Walmart safety premium

Good morning. Quiet on the market today. . . too quiet After a crazy ride last week and big earnings reports and economic indicators in the coming days, is this just the eye of the storm? Send us your thoughts and meditation practices: [email protected] and [email protected].

On Wednesday at noon UK time and 7am ET, I (Rob) will be joining FT experts from New York, London and Tokyo for an event for FT subscribers on the recent spike in market volatility. I plan to stir things up as much as I can. I hope Unhedged readers will join us. Register for your subscriber pass and submit questions for the panel at ft.com/marketswebinar.

Walmart and the high price of safety

Walmart and Alphabet make an interesting financial comparison. It sounds a bit random, and maybe it is. But stay with us.

Alphabet is growing fast and very profitable. Over the past five years, its revenue has grown at a compounded rate of 18%, and its average return on equity has been 24%. Walmart is growing at roughly twice the rate of GDP and is solidly profitable, with compound earnings at 5% and an average ROE of 16%.

The reason for the differences is obvious enough. Alphabet holds a monopoly on Internet search and has an iron grip on the online advertising market; it’s a relatively capital-light business (or was before the AI ​​data center wars broke out). Walmart is the strongest player in an old, capital-intensive and hyper-competitive industry. The surprise, if any, is that the gaps in growth and profitability are not wider.

The comparison is redundant as the two are in different industries. But shares of each compete as options for investors buying U.S. megacap stocks. Both are huge, liquid and closely watched stocks owned by a host of generalist global investors.

The punchline here is that the faster growing and more profitable oligopolist is a significantly cheaper buy for these investors. Walmart trades at 28 times this year’s expected earnings, Alphabet at 21. To put it another way, a dollar of Walmart’s earnings has cost an investor nearly 40% more than a dollar of Google.

In summary, this is strange because P/E ratios should increase with growth rates and ROE. However, from a common point of view, we all know what is going on here. Walmart is a much safer business than Alphabet. Weird things happen in tech (could AI upend the search industry? Could demand for online advertising decrease?), but people will always need cheap food and clothes. In addition, Walmart has proven that as difficult a business as it is, it has sustainable advantages. The stock has done well recently, as Evercore ISI’s Greg Melich pointed out to me, as the company’s 10-year investment in lower prices and better infrastructure is now paying off. Customer traffic is growing and the online business generated $30 billion in revenue last year. In Melich’s view, Walmart has successfully made its US stores as efficient as the local distribution centers of its online competitors, including Amazon, which will now struggle to beat Walmart in many product categories.

One could think of the valuation gap between Walmart and Alphabet as a very thick proxy for how much stock investors are willing to pay for safety. The chart below shows that Walmart’s valuation premium rose sharply at the start of the pandemic and did so again in 2022 as inflation rose and higher rates loomed. In recent weeks, the premium has risen again as Alphabet has sold off:

No matter what index levels or volatility indicators tell you, there is still a lot of fear in the market.

The tough decision of the Bank of Mexico

In this past rate cycle, emerging market central banks have consistently beaten their advanced economy counterparts to the punch. And no emerging market is closer to the US than Mexico. As the US’s largest trading partner, Mexico can be seen as the tail of the US economy: ripples here become shocks there. So the policy decisions of the Bank of Mexico (Banxico) often serve as a reliable indicator of the Federal Reserve’s future direction.

Last Thursday, Banxico faced a tough decision. Mexico’s economy has slowed rapidly, in part due to low US consumption. And our neighbor to the south found himself at the center of the market debate last week. The Mexican peso, a favorite target for yen carry trades, accelerated its downward trend, stoking inflation fears. The CPI, Mexico’s already weak stock index, also fell. Both the currency and the index recovered lost ground in the following days, but Thursday morning saw much higher than expected inflation.

Investors have started to reduce their expectations for an interest rate cut. From Kimberley Sperrfechter of Capital Economics:

Everything (made) Banxico’s decision more difficult. There were (were) factors in favor of a reduction and factors in favor of a maintenance. What (will be) most revealing about the choice is how they feel about the Mexican and US economies and the market. There was a weakness, highlighted in Banxico’s previous communications. . . But inflation is likely to rise in the coming months.

Did fears of an economic slowdown and subdued US consumption warrant a rate cut? Or did concerns about inflation, the peso and market volatility call for it?

By a hair’s breadth, Banxico chose to prioritize growth. In a 3-2 vote, Mexico cut its rate by 25 basis points. In its statement, it acknowledged that inflation would persist and suggested that it might adjust the benchmark inflation rate. But the focus was squarely on the faltering Mexican economy and, by extension, slowing US demand.

Banxico, with responsibility for a more volatile economy, has reason to worry more and act faster than the Fed. That it has turned out to be more concerned about growth than inflation at a difficult time says something important about the balance of risks in North America.

(Reiter)

Margin debt

The violent moves in the markets last week suggested that some investors may be over-leveraged. But what kind of leverage?

Finra, the brokerage industry’s self-regulatory body, tracks the dollar value of leverage in client accounts. It certainly is in nominal terms:

But interestingly, the ratio of customer account leverage to GDP has been constant since 2008, and both the ratio to GDP and the ratio to global market capitalization have generally declined since 2018 (except for one peak of Covid):

It’s important to note that this is only one corner of the leverage universe; as we saw with shipping, there are many other routes for investors, households and traders to build leverage. But if the market is indeed oversold, margin debt doesn’t seem to be the problem.

(Armstrong and Reiter)

A Good Read

Sardines.

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