DeepSeek Is Good News For The AI Gold Rush

•  In July and August of the past year, I explained the world had entered an AI and tech gold rush. Enormous amounts of money were pouring into building computer models that could extract and interpret golden data.

• Since that time, the number of AI miners and camp followers has exploded, making AI or Nvdia names that even your grandmother knows.

• In those articles, I cautioned that I believed the AI miners would find golden data, but how much of it they would find and how much investors would be willing to pay for it were big question marks.

• The other reality that I saw was that, with AI, we are in the mining phase, not the golden-products phase. No single product or service stands out at present as the game-changing prototype of things to come. 

This past week, a more ecnomical Chinese DeepSeek model caused lots of wild gyrations of most tech stocks. Net, net the tech market ended down only 3-4%. On the surface, DeepSeek, which costs a fraction of that of an NVDA, chip would seem to be a category crushing piece of software.

That many big techs rose sharply, such as GOOGL, AMZN, and Meta reminds us of what stage we are traversing in the gold rush. In short, those stocks rising clearly suggest that we are in the mining stage of the gold rush and not in the ingot stage. 

AMZN may be the biggest benefactor of the AI gold rush of any stock in America. They have millions of employees, millions of products, thousands of warehouses, millions of delivery miles worldwide, and billions of customers. If a better, more efficient, and less costly means of doing business is not in AMZN's future, AI will be the biggest bust since Beany Babies. 

Other giant benefactors of AI will be WMT, COST, the banking and insurance industries, and the industrial sector. If industrial sector companies like Raytheon, Caterpillar, Honeywell, 3M, and GE are to 'reshore', jobs from overseas, they must extract enormous costs from domestic manufacturing. My guess is they can do it, but it will take years, maybe decades, to get it done.

I believe DeepSeek will ultimately be viewed as a boon to the AI industry. It reduces the cost of participating in the AI gold rush and broadens the number of institutions and people who can afford to play.

Greg Donaldson has founded or co-founded four investment advisory firms and two families of mutual funds. He has authored two books, one on investing and a book of poetry published soon after he was out of college.  

This article is not intended as investment advice. You should seek an investment professional's views before making any investment. 

These views I have shared here are my own and not any company I am associated with.

Using Simple Mathematical Calculations to Value Coke vs. PepsiCo

 1. In my recently released book, The Hidden Power of Rising Dividends, I described my 40-year journey into finding methods of valuing stocks.

2. My journey of valuation discovery was always about finding methods that worked, not just focusing on dividend investing, although for many companies, dividends are the best indicator.

3. Over the next few months, I am going to do a series of valuation comparisons of great companies of our country and the world. These comparisons will describe the various methods I have found to be helpful. The first two are Coke and Pepsi.

4. Coke and Pepsi are powerful brands that have won over our taste buds, grocery shelves, and portfolios. Most people are in one camp or the other, but these two companies are very similar in many ways. My blindfolded taste test can't tell them apart.

5. Since they are so dominant and so similar in their products and marketing, I have found that most people assume they are almost always efficiently priced and valued at about the same level. In this first look at the tools I have learned to use, a surprise may be in store for you.

 In valuing Coke and Pepsi, I am using a multi-stage correlation model. This model computes a correlation score, called R2, for eight different fundamental indicators for each company, such as earnings, dividends, sales, profit margin, GDP, etc., compared to changes in the company's annual stock prices. With both companies, the correlation, R2, between their annual dividends and stock prices is above 90%, and overrides the need to include any of the other fundamentals. Very simply, this means that over the last 15 years, the annual changes in the dividends for each company were able to explain 90% of the annual changes in its price. 

Next, look at each chart and note that stock prices are on the vertical axis and dividends per share are on the horizontal axis. The red line is the actual annual price over the last 15 years and the green line is the predicted price using the correlation formula. Here is where the model begins to talk. While these two companies are very similar in what they do, they are not similar in prospective valuation. PepsiCo's chart shows its current selling price of over $175.00 is well under its predicted price of $190.44. Coke's story is just the reverse. It is currently selling for over $68 per share, but its predicted price says it should sell for $63.74.

