By Jack Forehand, CFA, CFP® (@practicalquant) —
As a value investor, I have a weakness that I have struggled with my whole career: I really like buying things when they go down a lot. That can be a good thing when a stock is down for reasons that are not supported by the fundamentals. But it also can be a bad thing when the decline is justified.
That is the dilemma I have been thinking a lot about with growth and technology stocks right now. There is little doubt that many of these stocks were dramatically overvalued in the beginning 2021. No matter what metric you looked at, the peak valuations for growth stocks in mid-2021 were extreme.
This is a chart of the valuation of the most expensive decile of our investable universe using the Price/Sales ratio.
Look at that peak in 2021. The Price/Sales ratio required to enter that top decile had barely crossed 6 at its highest point leading up to mid-2020. And then it peaked at 11 in 2021. That was almost double the previous high in the chart.
There is no doubt that growth stocks got to valuation levels that were essentially impossible to justify based on even the most optimistic future expectations. But, as you can see to the right of that peak on the chart, those valuations have also been almost cut in half since then.
But even after that decline, the overall valuation remains about 30% above its average for the full period. So if you think the Price/Sales is a reasonable ratio to use for this type of analysis, growth stocks are still far from cheap.
Valuation in the New World
But what about other metrics besides the Price/Sales? We could look at this same chart using the Price/Book or the Price/Earnings, but both of those are less relevant in today’s economy. Since intangible assets like brand and intellectual property account for such a large portion of the value of growth companies, and these metrics don’t properly account for them, they aren’t nearly as relevant as they once were for looking at growth valuations.
But the Price/Cash Flow can be a better indicator. And it paints a slightly better picture than the Price/Sales.
The current Price/Cash flow is 8.5% above the average for the full period.
Another possibility is that we aren’t valuing growth companies correctly using any of the standard metrics in the new technology driven world that we live in. Maybe we should be looking at price relative to things like patents and brand value and the talent within a company’s workforce. That is the point Kai Wu made to us on the recent podcast interview we did with him.
Seeking Diamonds in the Rough
One thing that it is important to keep in mind with growth investing is that it requires skill. The reason is that a basket of expensive stocks is likely to underperform the market over the long-term since expectations in the growth space usually exceed reality. But the best performing individual companies in the market are also likely to be found within that basket. Therefore, growth investing becomes a game of finding the diamonds in the rough. So even though the overall growth basket might not be cheap, there is clearly more opportunity for skilled growth investors to buy the future great growth companies at much better prices now than they could have 18 months ago. The challenge is that those companies are very difficult to identify in advance.
The Differences with 2000
Many investors want to compare the current period to the period that ended in the 2000 bear market. And there are good reasons for that. Both periods ended with some of the highest growth valuations in history. Both periods had extreme examples of speculation. And both periods ended with major growth declines once the bubble burst.
If those comparisons are accurate, then a lot of pain could still lie ahead for growth investors. But history doesn’t often repeat exactly, even if it does rhyme. In looking at growth stocks now vs. then, one of the things that stands out is that there are more high quality, profitable growth companies this time around. Although we can argue about the FAANG stocks’ valuations, it is difficult to argue that they are not very good businesses that are likely to be around for a very long time. They are also much cheaper than the tech leaders of 2000 were.
The current period certainly had significant excesses outside the leaders in terms of valuation, but even then it certainly appears more companies will survive this time than did in the 1999 period, even if they have room to come down more. As Robert Cantwell pointed out on our podcast interview, Technology and the Internet are more mature now that they were in 2000. He compared the current level of development of Blockchain technology today to what the Internet was back then.
The Question with No Answer
So is growth cheap?
I don’t think there really is an answer. When you look at it using standard valuation metrics relative to its own history, it still isn’t despite its recent decline. When you couple that with the long-term underperformance of the growth group as a whole, I am not sure there is much opportunity for quants like me that run systematic strategies spread across a group of stocks. But that doesn’t mean there is no opportunity. The next Facebooks and Amazons very likely exist within the current growth basket. And those companies are now much cheaper than the once were. For skilled long-term growth investors who can find these diamonds in the rough, there likely is significant opportunity in the current decline. Unfortunately for me, I am just not one of them.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
