Value Vs Growth. Did Gravity Start To Get The Better Of Greed?

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“The only two things you can truly depend upon are gravity and greed.”

Jack Palance, Ukrainian/American Actor

A new thought has been circulating in the echo chamber of financial punditry in the last few weeks - ‘tech stocks are now defensive ’. This includes Tesla, now trading on a multiple of 75 times what analysts hope earnings will be in three years. The valuation multiples for Amazon and the rest of the FAANGs are more conceivable yet it still remains difficult for a fundamental analyst to conceive of them as truly defensive. Their value is mostly contingent on the beliefs of mainly speculative investors, who can change their mind in an instant. Nevertheless, this idea started to take root during the onset of the COVID Crisis when the market correctly predicted that their cash flows would be less affected than those of industrial companies in the event of an economic shutdown. It is often said that all bubbles start with a sensible idea that gets exaggerated. The legendary investor, George Soros, went a step further and stipulated that you need a ‘fundamental misconception’ to take root before a bubble can truly be formed. The idea here is that a misconceived belief can become self-fulfilling if widely enough held and the fact that it is difficult to rationalise only serves to sever the links with fundamentals. Only at that point does the bubble really have the freedom to inflate.

The following chart shows how this self-reinforcing belief may have gained currency in the aftermath of the COVID Crisis and why a market fall last night in the US, that was led by tech stocks, might prove to be significant if it turns out to be a crack in the sentiment that has underpinned the rise and rise of tech stock valuations.

This might all seem a bit ‘micro’ and it’s true that a couple of hours of market action a rotation does not make. Nevertheless, it is worth paying attention because by the time it becomes really obvious something is happening it might be too late. The value rotation in early June was quite explosive but the gains evaporated just as quickly when the market sniffed the second wave in the US and further economic weakness. Yesterday may have witnessed a very different thought process - what if safety lies not so much in a blue sky future for evermore successful digital companies but in more mundane bricks and mortar assets or just earnings that someone else is not already paying a wild multiple for.

The last time we saw a rotation into value when the metrics between growth and value companies were quite so stretched was in early 2000 when the dot com bubble burst. It seems inauspicious that last week the tech-heavy Nasdaq Index reached a price/sales multiple last seen in 2000.

A technical note: Back in the (Dot Com) day it was de rigeur to value tech companies on a multiple of sales on the basis that 1) they had little or no earnings but 2) if they had enough sales and had cornered the market in online pet food or nappies then they could, at will, increase prices with little impact on volume until they traded on a reasonable price/earnings multiple. In that sense price/sales was a leap of faith that envisaged what a mature company might achieve and the same rationale still applies to Amazon (currently trading on a P/E of 140) given its market dominance. And it’s true that Amazon can probably just increase its margins without scaring off too many customers. Applying the same logic to a whole index of companies, many of which are still at the early, unproven and capital intensive end of the disruptive cycle seems again foolhardy. By the same token, many of the companies in the Nasdaq are now very profitable and still growing strongly so we might not necessarily expect the same kind of carnage seen after 2000 when the Nasdaq lost 80% of its value. Plus, with such low interest rates higher valuations are to some extent justified for companies with such a long tail of growth and potential cash flows (if a thirty-year government bond yields next to nothing potentially large profits far in the future are relatively attractive for long term investors).

Still, the parallels with the late ’90s remain striking and the first part of the graph on the left (1998 and 1999) looks eerily similar to the last few years. It also seems improbable that our present-day tech stars are not only relatively immune to the COVID Crisis but are somehow, fundamentally, 25% more valuable than they were at the start of 2020. Some degree of speculative fervour, similar to that of 1999, would seem to be at play. Mark Twain’s supposed remark about history not exactly repeating itself but having a propensity to rhyme is often invoked about financial markets - the implication being that we are unlikely to repeat exactly the same mistake twice but we might get close. Maybe in the world of high-frequency trading and social media, 20 years, give or take a couple of months, is long enough to forget everything.

The other thought that the above graphs might provoke is that such speculation will have dragged the whole market higher. If that is the case then maybe just steering clear of tech stocks might not be enough to generate decent returns amidst a bursting bubble and possible recessionary scenario. Indeed the trajectory of the Dow Jones looks like it was flat in the graph above but was actually down 15% after dividends three years later and by 40% at its worst point. So why bother investing at all? It might be safer and less painful just to stay in cash until the storm passes. But then there is the uncomfortable thought that the storm may never happen. And again cash and bonds are both yielding nothing, especially after the effects of likely inflation.

At this point a little local history is useful. In the lead up to 2000 Australian value stocks came to be seen as the dullest companies in the dullest market in the world. Resource stocks were the most hated of all and the rest of the market was all but forgotten (apart from News Corp and OneTel). Local value manager, Maple Brown Abbot, had doggedly maintained a hopeless portfolio of bricks and mortar stocks that ranged from boring to structurally challenged, and been roundly criticised for doing so from all quarters. Absolute performance was OK but when the rest of the market had just risen by 30% that seemed to be missing the point. The interesting thing was that when the winds of sentiment changed those boring stocks didn’t just stand still while the world fell around them, they proceeded to jump higher - there were significant gains to be made from the rotation into these supposedly ‘structurally challenged’ stocks. Reasonable dividends and high single-digit promised returns were suddenly an attractive proposition for fund managers that needed to invest somewhere.

The graph above shows not only the stellar performance of Maple-Brown Abbot’s stalwart holdings over the next three years compared to the local index but also the degree to which the local market was relatively unaffected by the Dot Com bust. This time around there is scant evidence that the whole market has been left behind to the same degree. In fact, two decades of superannuation flows may well have made our shares just as expensive, or more so, on a like for like basis. At any rate, there is nothing particularly hated about many of our current market darlings but we have been actively looking for pockets of the market that could benefit in the same way and they tend to be smaller companies, especially in Australia. Overseas they tend to be in industries that share the same structurally challenged or forgotten characteristics in unfashionable places like Europe, Japan and parts of Asia as well as the industrial backwaters of the US.

A word of caution: It may turn out that there is nothing that rhymes with Dot Com bust in the current market and if there is a bubble it might be a long time before its bursts. The market always, by construction, surprises us and if Warren Buffet had been an advisor he would have lost his business several times over by swimming against the prevailing current. However, he is stoic and he runs a close-ended vehicle with a long-term value style - people can say that he has lost his edge all they like but he can’t have outflows. Soros on the other hand fully recognised the behavioural element of markets and famously exploited greater fool theory through several boom and bust cycles in several asset classes. He also had an incredible sense of timing, part of which was reliant on indicators like his own back pain (a spasm in his back would often preempt a crash).

Our approach is a little more mundane than either or those investors - from a valuation point of view, we aim to ensure that the investments we hold are coherent with the objectives of the portfolio in question. But there is also a limit to how much we will second guess a market that is usually approximately right and so, like everyone else, we still have a reasonable exposure to the large tech companies that dominate world indices as well as the ‘quality’ healthcare stocks that have also done so well. At a point like this though, when the greater fool starts to become more visible through the market mist, we will start to focus our research on areas where mere high single-digit returns can be reasonably expected, just in case someone’s back starts playing up. And if, in the future, someone decides to pay more for those kinds of investments because they come back into vogue then so much the better.

Jonathan Ramsay14 July 2020