Remember, this analysis is pure math. It is not a deep analysis of each company's intrinsic value. This is just a statistically significant computation comparing the changes in each company's annual dividends with changes in their annual stock prices. Yet, with 90+% correlations for both companies, to ignore what the dividends are saying would be unwise. Indeed, these computations are saying Coke is over 15% more expensive than PepsiCo. A spread that wide would seem to favor PepsiCo at present. Next, however, we all know that the market always looks ahead. Next time I will share with you howe we can adjust the current valuations for a look into the future. In the meantime, let's just see how the the two stocks perform over the next few months.   

It's Official: The AI Goldrush Is Underway

 

1. Near the end of the dot-com bubble in 2000, my business partner and I stumbled onto the notion that the techs were acting much like a gold rush. Gold was being found in the dot-com world and creating riches, but its passion was producing ever more gold miners with golden dreams.

2. Our company had traversed the dot-com craze during the late 1990s, chasing the gold like everyone else. But in early 2000, our valuation models simply could not justify the tech prices . .  . not by a mile.

3. A simple truth spoke to us: Never in the history of the US stock markets had an industry grown fast enough, long enough, to justify the prices of most tech and big consumer stocks.

4. We decided to cut back on the hottest of the highflyers. It changed our company and our lives forever.

This seemingly bold move was not based on something we were convinced we knew, but just the opposite. It was because we knew we did not know how to value the techs, and that being the case, we decided to stand aside. Even then, there was nothing bold about our decision to start cutting back on techs. In fact, we visited every client we had and admitted to them we believed the techs had reached the gold-rush state, but they might just keep going higher like they had over the last decade. The only thing we could say for sure was that our valuation models showed that many slower-growing companies were great values. We advised them we recommended placing sell orders 15% below the current prices on the six most overvalued tech stocks. Should any of these sell orders be triggered, we would invest the proceeds in undervalued dividend-paying stocks with dominant positions in their industries. 

During the year 2000, all six of the stocks' sell orders were triggered, and we bought financials, consumer staples, and industrial companies whose prices had gone flat in recent years because their sales and earnings were growing in the high single digits, much less than the 25-50% annual earnings growth of the techs. Interestingly, these undervalued dividend-paying stocks actually rose in 2000 when the overall market fell by over 10% and the dot-com gold rush ended. 

Why am I sharing this old tale? Am I predicting the AI gold rush is near its end? Indeed, are there other stocks that offer much better value with good prospects for future growth? No I’m not. I am announcing; however, that the gold rush in AI is now a reality and there are two truisms about gold rushes of the past. 1) When everyone, everywhere knows that an industry or a particular stock is the center of the investing universe, there is a good chance that everyone owns the stocks and the new money needed to push the stock higher will soon be tapped out. 2) The analysis at the end of gold rushes has always revealed that the companies that sold the picks and shovels for the miners were the best place to put your money, not in the gold miners themselves.

As one who is old enough to remember the dot-com collapse, my reason for writing this blog is to just give everyone a heads up that in my judgment, the AI phenomenon has officially reached the gold rush state. I said last time, my valuation models are showing that an S&P 500 level of 5700 is reasonable. If the AI world can produce overall sales and earning growth for corporate America of 11-12% over the next five years, the market is fairly priced. If earnings growth is higher than that, stocks still have a good run ahead of them. However, if the earnings growth falls back to a 7% or 8% handle, stocks will fall. Additionally, I do not see a long list of undervalued non-AI companies. Thus, I conclude the gold rush has room to run. I’ll keep you posted on what my models are saying as we go.

If you would like to communicate with me directly, email me at info@gregdonaldson.com  

Why Are Stocks So Volatile?

Stock market volatility has increased dramatically over the last six months. Many commentators are saying the increased volatility is a negative sign for stock performance through the remainder of the year and perhaps beyond.  As usual they might be right, and they might be wrong.  Before we give you our view, let’s look at what we believe are the three main drivers of the increased volatility and see how they are trending.

1. Uncertainty about the timing of the Fed rate hike

2. Earnings worries

3. Valuation concerns

The Fed: Don’t fight the Fed, don’t fight the Fed, don’t fight the Fed.  As any seasoned investor knows, these are the first three rules of investing.  The Fed has incredible power to impose its will on the markets.  Back in the days prior to the Tech wreck, commentators were saying that the Fed’s power to rein in the technology stocks was dramatically reduced because most of these companies used very little debt.  The Fed raised its Fed Funds rate seven times before Tech stocks crumbled, but crumble they did.  Again in 2009, the chorus of naysayers was deafening in its assertion that the subprime crisis was too big for the Fed.  Today the S&P 500 is approximately 300% higher than its low in March of 2009.  In our judgement, the Fed can do what it wants.  So the single most important question facing investors is, “What does the Fed want?”

