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The Dangers of High Expectations

Investors need to understand the expectations that are built into their investments. When large scale events such as the Covid-19 pandemic occur, investors reprice equities based on new information. Expectations can often exceed reality though. Dramatic changes to daily life happen, but many times slowly. In 2020, a tech vs non-tech argument has developed amongst investors. There has been a clear performance trend in the work from home space, while physical businesses have suffered. With the recent announcement of Pfizer’s and Moderna’s clinical vaccine results, the world now has strong evidence that at some point in the near future, Covid-19 will probably end.

The question today is what the world will look like after the virus subsides. The work from home trend will likely continue to some extent, but how prevalent it will remain is unknown. Investors today are trying to price equities according to how the world will function in 2021, 2022, and beyond. When specific industries experience dramatically quick growth, pricing future cash flows becomes difficult. Investors need to be mindful of what they’re paying for.

Applied Finance believes that some portions of large-cap stocks have recently become expensive. In particular, large growth names are pricing in exceptionally strong future cash flows that may be difficult to realize. Below is a map of Applied Finance’s corporate performance measure, Economic Margin, in all sectors within the Russell 1000 Growth index. The blue bars represent implied profitability, while the gray bars represent actual profitability. In nearly every sector, investors are pricing in expectations for higher future profitability than what is currently being achieved today.

Diving into specific firms, below are three examples of companies experiencing lofty expectations in 2020:

On Friday, October 30, 2020, Twitter’s stock fell 21% after it reported horrendous earnings. During a global pandemic where people were forced to interact through technology, and in the middle of a peak US election cycle, TWTR reported only $29M in GAAP Net Income for Q3 2020. Quite small for a firm valued at nearly $50B! A perfect scenario occurred, but the company was unable to monetize. High expectations can drive stocks upward, but not achieving results can lead to drastic consequences.

Zoom has become the face of the 2020 pandemic for stocks. With a significant amount of companies moving to online meetings, “send me a Zoom link” has become the new “Google it”. Pfizer announced trial results for their vaccine in early November. Over the next two days, ZM stock fell from $500 to $376 and hasn’t recovered since. Although the company is cash-flow positive, ZM will likely need strong near-term growth to hold its current valuation.

2020 has seen online retail reach new records. Although Amazon is the largest example of the e-commerce market, investors are constantly looking for the next big thing. Many tech investors have praised Shopify as the up and coming giant. Shopify’s stock is currently up ~125% this year with sales projected to grow at more than 70% in 2020 FY. However, with SHOP earning $180M in Operations Cash Flow during Q3, they fall significantly short of AMZN’s $11.96B in Ops Cash Flow during the same period. SHOP will need to dramatically expand cash flows and margins over the next few years to sustain the current ~$110B market cap.

Investors should remember that they’re paying for future results, and someday, those results need to materialize. Promising stories and large top-line growth can drive stock prices in the short term, but cash flows in the long term are king.


  • John Holt, CFA joined Applied Finance in 2014 and is involved in the management of both quantitative strategies and analyst driven strategies.


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