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Bubble Stocks

Enough is Enough?

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For over a year now, we have been banging the drum saying that equities, particularly the equities of high-flying tech companies like Netflix were overpriced.  Today we say, enough is enough.  We are not ready to say that stocks, particularly tech stocks, are cheap across the board, but the extensive overpricing has disappeared, and some high-profile tech companies look downright attractive from a valuation perspective.

To start, the table below updates the results for the ten bubble stocks we called out on October 3.  The ten are down an average of 33.2% as of the close today.  They are down 36.9% if Tesla is excluded.  The ten are down 40.6% from their 2018 highs.  The table also shows the results for Apple and Goggle.  Apple is off 36.5% from its price on October 3 and 37.1% from its high.  Google has held up the best.  It is down 18.8% from its October 3 price and 23.4% from its high.

In our view, these large price drops were not accompanied by a corresponding decline in fundamental value.  Apple is a poster child in this respect.  Though iPhone growth may be slowing the company is the same cash generating machine it was on October 3.  On September 21, 2018, our colleague, Aswath Damodaran, posted what we believed was a conservative valuation of Apple taking account of the slowing iPhone growth.  Over the next ten years, Damodaran projected a rate of revenue growth below that of the overall economy and barely above the rate of inflation.  Using this low growth rate, he arrived at an estimated value of $201, below the then stock price of $220.  He also undertook a simulation analysis and concluded that $176 was the cutoff for the 10th percentile.  As the table shows, the price is now $146.83.  At that price, the company is trading below the average price at which Warren Buffett acquired his shares.  All of this points to a unique buying opportunity.

Apple is not the only example.  General Motors at less than $33 appears to be trading well below its fundamental value.  In our view, this is no longer the time to “get defensive,” but to start looking for opportunities.

Why Fundamental Valuation Matters

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First, a little humility.  When we posted our list of ten bubble stocks we were not predicting an imminent collapse.  (Though, in fact, a collapse has occurred.  The ten bubble stocks are now down an average of almost 25%, 30% excluding Tesla.)  What we were saying is that prices appeared to be well above fundamental value.  Assuming that the two are going to converge at some point implies one of two things can happen.  One, future stock returns will be low relative to fair risk-adjusted returns on equity for an extended period.  Two, there will be a sudden collapse that quickly brings price down toward fundamental value.  The fact that the second has occured was not something we could predict, but neither was it a complete surprise.  In the long-run it is fundamental value that matters, it fact it is virtually all that matters.

Looking Back at Bitcoin

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Benjamin Graham once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”  That statement is a little hard to interpret.  The market is only open now, in the short run.  The way we interpret Graham is to say although investors may be swayed by emotion and folly in the short run, particularly if information is nebulous, as things become clear the market eventually gets it right.  The trick to being an intelligent investor, according to Graham, is to realize now what the market will only come to appreciate later.  That is to invest based on wise assessments of fundamental value.

That brings us to Bitcoin.  In our book, The Conceptual Foundations of Investing, we discussed bubbles.  We argued that bubble can arise when enough investors buy an asset because the price has risen in the past and, as a result, they believe the will be able to sell it for even more to someone else in the future.  If enough participants employ this strategy, it can become a self-fulfilling prophecy and prices can rise without a fundamental reason for the increase.

In our book, we offered Bitcoin as a modern-day example.  We warned that we could see little fundamental value for Bitcoin as either an investment or a medium of exchange.   We said, “The problem is that if the main source of demand is the general expectation of higher future prices, as soon as prices stop rising, demand evaporates.  With few, if any buyers willing to purchase on the basis of the security’s fundamental value, prices collapse. We suspect this will happen to Bitcoin” (page 123).

At the time of our writing, Bitcoin’s price had been skyrocketing and it was trading at over $15,000.  Not surprisingly, it was the focus of a vast amount of attention in the financial media.  Now Bitcoin is in the headlines again, but for the opposite reason.  As shown in the chart below, its price has fallen from nearly $20,000 to less than $4,000.  We suspect it will fall further still.  As Benjamin Graham stressed, in the long run the market will get it right and prices will converge to fundamental value.

Bubble Stocks Latest Update

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The group of ten is now done over 26% since our post.  Even Amazon is off 25%.  Roku is nearing the 50% level.  Tesla remains the sole outlier that is up.  If it is removed from the average, the other group of nine is down over 30%.  The value of growth options can evaporate quickly.

ROKU : Growth Options and Bubble Stocks

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ROKU, a member or our “Top Ten Bubble Stocks (that could drop 50% or more)” list that we published in early October, reported earnings yesterday. Despite beating both top and bottom line earnings estimates, the stock was down a staggering 22% today.

We have talked extensively about “growth options” on this blog.  (High Expectations Can Bring Big Risks).  Recall that a firm’s equity value can be thought as being comprised of two components: 1) The value of current operations (which includes 5 years of future expected growth) and 2) everything else which is the “growth options”.  For tech companies like Roku, the growth options often include distant future opportunities that investors envision.

ROKU’s value is largely based on the 2nd components – the growth options. Companies whose value depends primarily on growth options can be highly sensitive to even a whiff of slowing growth.  That was the case with ROKU.  Despite the good top and bottom line performance, the earning release foreshadowed slowing user growth.  The related decline in the value of the growth options swamped any good news about current operations, sending the stock down 22%.  This underscores the need for caution among those considering investment in companies whose value is largely dependent on growth options.

Bubble Stocks Update

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            With all the turmoil in the markets, I felt it was time to take a look back at the ten bubble stocks from my post after the close on October 3.  The table below shows the performance between the close on October 3 and the close today (October 29).  The table shows that the average return for all ten has hit bear market territory – down more than 20%.  If Tesla, the one exception to the rule is eliminated, the average for the other nine is down an astonishing 25.5%.  Turning to the individual stocks, there (AMD, Roku and Square) are down more than 30%.  Amazon has shed more than $250 billion in market value.  It is stunning how quickly sentiment can change on relatively scant economic news.

 

Bubble Stocks: That was Fast!

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            Someone once said if you make a forecast and it turns out to be right, don’t let anyone forget it.  In the last couple of weeks Cornell Capital Group issued two warnings.  In Beware the Bonds of October, posted on September 22 we warned that bonds appeared even more overpriced than stocks and that a rise in yields could have a sharply negative impact on stock prices.  Next, in Bubble stocks: What goes up might come way down posted at the start of trading on October 3, we identified ten companies that we felt were significantly overvalued and could drop substantially.  Well we did not expect to be right so fast!  The table below shows the perform of the ten stocks we identified along with the ten-year Treasury bond.

 

            The results are dramatic.  The ten stocks are down an average of 17.9% and three are down more than 20% – in a week.  Of course, we did not know this was going to happen or our short option positions would have been much larger.  But for the reasons we stated, these ten companies were priced to a level of perfection that was hard to reconcile with a traditional measure of fundamental value.  The gap is still there, but it is a good deal smaller now.