Novum Alpha — Daily Analysis 8 December 2020
Top of the Tuesday to you and I hope that your week has gotten off to a good start so far!
In brief (TL:DR)
- U.S. stocks started the week a mixed bag with the S&P 500 (-0.19%) and blue-chip Dow Jones Industrial Average (-0.49%) down, while the tech-centric Nasdaq Composite (+0.45%) was higher, replaying familiar defensive themes.
- Asian stocks were mostly down in Tuesday’s morning trading session.
- U.S. 10-year Treasury yields dropped back toward 0.900% as risk-off sentiment built up (yields rise when bond prices fall).
- The dollar bounced back on a wave of caution.
- Oil was mostly flat with January 2021 contracts for WTI Crude Oil (Nymex) (-0.42%) at US$45.57 from US$45.76 and looming supply cuts by OPEC+ offset by caution.
- February 2021 contracts for Gold (Comex) (+0.10%) edged up to US$1,867.90 from US$1,866.00, as investor sentiment soured on risk.
- Bitcoin (-0.68%) fell to US$19,229 from US$19,361 as flows into exchanges rose and investors sought to cash out (outflows typically suggest that investors are looking to hold Bitcoin in anticipation of price rises).
In today’s issue…
- The Legacy of Covid-19 is Crushing Debt
- Valuing Cloud Computing Companies is Like Trying to Catch a Cloud
- When Companies Become Proxies for Cryptocurrency
As the year rounds up, investors are increasingly growing cautious, preferring to stuff their Christmas stockings with the gains clocked so far instead of holding out for what might end up being a lump of coal.
Caution was palpable in the markets as investors returned to familiar themes and bet big on the dollar and tech stocks, while dumping value stocks such as airlines, cruise operators and hospitality, just as those sectors were seeing a positive rotational play.
In Asia, markets fell alongside Wall Street with Tokyo’s Nikkei 225 (-0.30%), Seoul’s KOSPI (-0.87%), and Hong Kong’s Hang Seng Index (-0.18%) down, while Sydney’s ASX 200 (+0.32%) was up.
1. The Legacy of Covid-19 is Crushing Debt
- Firms with crushing levels of debt will have to suffer their effects for years to come even after the pandemic has subsided
- Removing government support will inevitably result in some form of moral hazard as governments more than ever before have the power to determine which firms live or die
They’re called “Covid-Lifers,” coronavirus sufferers who complain of medical ailments long after they’re supposed to have recovered from their bout with the pandemic.
From fatigue to shortness of breath, cough, joint pains and chest pains, the long-term symptoms are as varied as their sufferers, and the medical complications mean that someone infected with the coronavirus could be paying the price for that infection long into the future.
But it’s not just people who are suffering the long-term effects of the coronavirus, companies are as well, and in some cases, the treatment could be worse than the disease.
To prop up companies, government support measures, in the form of loans and grants, as well as monetary stimulus, have helped to keep businesses alive and millions around the world employed.
And while these measures have provided a much-needed and timely lifeline, they mask the grim reality building up — an avalanche of corporate debt that could serve as a drag on economic recovery.
Once state support is turned off, many businesses will be unable to bear the debt that they took on to survive, and many already aren’t.
According to estimates from Bloomberg, which studied the trailing 12-month operating income of firms in the Russell 3000, one out of every six firms on the index haven’t earned enough money to meet the interest payments on their debt.
By July, U.S. firms collectively owed a record US$10 trillion, or equivalent to almost half of U.S. economic output.
Accounting for other forms of corporate debt including partnerships and small businesses, that figure soars to US$17 trillion.
And while currently low interest rates will help sustain corporate debt in the short-term, the risk is that higher leverage could make companies more vulnerable to sudden interest rate spikes, or earnings shocks in the future.
Recession risks could also be prolonged as businesses cave under crushing debt burdens, while being unable to invest or recruit for growth.
But governments can’t afford to bail out companies indefinitely and the failure of medium and small businesses raises the specter of concentration risk, with corporate power increasingly coalescing in a handful of powerful firms.
At times like these, a flexible approach towards corporate insolvency may be more suited, with the goal to eliminate debt overhangs, while not killing off productive activity at the same time.
