Technology & Growth Stock Leadership — Will It Continue or Crumble?
What are your views on US valuations in today’s market?
Austin Hawley, CFA: At a high level, when you look at the valuations for the broad cap-weighted indices, they are very elevated by any historical standard. If you just look at all the companies more than a billion dollars in market cap that are listed on the NYSE and NASDAQ on a cap-weighted basis, those companies are trading at 22X to 23X times forward earnings today.
Now there are roughly 300 companies in that mix that are non-earners. If you exclude those companies that are losing money, that improves the number a little bit but we’re still trading north of 20X earnings, something like 21X earnings for the market cap-weighted indices, which is a very elevated level again.
If you consider the fact that we are starting from a place of those high valuations with operating margins that are reasonably high as well, and an expectation that interest rates are likely increasing and have been well telegraphed by the Fed at this point, it’s hard to imagine that investors are going to earn an absolute return in those cap-weighted indices that is anything close, in my opinion, to what the long-term historical results have been.
Now having said all that, those market cap weighted indices have become very skewed over the last 5 to 10 years by what has been extraordinary performance by a portion of the market–market leadership has been driven by large-cap growth and momentum stocks. If you focus on the value and the smaller cap portions of the market, the valuations are much more reasonable by a number of standards. The valuation spreads between value and growth are at near all-time wides. And the ratio of small-cap valuations relative to large cap are also rivaling tech bubble type ratios.
So, when I think about the context for us to add value for our clients, I think the opportunity for relative returns is extraordinarily good when I look out over the next five years. The absolute return environment still may be challenging, and even for us, it may not be quite what we hope for in terms of absolute [results]. But I’m fairly confident that from a relative return perspective, we are very well positioned for what the market environment is offering us today.
If you think about large cap–and you think about what it means to be positioned value versus growth–in a crude way, today, value versus growth for large cap really comes down to financials and a little bit of energy versus technology. And if you look at the large cap strategy today with our very large weighing in financials and a fairly modest exposure to information technology, we don’t look anything like the cap-weighted indices. And I think that positioning will serve us very well looking out over the next several years, the next five years.
Will technology and growth stock leadership continue at the pace we’ve seen over the past 10 years?
Austin Hawley, CFA: I usually have two responses to that. The first being somewhat philosophical where I say this is what value investing is about. It’s about the fact that if you own the whole company, there’s no way around the fact that your return over the long term is going to be derived from the cash that that company produces. And we try to think like owners that own whole businesses. And over the long term, you can’t get around the fact that cash is what matters and eventually those companies have to produce it.
There are emerging, in my view very clearly, some cracks in that large-cap growth and momentum leadership. If you look at those non-earners that I referenced, there are about 300 of those companies. The majority of those companies were down in absolute return in 2021, and many of those companies, the majority of that drawdown took place late in the year in November and December as interest rates started to move higher. We had November 9 and then December 6 were both bottoms in the 10-year yield, and rates have steadily moved higher over the course of the last month. And if you look during that period of time, there are a number of very prominent large-cap tech companies that do not have earnings that have had declines of 20% to 30%. Companies like Square, Zoom, DoorDash, CrowdStrike. These are all well-known companies with $20 billion to $50 billion valuations that have seen their prices decline very meaningfully over this period of time. I think it’s just one indication that the market environment is clearly changing. And one of the things that can be a real catalyst is interest rates starting to move a little bit higher.
Also, we have to put into context kind of the magnitude of the changes we’ve had in the fact that expectations have just moved to a point where that growth leadership may be starting to crumble, kind of under its own weight. Just to conclude, I want to reference a couple sets of the numbers that I think helped put this into context. Kind of where we’ve been in the duration and magnitude of the change in valuations.
So, the Russell index that we all think about is typically the Russell 1000 or the Russell 2000. Russell also has a Russell 200 Index, which is the largest 200 stocks. If you look at the Russell 200 Growth Index, over the last one year, that index or excuse me the last three years, compounded annually, that index is up 37%; over the last five years, that index is up 27%; over that last 10 years, that index is up 21% compounded. So, the math on 21% per year compounded is that every $1 turns into $7 at the end of that 10-year period of time. These are numbers that are clearly not sustainable, because if they continue for 3-5 more years, all of the sudden those companies are a very large component of not just the indices but the overall economy. And given the fact that some of these companies don’t even have earnings today, you know I think we are starting to see those expectations get to a point where again the weight starts to crumble—kind of the underlying edifice that’s held these companies up, which has been based on nothing but sales growth, in my opinion.
So the second number I’ll reference, which has been a bit of an obsession of mine over the last 24 hours is that Apple yesterday crossed the $3 trillion mark in terms of market capitalization. So if you do some very quick internet sleuthing to try to figure out where that stands in history in terms of the largest market caps of any company of inflation adjusted, there are three or maybe four companies in the course of the history of all publicly traded companies that have ever reached that sort of scale in terms of market capitalization. And the three that are clearly larger than Apple are the Dutch East India Company in the 18th Century, the South Sea Company in the 17th Century, and the Mississippi Company in the 17th century. These are all government-sponsored monopolies that turned into massive bubbles–like the largest bubbles of all times and collapsed eventually.
Clearly, Apple is not one of those companies. It is a fabulous company, but I think if you look at that valuation and try to put it into context, the expectation for gross profit at Apple in 2022 is approximately $170 billion. So, at a $3 trillion valuation, it’s trading at a high-teens multiple of pretax gross profits, so before any spending on any operating expenses and so that implies that the market thinks you’re going to have very significant growth from a company that is already generating $400 billion in revenue and at a $3 trillion valuation.
And again, I reference these numbers because I think it’s important to think about what’s happened over the last 10 years, which is that the market is a mechanism to basically put the odds on all these companies on the expectation for their ability to deliver a return over the life of those companies. And over the last 10 years, what’s happened is a very rational, good idea early on after the financial crisis, which is recognizing that high quality, you know, software and tech businesses that have very good unit economics deserve high multiples. That was a valuable insight at that period of time, but over the last 10 years, what’s happened is those valuations have slowly ratcheted up the odds against the investor to achieving reasonable results over the long term by driving the multiples up and up and up for these companies to the point today where I think it looks much less like a kind of game of skill when you think about the probabilities of investing in growth stocks or momentum stocks. It’s much more like buying lottery tickets. And certainly, when you add in the presence of retail investors in a big way–IPOs, special purpose acquisition (SPAC) vehicles–it just adds to that speculative flavor that has been very prominent, especially over the last two years as we’ve seen valuations move to really extremes in my view. That’s a very long-winded kind of exploration of where I think we stand in the world today and the market environment. And why I feel really good about our ability to deliver good relative results. I think from an absolute perspective, it may be a bit of a challenge if the overall market is selling off, but I feel great about where we stand today and very optimistic about our ability to deliver good value and relative returns over the next several years.