We believe the Fed has no intentions of causing a big sell off in stocks. Indeed, Quantitative Easing was all about pushing investors out of riskless securities and into riskier assets, including stocks.  Why would the Fed have moved heaven and earth over the last six years to avoid a deflationary mindset from setting in with banks and investors, to toss it all away and send stocks into a tailspin?  That is an absolute recipe for recession, and they know it.   

The Fed wants to keep a lid on inflation and stimulate job growth, yet it also wants to avoid both another 1995-1999 stock market melt-up and a 2000-2002 meltdown.  Our Macro Team believes that the lessons of the 1990s are still very much alive in the minds of the Fed.  To accomplish their purposes, they are likely to do a lot of talking but very little acting.  We believe Fed Chair Janet Yellen said as much in her speech last Friday.  The uncertainty about what the Fed will do is not going away, yet we believe the odds of the Fed slamming on the brakes are extremely low.  They will increase rates modestly at some point, but we do not forecast a long string of hikes that would freeze the markets or cause a big sell off.

Earnings: Earnings growth for the S&P 500 over the last 12 months has been a paltry 4.3%.  During this same time, stock prices have risen nearly 13%.  At the beginning of 2014, we said that stocks were about fairly valued, so the returns for the year would likely be about the same as earnings and dividend growth.  A 13% price return on earnings growth of about one-third of that is front and center in the minds of every investment firm we know of.  The market has given the weak earnings a pass so far because of two unusual events:

1. The dollar has risen by as much as 20% versus the currencies of other developed countries.  Since S&P 500 companies generate nearly 50% of their revenues outside the U.S, they have had to absorb currency losses for the last four quarters.  These currency translation losses have significantly reduced reported earnings.  This trend cannot continue indefinitely.

2. The entire Energy sector took a huge earnings hit in the fourth quarter of 2014 and will again in the first quarter of 2015.   Since the Energy sector represents nearly 10% of the S&P 500, it has also produced a drag on corporate earnings.  Once oil prices reach a bottom, this too will cease to be a headwind.

The good news here, which gets almost no attention in the media, is that S&P 500 dividends increased by over 13% during the last 12 months.  We consider that an important signal that corporate America believes the two headwinds hurting earnings are temporary.

Valuation:  If prices rose in 2014 by 13% and earnings grew by only 4.3%, then the price-to-earnings (P/E) multiple expanded.  Indeed, the P/E multiple now stands at nearly 18 times earnings, which is the highest level since 2007. Stocks are not cheap from a P/E perspective, which worries a lot of investors. We have modeled P/Es going back to the 1920s and we find there is no such thing as a “normal” P/E ratio.  

Our research shows that P/Es are inversely correlated with inflation.  In high inflation periods, P/E ratios have almost always been low and high in low inflation eras.  Think of it this way:  If we divide earnings by price, we produce something called Earnings Yield.  Earnings Yield is stated as a percentage.  It is essentially a computation that shows how much a company’s earnings produce as a percentage of it price.  This percentage can then be compared to bonds, inflation, or other stocks to determine how good of a deal you are getting.  This is how an investor like Warren Buffett determines if Heinz or Kraft is a good deal.

As we said before, the S&P 500 is currently selling for about 18 times earnings.  To convert this into an Earnings Yield, we divide 18 into 1 to see that the current level is 5.5%.  That means if Warren Buffet was interested in buying the whole S&P 500, he would earn a 5.5% total annual return based on the current earnings.  5.5% does not seem like a great return, but there are two important considerations.

1. How does that return compare to my other alternatives?

While 5.5% may not seem like much, it is terrific when compared to a short list of alternatives.  A five-year U.S. Treasury bond yields 1.3%, and a ten-year U.S. Treasury bond yields about 1.9%.  Thus, not counting any earnings growth that we may receive in the future, stocks would seem to be a good deal with an earnings yield much higher than bond yields.  

