In a broader sense, the “dog chasing its tail” market action continues. All said, the S&P 500 entered today (Friday) down less than 1% for the year and the broader New York Stock Exchange Index was actually around flattish. Put in those terms, we see a market that is certainly frustrating for those that became accustomed to last year’s steady and satisfying upward march, yet a round and round yawner at the end of the day. Why all the hand-wringing, then, with this week’s declines? The high-flying momentum names have been crushed. These are the names that have been media darlings and obsessions for months and that have produced some amazing returns over the past two years. Biotech has been completely beat up, with the biotech ETF falling nearly 20% from its peak on February 25th (though amazingly it’s still basically flat for the year). Techie names such as Tesla, Facebook, Amazon, and others have faced heavy distribution.
What’s the lesson here? You live by the sword you die by the sword.
We’ve seen a bunch of whining in the popular business press about a “lack of justification” for the momentum selloff or a lack of catalysts or news. There was a particularly funny article in the Wall St. Journal this morning concerning the biotech sector selloff with one analyst proclaiming, “Horrible day in #biotech. I’m frankly at a loss for an explanation. And it’s my job to at least know why. Humbling day.” Another gem comes from an analyst that had the gall to express a cautious view about the sector: “At some meetings and dinners with investors’ nerves have become frayed and tempers a little flared,’ he said. ‘Nothing in an aggressive way, but: ‘Why are you doing this?...Why are you ending this terrific ride?” Again, let us remind you that the sector was up approximately 100% between 12/31/2012 and the end of February 2014. Facebook stock was up 175% from 6/30/13 to the end of Februrary. The list goes on and on.
Growth and momentum strategies are perfectly valid ways to approach the investment universe. We happen to prefer the value side over the long run; there are plenty of professional and individual investors, however, that know the growth markets inside and out and have generated very successful long-term track records navigating the space. In value, the big risk oftentimes is getting into names too early and having them move against you, or buying the dreaded “value trap.” The key is making sure that risk management techniques are such that the “value traps” don’t drown bog down performance. In growth, the key seems to be capturing gains in names that trade at very high multiples before the dreaded “missed expectations” bug hits and brings performance down to earth, or before profit-taking morphs into broader, more violent declines, which is probably the case here.
In any case, we know that over the long-run, regression to the mean exists, companies’ growth prospects ultimately return to a normal trajectory, and that valuation multiples tend to compress back to more pedestrian levels. Looking at some of the multiples for the names and sectors that have been hit, it shouldn’t be a surprise that they’re facing this type of volatility. The biotech sector, for instance, is trading with a price to book of 7.51x, approximately 3x the level for the broader S&P 500. On a price to sales basis, the level is 7.9x versus 1.7x for the S&P 500. Price to cash flow? The average for the underlying names is 50.75x, upwards of 5x the level for the S&P 500. Amazon? The EV/EBITDA is 34x and price to book is 14.8x. Facebook? EV/EBITDA comes in at 37.7x and price to book 9.8x. Priceline? 22x and 8.8x respectively. Yes, some of these companies are growing rapidly though even at very generous growth rates it’s hard to back into and justify these valuations. Sky high multiples form the basis for the performance air pockets seen from time to time in these names.
In the end, trade away in the super-momentum stocks all you want and enjoy the good times when they happen. Don’t complain, though, when emotion and sentiment reverse and investors begin refocusing on valuation metrics and other factors creating big-time downward thrusts. Ultimately, valuation does matter. While nothing we’ve observed in recent weeks comes close to the tech frenzy of 1999, there are companies whose stock prices were running on fumes that have seen price declines of 40% to 50% plus in a matter of weeks. Getting caught up in media and market sentiment driven frenzies while taking the eye off the valuation ball can lead to some significant pain and volatility in portfolios. Unfortunately, those with the least experience in markets end up piling into these names at the end of the run. The more things change the more they stay the same.
