GAAP bubble – is it 2000 all over again?

David Keir, CEO, discusses valuation anomalies in the market…

We have written at length over the past 12 months on valuation anomalies, where share prices appeared to diverge from the underlying prospects for a business.

We highlighted the ratings of the so-called quality shares or the “bond proxies” which appeared at odds with company fundamentals.  The prevailing wisdom was to simply own these shares forever, irrespective of valuation.

Catalysts to change are typically only obvious in hindsight, but a combination of an amelioration of macro-concerns and disappointing Q3 results led to the underperformance of many of these quality shares as investors reassessed their fundamental prospects.  We now get much less push back on our long-held view.

Despite the pull-back, quality shares remain expensive – as they are in the 96th percentile of valuation (source: Morgan Stanley) – and it is still too early for us to consider them attractive for investment.

The other major anomaly, in our view has been the outperformance of the US market pre-dominantly led by the FAANG shares – Facebook, Amazon, Apple, Netflix and Google.

The chart below looks at the performance of the US market versus European markets since 1950 and highlights its significant outperformance over the last 10 years.  It has reached well over a two standard deviation event, which is incredibly rare (<5% probability).  The chart looks similar for the US against most other global indices.

US equities at 70-year high versus Europe

Clearly a massive driver of the US’s outperformance has been the growth of technology shares, which has not been replicated within Europe.

Nevertheless, the scale of relative outperformance has reached levels that appear to us as being within ‘bubble territory’.  In the chart below we consider the original FANG shares and include Apple and show the performance against the S&P 500 over the 5 years.  It is noteworthy that  the bubble is being inflated by the largest shares in the biggest and most liquid stock market in the world.  Anomalies persist frequently for small and mid-cap. companies, which either have poor analyst coverage or where they can achieve explosive growth from a low starting point.  However, it is rare that big businesses can achieve this, partly due to the their already high market shares, but also as a result that companies are rarely able to achieve supernormal returns indefinitely: they tend to attract competition or regulators!

To put this into context Apple, Microsoft and Google now have market capitalisations over $1,000,000,000,000 (trillion) and Amazon is close to joining the club!  To justify these valuations, we must conclude that investors believe that their prospects to grow are still bright and remain underappreciated by investors.

FAANG stocks are driving the US market higher

Our holdings are not driven by any benchmark considerations.  We try to build a portfolio of global leading businesses, with double digit margins, strong balance sheets, attractive valuations and supportive dividend yields, with a capital preservation focus.  Consequently, we only own cheap shares in the fund and have a strict sell discipline.  We have no exposure to any of these FAANG shares.

Like “peak quality” in summer 2019, we currently get lots of pushback on our view that these shares are discounting a lot of good news and that there are better opportunities in other geographies and sectors.

We are frequently told that it is indeed “different this time” and not a repeat of 2000.  The FAANG businesses are embedded into our daily lives and have massive and sustained growth ahead of them.  We are told that these shares will grow into their current ratings and will remain the “must own shares” given the current anaemic global growth rate.

We have no doubt that the FAANG’s are currently great companies.  The debate we have with such investors is about investment process and at what valuation point will they consider selling these shares?  We also see the long-term risks posed by global anti-trust regulators and tax authorities given the current lack of regulation and tax paid.

Our view is that there is significant optimism in the share valuations and investors who perhaps  have one eye on the benchmark, are dispensing with their sell process in order to continue owning these highly rated shares.  This can persist for some time, but we don’t believe it’s different this time.  If the best way to generate returns is to calculate the value of a business and buy it at a significant discount, then owning overvalued and over-owned shares is playing with fire.

While many of these businesses have currently strong market positions , it would be naive to suggest that technological change will not bring new competitors or that returns may fade as the business matures, or regulators become more interested in competitive practices.

We have no idea about the catalyst for a change in market leadership – as ever these will only be obvious in hindsight.  However, we would make the following observations.