Companies with antiquated business models should be allowed to fail, and who determines those failures should ultimately be market forces and not governments.
There is a real risk that politicians may fall on the side of their donors and that corporate capture of government will result in prolonging the existence of firms that have no business being in business, particularly when central banks have demonstrated that “moral hazard” is no longer a real concern.
Just as in the last financial crisis, there is a real risk that policymakers deciding which companies live and which die, may fall down to which networks and circles their CEOs and top shareholders move around in — that should be avoided as far as possible.
Because of the pandemic, governments are playing a larger role than ever in the economy and with that comes the risk that politicians themselves become beholden to corporate interests as opposed to those of the people they are supposed to serve.
A coronavirus vaccine may be on the way, but for thousands of companies, the consequences of the pandemic may be felt for years to come.
2. Valuing Cloud Computing Companies is Like Trying to Catch a Cloud
- Accounting rules ill-suited to measure revenues for cloud computing firms obfuscates the true nature of their prospects
- Record high valuations put investors at risk of rude shocks if cloud computing service growth slows or revenues booked don’t pan out
The logic is attractive in its simplicity — with so many people working from home than ever before because of the coronavirus pandemic, the ability to interact with corporate servers securely increases the demand for reliable cloud computing services.
From storage to applications, the corporate cloud has come to replace the physical servers that used to take up acres of prime office space in many companies, enriching the shareholders and founders of cloud computing companies along with it.
The trend towards greater demand for cloud computing services was in place well before the first sneeze started the coronavirus pandemic, and appears to be durable.
And investors are pouring into the stocks of cloud computing companies on the basis of that narrative.
The BVO Emerging Cloud Index which includes firms like Adobe (+1.29%), Salesforce (+0.81%) and Zoom (-0.53%) is up 84% this year alone, versus a 36% rise in the Nasdaq Composite and a 13% increase in the S&P 500.
But some analysts warn that the seemingly bulletproof and pandemic-resistant revenue streams of cloud computing firms may be nothing more than a cloud — fluffy, formless and impossible to grasp.
Exacerbating the difficulty of analyzing cloud computing firms’ revenue streams has been a new accounting regime which has made it hard to assess the performance of the sector, or key yardsticks that are widely used for valuation.
The challenge comes from adapting traditional accounting rules to a new generation of companies that sell services not as a single, long-term contract, but costed out over several years, similar to subscription-based businesses.
At the heart of the accounting issue is how subscription to cloud-based services are marked as revenue and how much of that is reliable.
Cloud computing companies typically sell bundles that include some integration and software implementation, as well as customer and staff training, alongside multi-year subscriptions.
But because investors have rewarded businesses that can show dependable future revenues, there is an incentive for cloud computing firms to characterize as much of their revenues as repeat business as possible.
But when does that revenue get booked?
Cloud computing firms may split a three-year contract evenly, or vary the amount based on the value they believe they have delivered in any given year.
And newer cloud computing firms, including some eye-popping IPOs may not have sufficient experience to correctly book the revenue from complex multi-year contracts, a problem that could affect investors as companies go public at earlier stages.
The novel nature of cloud computing businesses has led some analysts to an approach which is far from scientific, including what’s known as “net dollar retention” which simply measures how much business a company generates in a given year from its customers compared to a year earlier.
But differences in defining what a “new” customer is make this calculation less than clear — is a “new” customer someone who has never had an existing relationship with the firm or someone who is buying new products or services?
Then there’s the issue with churn rate — the rate at which customers fail to renew contracts when they expire.
Most cloud companies conceal this metric, though it is commonly reported at the time of IPO, to suggest customer stickiness.
But how this figure is calculated can make a big difference.
For instance a company that started the year with revenue of US$50 million but lost customers worth US$10 million but added enough new business to get to US$100 million could report a churn rate of 20% (alarming!) or a growth rate of 10% (great!) — and the difference matters.
Because while a high-growth IPO can mask customer churn in the early days, eventually the obviousness of that slowing growth rate will come back to haunt it.
And what does “recurring” mean anyway?
Because a customer who has the right to terminate a three-year contract, just 12-months in, will change the revenue make-up of a firm for the next two years.
