|The Valuation Edge Newsletter™ – September Issue|
It’s becoming increasingly difficult to avoid the conclusion that today’s stock market resembles that of the late 1990’s. I’ll have a better feel if that is indeed the case when I visit my dentist next week for a routine check-up. If he recommends NVIDIA, we officially have entered another Tech Bubble. In an analysis that has aged quite well, Then and Now, we contrasted the investment landscape in 2009 versus 1999. In 2009, dentists talked up flossing, in 1999 they talked up Pets.com.
Paul Blinn’s latest Market in Pictures is out, and opens with a reminder of the importance of coffee to human progress. While we are not sympathetic to the plight of traditional value managers here at The Valuation Edge, we are sympathetic to their clients. We’ve posted a succinct summary graphic of their pain. Dan Rasmussen of Verdadcap identified a must-read white paper on value investing and technology, Cliff Notes version – Value investing has devolved into a bet against technological disruption. Each slide lives up to our motto to Entertain, Engage, and Enlighten.
As Valuation Driven® managers at Applied Finance we are just now starting to struggle with the proper price to pay for disruption companies. Until recently, we understood the returns these companies generated warranted high multiples, which cheapness managers cannot properly square from a valuation perspective. Today many of the most profitable companies that led the market out of March lows, reflect very high future expectations. Some are still acceptably priced while others are candidates to sell. For example, we initiated entry into NVDA at $13, and were laughed at by many value managers as we continued to hold it at $100 with a 60x multiple. While a 60x multiple looks grossly expensive by any traditional “value” standard, such approaches ignore the wealth compounding effect of combining high economic profitability with reinvestment. Relying on simplistic ratios such as book to price as a valuation compass on NVDA at $100, resulted in missing a subsequent 5x move to $500. We sold NVDA in the low $500’s last week. Fantastic company, but the future economic profit expectations built into its share price make it a poor risk/return trade-off investment from our perspective. Ultimately that is what sets Valuation Driven® investing apart from “value” investing – being able to properly express future expectations relative to current prices. Simplistic multiples will never properly catch that dynamic. Next month, look for an interview with Dhaval Sanghavi, our technology analyst discussing our decision with NVDA and an overview of the technology sector in general.
Like the old Domino’s Pizza promotion, “Something for Nothing”, it has been the case that the market has been giving away free returns to the largest firms regardless of their valuation or expected future corporate performance. This is a point made by Leon Cooperman recently, when he said the market has likely absorbed future demand. For a historical perspective on markets getting ahead of themselves, Derek Bergen analyzes how risk is rewarded through various market regimes. Ironically, it’s the “safe” stocks today that are extremely risky for your portfolio, … time to party like its… you get the picture. One thing to remember though, is that the market is usually considered from the perspective of a market cap-weighted index, which over time has significantly underperformed its equal-weighted counterpart. Thus, while the cap-weighted market may perform poorly, the equal weighted market may perform very well.
We firmly believe in a modified version of the old saying – Those that can, add alpha; those that can’t, should index. Passive investing has the disadvantage of consistently over-investing in overvalued stocks and under-investing in undervalued stocks. Sometimes such discrepancies don’t matter. However, sometimes like in 1999, they matter a lot. How about today? John Holt examines what percent of stocks in the S&P 500 are statistically overvalued. It’s time to party like it’s 1999….
Have a great September!
It depends. The push in megacaps has caused index concentration to be at their highest levels since the 1970’s.
The number of S&P500 companies signaling significant valuation downside has recently crossed a threshold that signals that the market is experiencing an unhealthy appetite for risk amongst investors. Similar trends were seen during the Tech Bubble.
A significant valuation gap has formed between “high risk” and “low risk” equities. “Low risk” stocks currently trade at historic premiums last observed at the peak of the Tech Bubble.
Performance differences between firms that repurchase shares and issue dividends, vs. firms that constantly dilute shareholders, are staggering.
According to the Applied Finance Intrinsic Value Factor™, “growth” stocks in the Russell 1000 are now at levels last observed in the peak of the Tech Bubble and The Russell 2000 relationship exceeds any level observed over our live research horizon.
Small-Cap “value” space looks like a solid starting point to identify companies trading at a discount. Quality companies that can fund themselves at low rates and pay attractive dividends also merit attention.
Market Realized Earnings & Forecasts
Although much of the nation has reopened from full lockdowns, it is unlikely that earnings in 2020 will reconcile with current analyst forecasts and increasingly difficult for analysts to provide meaningful guidance on stocks hammered by Covid. Focus on cash flow and capital levels, not headline earnings.
For August, we highlight the importance to productivity of waking up properly, the plight and pain of traditional value managers, a must-read white paper on value investing and technology and touches on several other hot topics in the current market ie. Tesla, China, Tech etc.
Until next month.Wishing you all the best!
The Valuation Edge™
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