As of yesterday (June 8, 2020), the S&P 500 had recouped all its COVID-19 losses incurred in March, while the NASDAQ reached new all time highs. We all instinctively know that times are difficult, yet investors who are watching “the markets” could be forgiven for thinking that things may not be so bad.
The first question investors should be asking themselves now is: are these indices really the best indicators of the health of companies and markets?
Because both of these indices are “market-weighted”, it turns out that five companies: Microsoft, Apple, Amazon, Facebook and Google (Alphabet) make up ~46% of the “weight” of the NASDAQ and just above 20% of the “weight” of the S&P (higher than almost any point in history).
These companies have performed well this year, dragging up the performance of the “markets” but masking the true situation for the majority of public companies, where just over 60% of S&P 500 constituents remain down in 2020.
Why have these 5 stocks rallied throughout this crisis? No doubt they are fantastic companies, with sticky revenues and loyal and growing customers. But according to a Bank of America research report published on June 8, 2020, the rise of the S&P 500 and the FAANG stocks (the stocks mentioned above + Netflix) has been closely tied to the liquidity the U.S. government has injected into the economy during this pandemic.
I would also suggest the “piling in” to these stocks is a continued theme of investors chasing growth and comfort in the popular stocks, resulting in passive investors (via exchange traded funds) having to continue to buy these stocks, resulting in their stock prices increasing, resulting in investor greed and fear of missing out, … , and the cycle repeats.
Another indicator of investors’ current insatiable appetite for growth can be seen in the historical percentage of unprofitable IPOs (initial public offerings), which currently sits at an historic high and above the Tech Bubble levels.
So with that as a backdrop, the second question an investor should ask is: What is an investor to do now?
There are no definitive answers. The only magic bullet I can offer is as follows: buy and hold high quality companies, trading at reasonable (or ideally, discounted) valuations.
It turns out that what one pays for a company (valuation) is the most important determinant of long-term stock returns.
The chart below tells us a few key things:
- Most importantly, when looking at the returns of the S&P 500 over the past 30+ years, generally, the higher the valuation (measured using price/earnings ratio), the lower the subsequent annualized returns have been.
- Even during this COVID-19 pandemic, the market is trading at above-average valuation multiples.
- When valuation multiples get above 30x P/E, subsequent 10-year returns tend to be negative. (Note that according to Yahoo Finance, Facebook, Apple, Amazon, Netflix, Google and Microsoft currently trade at P/E multiples of 32x, 26x, 122x, 85x, 29x, and 31x, respectively. And everyone’s favourite new stock, Zoom, trades at 1,234x earnings – not a typo).
You will also note from the chart above, that average valuations tend to cluster between 13-18x P/E. The challenge with sky-high valuations, is that companies either have to “grow into” their valuation to maintain their stock price, or suffer stock price declines.
As per above, assume the average high-quality S&P 500 company ultimately trades at a multiple of 15x earnings. Netflix currently trades at ~9x revenues and ~85x earnings. What would it take to grow into its valuation?
At its current market capitalization, if Netflix traded at a P/E of 15x, its net income would have to be ~$12 billion. For net income to be ~$12 billion, at its current operating margin, revenue would need to exceed $85 billion (a 4-fold increase from here, or >30% revenue growth per year over the next 5 years). Recall that Netflix grew revenues to $21 billion with little competition for much of its existence. And you know what they say…“the first $21 billion is always the easiest.”
Netflix’s current valuation combines comedy, drama, suspense, thriller and horror.
During the tech bubble, Sun Microsystems was trading at similarly lofty valuations before crashing spectacularly. In an interview in 2002, its CEO Scott McNealy famously stated:
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
So to repeat the second question again: What is an investor to do now?
Value over Growth
Using history as a guide, it may be time for “Value” investing to shine. According to Bank of America, Value led in 14 of the last 14 recessions, and by ~23% on average.
However, Since the fall of 2014, the gap between the price-to-earnings valuations of the S&P 500’s most expensive (“growth”) and least expensive (“value”) stocks has doubled. Expensive stocks have gone from 24x to 33x P/E while cheaper stocks have gone from 11x to 8x. Only 3% of the time in history has the gap been wider.
When valuations revert to their means, as they inevitably do, undervalued stocks have the potential to significantly outperform overvalued stocks, as they have in the past.