But that hasn’t discouraged the scores of investors pouring into cloud companies and their rock star IPOs.
Low interest rates and bond yields have meant that cloud computing firms now attract eye-watering valuations, but investors may one day find out that the reason why they’re eye-watering is because of the clouds in their eyes.
3. When Companies Become Proxies for Cryptocurrency
- MicroStrategy (+2.51%) doubles down on Bitcoin bet, seeking to raise US$400 million by way of a convertible bond that will buy more of the cryptocurrency
- MicroStrategy’s share price has soared on the back of its Bitcoin investment, which may encourage other firms whose stocks have languished to do the same, feeding into a self-perpetuating feedback loop that could precede a Bitcoin bust
In late 2017, a “ready-to-drink” iced tea and lemonade maker based in Farmingdale, New York saw its share price surge by as much as 289% after the it changed its name from Long Island Iced Tea Corp to Long Blockchain Corp (-1.72%).
At the time, Long Blockchain, whose core business has been selling non-alcoholic beverages, said that it would seek to partner or invest in companies that develop the decentralized ledgers known as blockchain, the technology that underpins Bitcoin.
That should have been the first sign that all was not well in the cryptocurrency world.
Just months later, Bitcoin would soar close to US$20,000 before crashing and languishing for another three years thereafter.
Like the dotcom bubble and bust almost two decades prior, simply changing the name of a firm doesn’t do much for its business model, let alone its prospects — yet investors clamored for shares of firms that simply added a “.com” at the back of their names at the turn of the century, even if they had almost nothing to do with the internet or technology.
Some are wondering if history isn’t repeating itself again as MicroStrategy, a purported business-intelligence firm, is looking to allocate more of its capital in Bitcoin.
MicroStrategy has been doubling down on its capital-allocation strategy, disclosed in July this year, which saw the firm investing up to US$250 million in assets including Bitcoin.
Earlier this month, MicroStrategy, in a regulatory filing, disclosed that it had bought more Bitcoin, brining up its total stake in the cryptocurrency to 40,824 Bitcoins.
And investors have been buying-in to MicroStrategy’s buy-in, doubling its share price as Bitcoin closed on US$20,000.
The danger is that more and more investors are treating MicroStrategy as a proxy for an investment in Bitcoin, or an ETF for Bitcoin, which is an inefficient way to invest in the cryptocurrency.
By some estimates, only US$0.23 out of every US$1.00 invested in MicroStrategy is underpinned by the value of Bitcoin.
But MicroStrategy’s, well, strategy, of making macro bets on Bitcoin may embolden other firms whose stocks have languished, to do the same, fueling the same sort of speculative behavior among investors that preceded the last Bitcoin crash.
MicroStrategy’s revenues for the third quarter of 2020 were up 6% year-on-year, its best quarterly performance in years, on the back of improved demand for its managed cloud platform.
Yet shares of MicroStrategy have tread sideways for years until recently when it started to take big bets on Bitcoin.
And now the firm is taking advantage of that interest in all things crypto to raise US$400 million in convertible bonds, to buy more Bitcoin.
According to MicroStrategy, the proceeds from the offering will be invested in Bitcoin “pending the identification of working capital needs” — that announcement was enough to boost shares in the firm by over 2%.
The problem is that MicroStrategy’s moves and Bitcoin’s price could feed into a self-perpetuating feedback loop before sparking off a massive crash.
Bitcoin’s price rises so investors buy into MicroStrategy, boosting its share price, MicroStrategy buys more Bitcoin, fueling its price rise, which draws more investors into MicroStrategy, which encourages it to buy more Bitcoin.
To be sure, MicroStrategy is hardly alone in allocating more of its capital towards Bitcoin, so has Square (+2.20%), as well as billionaire hedge fund managers include Stanley Druckenmiller and Paul Tudor Jones.
But with a difference — those firms and investors haven’t seen their share prices or funds move virtually in lockstep with the fortunes of Bitcoin.
And that is the bigger concern.
Bitcoin proponents have talked up the market and while there has been evidence of increased institutional participation for cryptocurrencies, such investors are just as happy to sell it down as to buy it up.
A bet on MicroStrategy however is very much one way.
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