The Hazards of being In the Grip of a Growth Mania
- Big Data is being used to substantiate indefensible valuations and assert that traditional valuation is dead
- Firms benefiting from this like Carvana, Tesla, Uber, and many others are no different than the firms which, in the internet bubble, literally issued stock to sustain fundamentally failed businesses
- The historically failed “addressable market & winner-take-all” rationale today is identical to 1999
- This narrative device “…illustrates the timeless appeal of investing and the hope, usually unrealized, that the new thing will make us rich” has been a recurrent theme in manias since the days of John Law
- Even with perfect foresight, overpaying for firms which would thrive in the decades ahead overwhelmingly led to investor losses
- The performance leadership of overvalued firms is more pronounced today than in the run-up to 2000
- This may be unfortunate because 50% of High Growth showed up in the worst two deciles of performance in the years subsequent to the market’s 2000 peak
- Many IPO stocks are the epitome of this narrative delusion with the recent additions to indexes being more richly priced and fundamentally flawed than those seen at the peak of the internet bubble
- Valuations of today’s new High Growth stocks are equally, if not more, overvalued than those in 2000
Figure 1 below seeks to build on the items above by showing the historical percentage of High Growth firms that outperformed over the next 12 months. From 1996-1999 betting on High Growth stocks was a winning decision as their win rate vs. the market soared from 19% to 62% before the group imploded, and its batting average fell to 6%. In a near-perfect reprise, the period from 2015-2019 encompassed a run from 20% to 71% before falling to 57% today. While impossible to time, Kailash believes the winning streak of today’s Growth stocks will follow the 2000 trajectory and eventually crash toward the zero bound as it did towards the end of 2000.
In This Time is Different: The Death of Valuation Kailash presented the below table as evidence that the high-Growth cohort is as dangerously overvalued today as it was at the peak of the internet mania. Kailash did note that one might suggest the 23x Price to Sales ratio of these firms today might look “inexpensive” relative to the 90.1x seen at the peak of the internet. Our explanation in that paper sought to highlight that the Price to Sales ratio of the most expensive decile of firms in 2000 was not all returns-driven and leaped from 30x to 90x sales in a matter of months. Kailash also promised a paper that would explain how 20x price to sales offers limited if any improvement over firms priced at 90x sales.
Figure 3 below shows the percentile distribution of Price to Sales ratios for the R1000’s Growth firms:
- When Growth stocks are cheap (10th Percentile), they trade at ~6x Sales
- When Growth stocks are expensive (90th Percentile), they trade at ~15x Sales
- Today Growth stocks are at 23x Sales, among the most expensive of all observations
- Today’s valuation at 23x P/S is identical to August of 1999 – right before the batting average of overpriced Growth stocks cratered from > 62% to 6% as documented in Fig. 1
Figure 4 below builds on the observations from Fig. 3 above. The first two bars show the batting average and excess returns of buying Growth stocks when they are in the cheapest decile of their historical Price to Sales range. Buying High Growth firms when it is historically cheap has generated an impressive 79% batting average and 8% average outperformance.
The second two bars show the long-term batting average and excess return of buying Growth firms dating back to 1989. On average, betting on the most richly priced Growth stocks over the full history of the group has resulted in a 51% batting average generating a 2% excess return compared to the market. Kailash believes it worth noting that this data includes the current period. This is the empirical equivalent of ending a data analysis in December 1999, just before Growth collapsed from their speculative extremes.
The last two bars show what Kailash believes is a precursor to the future: what happens when you invest in Growth stocks valued at speculative extremes like today. The batting average when you buy Growth in the 10% of periods where it is most highly valued is 26%, with average 12-month forward underperformance of 13%. Kailash reminds readers that the High Growth cohort is valued in the 95th percentile today.
