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How the current IPO market echoes the dotcom bubble

31 October 2018

AXA Rosenberg’s equities team points out more than four out of five new listings in this year’s US IPO market have yet to turn a profit – the highest since records began.

By Anthony Luzio,

Editor, FE Trustnet Magazine

The prominence of profitless companies in this year’s IPO market has dangerous echoes of the dotcom bubble, according to AXA Rosenberg’s equities team.

In its Q3 letter to investors, the team said that a focus on earnings is one of the foundations of its investment philosophy as this is what “sustains a business, funds its growth and justifies its existence”.

However, it said that 30 years of experience has taught it to accept the connection between a company’s earnings and its stock market returns doesn’t always hold over short periods of time.

“This year has been a case in point as investors have bid up the prices of unprofitable companies, making them among the top performers across broad swathes of the global equity universe,” the team said.

It added that beyond returns, signs of investors’ recent ambivalence towards earnings are also evident in the rising proportion of loss-making companies on major equity indices – over a third of the Russell 2000 index, for example – and the fact that more than four out of every five new listings in this year’s US IPO market have yet to turn a profit.

The team warned that although the latter is the highest since records began in 1980, it has seen this pattern before.

“The current prominence of profitless technology and health care companies has echoes of ageing growth markets of the past, such as that of the late 1990s,” it said.

“Back then, many investors became convinced that accounting metrics such as earnings failed to capture a new reality of disruption and innovation.

“Those investors were right for a time, but when the cycle turned, the old tenets of fundamental investing forcefully reasserted themselves. We expect the same to happen this time around.”


Another similarity with the bursting of the dotcom bubble is the lack of attention investors are paying to valuation.

The AXA Rosenberg equities team pointed to a chart splitting the stocks in the MSCI World index into six buckets according to their P/E (price-to-earnings) ratio. It shows the only group of stocks to outperform loss-makers so far this year is those with P/E ratios of 25x or more.

“This recent pattern of outperformance by the most highly priced companies is in stark contrast to long-term experience, which shows that lowly valued companies have historically outperformed,” it said.

“This observation – the foundation of ‘value’ investing – has held across the world and across a variety of valuation metrics, well beyond price-to-earnings ratios.”

In a recent article on FE Trustnet, Andrew Wellington, who runs the global quality value mandate at Alliance Trust, produced a similar piece of research. He split the 1,000 largest stocks in the US market into 10 equally-weighted buckets of 100 based on P/E ratios and found that historically the cheapest stocks do better than those that are more expensive. However, he found the best-performing group this year to the end of September was the most expensive, with a P/E ratio of 406x.

“So, this time it could be different, but that’s not the way I would bet,” he said.

In another graph, AXA Rosenberg compared the price-to-book (P/B) ratios for the most expensive half of the market with the cheapest half to highlight the premium paid for growth.

The results suggest the recent outperformance of growth stocks has resulted in a growth stock premium seen only twice in the past 30 years, most recently in the tech bubble.


Following both prior periods, the premium paid for growth suffered a major correction, benefiting investors who paid attention to valuation.

“As highlighted above in the sections on valuation and earnings, we see evidence that the long-established growth bull market is increasingly disconnected from fundamentals,” the team continued.

“The bout of market turbulence in early October resulted in a meaningful rotation in a number of sector and factor trends. In particular, there was a sharp reversal in the performance of growth styles relative to value styles.

“While we would refrain from drawing any conclusions from short-term market moves, volatility such as that experienced in early October is a timely reminder for investors to avoid complacency and that all investment cycles, be they ‘value-growth cycles’, ‘bull-bear cycles’ or ‘earnings cycles’, are called ‘cycles’ for a reason.”

Schroders’ Simon Adler is also predicting a reversal in the performance of growth versus value. In a recent article on FE Trustnet, he said that the human emotions responsible for every rally and correction in history aren’t going anywhere any time soon, suggesting the market will always revert back to a focus on fundamentals.

“We’re all just as greedy, just as fearful and just as emotional as we ever were and that’s what drives markets,” he said.

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