense of investments in the company. But this reflects a fundamental misunderstanding of how stock buybacks work and what drives business leaders’ decisions about spending profits and deploying capital.

False.

My complaint with them is that they are frauds.

Faux Snooz continues:

When a company turns a profit, one basic way to address the balance is to buy back shares; it’s a common mechanism for companies to distribute earnings to shareholders. The alternatives are to increase investment or pay out more in dividends, the latter of which is functionally identical to buying back shares.

No it's not.  Leaving aside tax differences, which are significant, the financial and market impact of buybacks is not functionally equivalent to a dividend.

When a company pays out dividends the total number of shares does not change.  Therefore the EPS does not change either for a given level of earnings.

If you earn $1 billion dollars and have one billion shares then the EPS is $1.00.  If you pay out half of that billion dollars in dividends then the EPS next quarter, assuming you still make a billion dollars, remains $1.00.

Now let's assume you take that half-billion and buy back shares.  The denominator gets smaller.  This means that for the same billion dollars in earnings next quarter (the size of the company hasn't changed) the EPS goes up.

This is a major functional difference.  It sounds like a free lunch to many people -- EPS goes up and since the "P/E" ratio is a common way to value stocks the instant effect on P/E is for it to fall, and thus price per share will tend to rise to make P/E the same.

This sounds like a buyback is superior to shareholders, and thus ought to be not only permitted but every firm should do it instead of issuing dividends.

If only it was that easy.

If only Unicorns that crapped out Skittles existed.

If only.....

When you reduce the denominator it is true that EPS goes up for a given level of earnings.  But so do the losses per share when there are losses, and by an exactly equal amount.  In other words market violence, which is called "volatility", associated with said firm's results increases exactly at the same ratio.

There is no free lunch in this regard.

Second, however, and the reason that buybacks were generally illegal before the government changed the rules is that this fact is actively hidden by everyone involved -- on Wall Street, in the media, in earnings reports and the statements made by everyone involved.

Why would all these people intentionally mislead the public?

Simple: They use buybacks as a mechanism to rob you as a shareholder.

Let's take a hypothetical company that issues 1,000 shares of stock.  We'll make it nice and small.  The insiders -- that is, the founders, mostly, and other key people at the outset hold 250 of those shares; they sell the rest of them to the public.  (This, by the way, is another scam that is commonly run -- companies sell a minority of shares to the public by one means or another and thus prevent the public shareholders from ever voting out the officers and directors!  That's fraud because such a firm is not publicly-owned and ought to be flatly illegal in the so-called public markets -- if you wish to do this you ought to be limited to selling to accredited investors who understand what's going on and are willing to buy what amounts to a private placement with no voting rights -- because that's what these companies are!)

Ok, so we have our 1,000 share company with 250 of them held by inside executives -- probably half of that 250 is held by the founder who is frequently the CEO.  All good so far; the other 750 shares are enough that you, along with the other public shareholders, can vote out and eject the CEO and board.

Now the company runs and makes a profit.  So what the board does is vote to buyback 100 of the shares in the public market.  What just happened?

The public's interest of 75% of the company just got cut; the insiders held 25% but now they hold 28%!

It doesn't end there.  The 100 shares gets bonused out as "restricted stock units" to the officers and directors!  So the total number of shares doesn't decrease; now there are 350 shares in the hands of insiders and only 650 in the hands of the public.

Do this for two more years and the public no longer has any control over the board or executives since they are now a minority and cannot vote anyone out!

You just had control of the company stolen from you.

The same strategy is sometimes used by closely-held firms where you have outside minority shareholders.  The reason you have to be an "accredited" investor to buy such a position is that it is very easy for the majority holders, who are usually the founders and running the place day-to-day, to steal from you and absent some extremely strong controls you have written into the bylaws of the company if and when it happens there's damn near nothing you can do about it.  Unless you're very savvy and insist on such as part of your deal you are open to a rank ramjob that will diminish your investment by an arbitrary amount as soon as the insiders decide to screw you.

There is nothing in the law, for example, to prevent the majority holder of such a firm who is the CEO from voting to bonus out more shares to himself as part of his compensation.  This dilutes your ownership interest and as a minority shareholder you can't vote a stop to it.  The only hope you have is to sue and you will probably lose so long as the firm can show that it's making money and the executive(s) who got the bonus are substantially why it's making money.  In other words you're almost certain to take it up the pooper with exactly zero recourse, and if you do sue not only will you almost-certainly lose the company defends against your lawsuit with what is ultimately your money since it comes out of company coffers and not the CEOs personal checking account.

Stock buybacks where the executives and other insiders are getting share grants are the exact same scam played out in the public markets.  The claim that it "makes value go up" is a lie.  Until you sell your shares all you have is numbers on a screen; the lower the float in a given firm (that is, the fewer shares outstanding) the less-likely you can sell them without moving the price downward, and thus your so-called "gain" is likely to be illusory.  In addition you permanently give up your voting control piece by piece until you have effectively none; while you may still own the same number of shares the public ownership of the whole is reduced and at the point it reaches less than 50% you have no voting control whatsoever.

Buybacks, in short, are nothing more than a parlor trick.  They look real good so long as the economy is very strong and there are no recessions.  But as soon as the inevitable downturn comes you discover that not only are losses magnified exactly as are "earnings" but you have had your ability to throw management out on their ear either diminished or completely destroyed by an under-the-table trick at the same time.

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