Bubble Stocks 2.0

By July 17, 2019 Blog

In Bubble, Bubble, Toil and Trouble, Rob Arnott, Shane Sheppard and I offered a real time definition of a bubble.  We stated,

We define a bubble as having two characteristics.  First, the asset or asset class offers little chance of a positive risk premium relative to bonds or cash, using a generally accepted valuation mode with a plausible projection of expected cash flows.  Second, the marginal buyer of the asset or asset class disregards valuation models, presumably buying based on a popular narrative and expecting to resell the asset to someone else at a higher future price – and as if the market will tell them when to sell!

In the Bubble paper, we stressed that identifying a stock as a bubble stock did not necessarily imply that taking a short position or writing naked call options was a wise choice.  We warned, “Identifying a bubble, however, does not guarantee that the bubble will burst (although that outcome is highly likely) nor does it provide any insight into when it may burst.”  In light of the warning, we recommended avoiding bubble stocks, but being very careful about going short.

Despite our warning, the temptation to identify bubble stocks and track their performance is strong.  In the paper, we mentioned a few potential bubble stocks, but here we offer a more extensive list.  The attached spreadsheet lists 11 companies all of them lost money in the last twelve months except Uber which broke even and Netflix which had a meager profit in comparison to the $158 billion-dollar valuation.  Many of the companies have yet to turn a profit in any year.   Yet all 11 companies have huge valuations – valuations that require significant free cash flow to be justified.  We also include Bitcoin which was identified as a bubble asset in the paper and which is never likely to produce any free cash flow for investors.

Of course, each of the bubble stocks (and Bitcoin) has a story to tell about how they will disrupt markets, change the world, and eventually produce huge free cash flows – without such a story the bubble would not get going in the first place.  One of those stories may come true as was the case with Amazon during the dot.com bubble.  Unfortunately, there is no way to tell.   But remember to provide investors with a fair return these stocks, none of which pay dividends, must appreciate at about 10% per year from the current stratospheric prices.  How much can expectations improve from levels that already imply massive growth and pronounced take-off into profitability in order to drive further price increases?  And what if sentiment changes due to a negative event such as an earnings or revenue miss?  It will be interesting to see what happens.  We urge you to follow the list, but not to place undue weight on short-term fluctuations.  The spreadsheet is set up to download the current stock prices to make it easy to track performance.

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