The chart below looks at the market concentration in the US market over the last 25 years.   It highlights a couple of very interesting points.  Firstly, the top 5 companies now represent 18% of the total market capitalisation of the S&P.  This is unparalleled, even in the 2000 tech bubble where the top 5 represented 16%.  Secondly, like 2000, there is a growing divergence between the top 5 companies and their share of net income – i.e. the market capitalisation is a result of a re-rating of the shares as opposed to growth in net income.  We do not believe this is sustainable!

Growing divergence between the largest companies in the S&P and their net income contribution

We detail the valuation of the top 5 constituents of the S&P in the table below.  We observe the lofty PER’s particularly on Amazon, Apple and Microsoft – which has re-rated from 9X to 30X in the last 8 years!  We also note the lack of dividend yields on offer.

FAANG stock valuations

 

Year 1 PER

Dividend Yield
Facebook 21X 0%
Amazon 68X 0%
Apple 24X 1%
Alphabet 24X 0%
Microsoft 30X 1.2%

Source: Bloomberg (17 January 2020)

We like to buy companies that can grow but are completely focussed on the price we pay.  Our current holdings in the technology sector look very attractively valued and have supportive dividend yields.  They also will benefit from many of the growth drivers of the FAANG stocks.

SGIG current Technology holdings

  Year 1 PER Dividend Yield
Cisco 15.0X 2.9%
Corning 16.3X 3.0%
eBay 12.7X 1.6%
IBM 10.4X 4.9%
Intel 12.7X 2.2%
Sabre 18.6X 2.5%

Source: Bloomberg (17 January 2020)

The following chart looks at the relative performance of the technology sector versus its earnings.  Whilst similar but not yet as extreme as 2000, the relative performance has significantly outpaced earnings in recent years.  For example, at the beginning of 2015, the consensus 5-year earnings growth for Google – now called Alphabet – was 18%.  Today that figure has dropped to 15%, yet the shares have re-rated by over 40% over the intervening 5-year period.

Technology sector relative performance has significantly outpaced earnings

Apple shares were up an astounding 85% in 2019 having re-rated by over 50% over the last five years.  We need to remind ourselves that Apple is a primarily a hardware company that earns most of its profits from selling high quality but expensive mobile phones and is clearly prone to product cycles.

We note with interest that the market capitalisation of Apple is now close to topping the entire Australian market!!

Apple market capitalisation versus the entire Australian market

Whilst these trends can persist, share prices must follow earnings over the long-term.  Earnings will have to increase materially, or the share prices will fall.  We suspect it will be the latter.

It is impossible to disaggregate the key drivers of the current outperformance of the FAANG stocks.  It may be a combination of low interest rates, low economic growth, the relentless shift to passive investing, the development of the ETF market and benchmark driven investors being forced to own some of the shares given their weight in the index.  Or perhaps we need look no further than the  liquidity provided by the Federal reserve balance sheet, highlighted in the graph below, which is flowing to the largest and most liquid names at the top of the S&P 500.

US Federal Reserve Balance Sheet Expansion

The dynamics of outsized US market performance and the extreme valuation of some of the largest companies in the index ties in with our research and portfolio positioning, which suggest that there are better opportunities for investors in other sectors and global markets.

So, what do we expect to happen from here?

Our central case is that global economic growth persists.  If this occurs, we would expect the market leadership to change and market concentration to expand to more attractively valued parts of the market given the significant valuation differential.

The less palatable outcome is a significant market correction caused by a growth scare or inflation shock which will affect all parts of the market but particularly the expensive growth stocks.  We would then get a proper understanding of how much of the current bubble is being driven by excess liquidity and ETFs.

We have seen this movie before, and it didn’t end well.  Owning expensive shares in the hope that you can sell them to someone else at a higher price, is not a game that we would encourage any investor to play.    Especially not in companies which are massively changing our daily lives but are not regulated and arguably don’t pay their fair share of tax.

Many thanks for your continued interest and support.

David Keir (David@saracenfundmanagers.com)

Graham Campbell (graham@saracenfundmanagers.com)

Co-Managers, TB Saracen Global Income & Growth Fund

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