A few little questions we address this week. Can the bulls and the bears both be right about stock markets? Why would growth/technology stocks become so highly priced? What have interest rates got to do with growth and technology stocks? Are growth and technology stock values sustainable? What can change? Buy Now, Pay Later Examples. The effect of capital raisings? What effect does portfolio rotation into recovery stocks have?
Can the bulls and the bears both be right about stock markets?
The US markets have been swept up in a frenzy of buying in technology stocks. Indeed, much of the growth in the US markets has been from a small number of technology stocks. Now markets are debating what comes next and there are 2 divergent visions of the future. The bears are foreseeing a “growth/technology” stock bust versus the bulls who believe in a strong cyclical recovery from depressed earnings. To understand this argument, we need to know explore growth and technology valuations.
Why would growth/technology stocks become so highly priced?
These “expensive” stocks tend to be high growth stocks with a strong sustainable competitive advantage which means they can grow when most others can’t. In the current environment any structural growth is unusual and therefore prized and is worth paying for – making it more highly valued.
Interest rates are low due to government policy around the world. Rates can scarcely go any lower. In fact, real rates (interest rates minus inflation) are negative.
Rates are unlikely to be able to increase for some years due to the (health induced) global economic recession’s effects on business. Moreover, policy makers have committed to let their economies “run hotter than normal” to allow an economic recovery before trying to slow the economy using interest rate increases.
What have interest rates got to do with growth and technology stocks?
Valuation models have 2 implicit moving parts – interest rates and earnings. When people value these companies, particularly by using discounted valuation models, the interest rate is linked to rates of today. With such low interest rates, valuation models attribute a lot of value to earnings in the “never never” – i.e. the long term.
In addition, with “growth stocks” analysts are using earnings growth forecasts which they view as sustainable, into the very long term. They typically assume that the competitive advantage the company has now is maintained into the future.
It’s how valuation models work and how people have had the confidence to buy growth and technology stocks so aggressively. This means that the high values can be justified under most circumstances. It is also what has caused the hard run up in the growth and technology stocks which are such a powerful force in US markets.
Are growth and technology stock values sustainable? What can change?
Firstly, rates are sustainably low for some years – there appears little risk of a near term rate rise. Importantly, rates can’t be allowed to rise due to the repayment obligations of governments. Just as interest rates hurt individuals in the 80s, interest rates would crush governments in the 2020’s. The difference is that governments control interest rate policy! We know what will win.
Secondly, earnings assumptions could change through time through achievement or lack thereof. They could also be affected by a change in the competitive structure.
Buy Now, Pay Later
Even “minor” changes have valuation impacts and therefore price changes. Big changes lead to big impacts. A local example of growth stocks with competitive landscape changes is the Buy Now, Pay Later group – including Afterpay (APT), Sezzle (SZL), Zip (Z1P) and Splitit (SPT). PayPal’s (NASDAQ: PYPL) announced entry into the Buy Now, Pay Later market in the US caused share prices across the sector to drop on Wednesday this week. To illustrate the sensitivities these companies fell between 10-20% on that 1 day. Knowing whether this entry into the market is going to be a problem will need to be modelled and understood. The PayPal announcement is one thing. Encroaching on these companies in such a fast growth market is completely another.
We don’t offer recommendations on Sezzle (SZL), Zip (Z1P) and Splitit (SPT). But for the adventurous we do offer Afterpay (APT). This month Pythagoras has been mathematically recommending buying in Afterpay (APT) in these recent times of valuation distress.
Another factor which could affect growth and technology stocks is capital raisings. Raisings can be for a number of good reasons, but it is generally dilutive to existing holders even if the raising is done at a very small discount to the current price.
A good example of this sensitivity to capital raisings is Nearmap (NEA). The company promotes its growth opportunities are strong and the capital will be deployed to maintain momentum. This means that in the near term the share price has fallen (14% on Friday) but as the capital is deployed shareholders will get the benefit. Through the recent rally (beginning in March) the Pythagoras returns in Nearmap (NEA) have been phenomenal for those with the courage to invest when we recommended buys.
What effect does portfolio rotation into recovery stocks have?
With expectations of a vaccine strengthening, growth will be anticipated in other segments of the economy. It creates competition for capital to be invested in areas which aren’t just growth or technology stocks. Investing in the “highest and best use” is not just an institutional issue –it’s a source of impact everywhere. In regards to selling these growth or technology stocks, once it starts it will gather steam. That capital is then redeployed into areas where “cyclical recovery” growth is available.
There is likely to be a phased rebalancing of investments from growth or technology stocks to recovery stocks. Valuations of growth and technology stocks could lead to an implosion or a slow deflation of the segment and some real volatility. All eyes will be on the Nasdaq at that time.
Technology stocks took the US market strongly up. Now we need to see if the cyclical recovery stocks can take the baton when growth and technology stocks handover.
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