Kailash understands that history rhymes but does not repeat. Nonetheless, we felt walking our readers through the month-by-month progression of Growth during the internet bubble an informative exercise. As seen in Fig. 1 above, buying the most richly priced Growth stocks in August of 1999, a time when Growth’s valuation mirrored today, led to disaster in the coming months.
Figure 5 below shows the evolution of:
- Navy Blue Bars: 12 month forward batting average of High Growth (higher numbers are better)
- Light Blue Bars: 12 month forward excess return of High Growth (higher numbers are better)
- Grey Bars: Price/Sales of High Growth (higher numbers are more expensive)
Conclusion: From August to November of 1999, the batting average of High Growth fell from 60% to 34% while P/S jumped from 23x to 36x. By that November, the wreckage borne by those betting on game-changing Growth began in earnest. As the batting averages plummeted toward the zero bound, the losses came with career-ending fury. By February of 2000, only 2.5% of these richly priced 47x sales Growth stocks would outperform, with the average loss being -54%. While the batting average did rise to 16% by May, the carnage for portfolios holding these narratives continued unabated through August of 2000, where P/S peaked at 90x
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The Resurrection of Value Post a Period of Manic Growth
Figure 6 below plots the batting average of deep Value stocks and is the mirror image of the data presented in Fig 1. In August of 1999, when the market’s manic obsession led to a 60% batting average in Growth stocks, Value was so out of favor its batting average had fallen to 18%. This dismal performance proved fleeting. Value stocks went from “can’t win” to “can’t lose” as batting averages soared from 18% to 89% between August 1999 and August 2000.
Readers can see a similar phenomenon at work today. The last data point on Value stocks’ batting average is nearly identical to the all-time low seen at the peak of the internet bubble. While the timing is uncertain, Kailash is confident that the most shunned and inexpensive firms today will, eventually, experience a stunning come-back similar to that seen in the period from August of 1999 through August of 2000.
Figure 7 below walks through the evolution of Value stocks’ batting average (navy blue bars), excess returns (light blue bars), and P/S (grey bars) over the same period used in Fig. 5 above. The inversion is as compelling as it is informative. The data shows that post periods of extremely manic price distortion in favor of Growth stocks in periods like the internet mania, Value goes from being reportedly obsolete to ALL THAT MATTERS.
Conclusion: After a prolonged period of outperformance, Growth stocks today are as expensive as they were in August of 1999. Figure 8 puts what Kailash believes is a simple and fundamental truth to our view that the dispersion between Growth and Value today is equally, if not more, alarming than at the peak of the internet bubble. What stands out to us most profoundly is the free cash flow and shareholder yields found among today’s Value stocks.
At the peak of the internet mania, the stocks that would prove to be “shiny objects” with fatal consequences burned 1.2% of cash relative to their bloated EVs while their Value peers generated 2.4% FCF yields. While the Growth stocks of today look very similar to those of 2000, the Value stocks today generate immense cash yields relative to EV despite negative GAAP earnings.
Figure 9 below shows the fundamental characteristics in order of rows:
Today’s Growth firms
Today’s Growth firms that are also in the bottom quintile of the Kailash ranking model
Today’s Value firms
Today’s Value firms that are also in the top quintile of the Kailash ranking model
Conclusions from Figure 9:
As documented in this paper, High Growth firms are trading at indefensible valuations. Among these Growth firms, looking for shorts in the bottom of our model finds firms that trade at slightly higher premiums based on valuation despite having ROEs, Margins, Shareholder Dilution, and ROAs that are 2x worse than the Growth firms as a whole.
Looking at Value firms that are in the top quintile of our model ranks (4th row) vs. all Value firms, the advantages are enormous. The FCF yield soars to a double-digit number, ROE flips from negative to positive 9.5%, ROAs are positive, and net debt is lower. Kailash believes now is as good a time as any to be avoiding or shorting High Growth firms and shopping for Value firms favored by our models.
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For a list of the Top/Bottom-ranked Value/Growth firms in the Kailash R1000 universe, please see the exhibits to follow.