Stocks trading at expensive valuations rarely live up to expectations, according to research by Man Numeric, the quantitative focused manager.
While passive investors and traders may not concern themselves with enterprise value – market capitalisation plus net debt –to sales (EV/S) ratios today, Man Numeric’s research team explored what has happened historically when large-cap stocks have traded at extremely inflated levels.
The asset manager highlighted the number of extraordinarily high-priced companies in the MSCI World index, using EV/S) as an indicator.
It found that when stocks have become as expensive in the past, although they haven’t performed well, they haven’t performed as badly as one might expect.
Man Numeric found that for stocks in the Russel 1000 whose EV/S ratio exceeds 10x for the first time, the median underperformance is 65 per cent cumulatively over the following five years, compared with 33 per cent for the MSCI World.
“However, if we look at even more extremely valued companies, using 20x as our threshold (and these companies do exist today!), the prospects look dimmer,” the Man Numeric team explained.
For stocks trading at 20x EV/S, the median cumulative relative underperformance averages at 73 per cent compared with 50 per cent for MSCI World companies.
“While it may not be totally fair to say these companies are un-investable, historically the odds have been stacked against them,” the research noted.
MSCI EV ratios at all-time highs
Source: Man Numeric
However, many investors may make exceptions today for the outperformance of the FAANGM stocks – Facebook, Apple, Amazon, Netflix, Google, and Microsoft.
“Of course, everyone wants to find the next FAANGM stock, and what better place to search than among companies whose obvious potential for growth has led them to be valued at extraordinarily elevated levels?” the team noted.
“However, the reality is that even the FAANGM stocks only infrequently traded above 10 or 20x sales, Amazon.com traded well north of 10x (and 20x!) during the peak of the tech bubble, but has mostly traded at a more modest multiple over the last two decades – which also makes sense given that historically it was predominantly a low-margin but fast-growing company,” the team explained.
“Microsoft also exceeded these thresholds during the tech bubble, but has similarly spent most of the last two decades below 10x, although it has approached that level in recent months.”
“Google also exceeded 10x early in its history, although only briefly touched 20x, and Facebook is the only other company to spend meaningful time above the 10x threshold.
“Today, all of the FAANGM stocks trade at or below 10x sales, and while it is difficult to label them ‘cheap’, the market has plenty of more grievous offenders today.”
For investors who are happy to hold stocks trading at high multiples, the team at Man Numeric admitted that there are two material differences between the markets of today and those of previous cycles.
First, the risk-free rate is close to zero in developed markets, meaning in theory a company with accelerating growth at a zero discount rate has no upper bound on its valuation. This means that the return on capital for the best cohort of companies, like the FAANGMs for example, “has entered a new paradigm in terms of the potential for persistence at a higher plateau”.
At first sight, very high return on equity and low discount rates do seem to justify eye-watering valuations, the team said.
However, this conclusion assumes the current cohort of the most expensive stocks are also the most profitable, which is not always the case.
Median Return on Equity (ROE) over the last 20yrs
Source: Man Numeric
The asset manager’s research showed that median return on equity (ROE) for the cohort of Russell 1000 stocks with an EV/Sales ratio of more than 10x has been no better than zero on average since 1999.For an EV/Sales ratio of more than 20x, ROE has been materially more negative over time.
The team added that the median ROE for the five years after crossing the 10x and 20x sales thresholds does not improve for either Russell 1000 or MSCI World.
“Nothing in history supports the idea that today’s absurdly expensive stocks become tomorrow’s global leaders, at least as far as returns on capital goes,” the team said. “When an investor is paying 10x, 20x, or more in terms of sales, clearly there is the expectation of significant future growth.
“The key to success with the FAANGM stocks is that investors were not entirely pre-paying for future growth – for the most part, they paid a price that allowed them to benefit from realised future growth.
“At first glance, it looks like investors in stocks valued at excessive levels are in fact acting rationally.”
Given the ultra-low interest rates and persistently high returns on capital for a significant number of companies, and the high-profile success stories of the FAANGM stocks, the team admitted: “it does appear that we may have entered a new paradigm”.
However, the exception of the FAANGM stocks “appears to mask a more powerful and persistent truth: that stocks valued at excessively high levels very rarely deliver the kind of earnings to justify these inflated prices”.
“There appears to be little relationship between sky-high multiples and persistently high return on capital; if anything, companies with such excessive valuations tend to produce lower returns over time,” the research concluded.
The team said while it may appear ‘unfashionable’ in the age of the $1bn unicorn to suggest that fundamentals and valuation techniques still matter, historical precedent shows that long-term investors should think hard before launching into the next “scramble” to find the next “miracle” FAANGM stock.