As we said earlier, our work has shown that Earnings Yields or P/Es are most highly correlated with inflation.  Today, the inflation figure that the Fed uses, the Personal Consumption Expenditure Deflator (PCE) stands at 1.1%.  We have found that the spread between Earnings Yield and the PCD over the last 50 years has averaged 3.4%.  By adding the current level of inflation of 1.1% to the average spread of 3.4%, we find that the model would suggest that the right level of Earnings Yield for today’s inflation level is 4.4%.  

So we can get back to how we normally talk about earnings and prices, let’s re-convert the predicted 4.4% Earnings Yield back to a P/E ratio.  A 4.4% Earnings Yield would equate to a P/E ratio of 22.7.  With stocks currently selling at 18 times earnings, our P/E finder model would say they are  cheap.

2. Is that return all we are likely to get?

The current earnings yield of 5.5% does not factor in any future earnings growth.  If the long-term growth of earnings approximates nominal GDP growth of 5% or 6%, the effective earnings yield for today’s investor would double once every 12-14 years.

In addition to P/E, we have another way of looking at market valuations.  As we have discussed over the years, we have a S&P 500 valuation model.  This is a statistical model that calculates the relationship between various factors including dividends, earnings, inflation, and interest rates.  According to that model, we are currently selling about 7% under where year-end 2015 data for the variables are now predicted to be.

Bottom Line

Uncertainties about many different factors have caused stocks to become more volatile.  We believe we will know a lot more about Fed actions and the outlook for future earnings beginning in August once the impact of big changes in currencies and oil prices are better understood.  Furthermore, valuation is not a problem according to both our P/E finder model and statistical S&P 500 model.  

The current market’s volatility will ultimately pass.  Based upon what we see, the path of least resistance for stocks is still up.  However, it will take a few more months before many of investor concerns will subside.  The best course for investors is to ignore market volatility and remain committed to building a stream of growing dividend income.     

The Dividend Theories of John Burr Williams, Part II: Investing versus Speculating

This is the second blog in a series exploring the theories of John Burr Williams. You can read the first post here.

John Burr Williams’ book, The Theory of Investment Value, was not about beating the market or getting rich in the market.  It was really a wake-up call to the investment elite to offer them a theory of investment value that would encourage more long-term investing and less speculation.  Williams postulated that investors’ inability to properly value stocks increasingly led them to become speculators. Most people would not admit that they were speculators, but it was clear by their decisions that they were not appraising the intrinsic value of companies but betting that they knew something that the market did not.

Hot News Comes and Goes, But Dividends Are Forever . . .

Investors are constantly inundated with the latest regional conflict, political debate, economic data and interest rate predictions. All of this information represents the collective viewpoint or “consensus” of investors at any given point in time.

Over the many years we have spent studying the markets, the truest thing we know is that the consensus is already priced into the market... and the consensus is almost always wrong. If an investor believes the economy and earnings will be better in the future, they will “vote” with their money. In aggregate, all of those votes create the price level for a particular stock. If the consensus comes true, you won’t see much of a change in the markets and prices will generally drift sideways.

What changes the price of stocks are the things that the consensus doesn’t already expect. Therefore, the only way to make excess risk-adjusted returns is either:

1) Find where the consensus is wrong.

2) Look outside the box.

The ABCs of Dividend Investing: Part II, Dividend Growth Is Vital

In our previous blog on dividend investing, we offered some of our dividend research and a general theory on how to think about the importance of both dividend yield and dividend growth.  In this edition, we will share some of our insights into how different combinations of dividend yield and growth act in various kinds of stock markets.

When most people think of dividend-paying stocks, often they incorrectly think that such companies are unusual.  The truth is among the 500 stocks in the S&P Index, nearly 400 of them pay a dividend.  What makes a company valuable, according to our research, is that it has raised its dividend persistently and consistently over a long time.  We do not place hard limits on these descriptors because we do not want to eliminate companies that have persistently and consistently raised their dividends but not on a calendar basis. United Technologies (UTX), for instance, increases its dividend every six quarters; thereby, having years where it does not increase its dividend on a calendar basis.  The every-six-quarters approach is consistent and persistent, but UTX does not make the lists of dividend stars because of the occasional calendar miss. 

Our research in the dividend world began with the utility sector in the late 1980s.  That early research revealed some surprising results.