Don't ignore growth stock volatility

We have made regular comments regarding the plethora of domestically listed companies exhibiting excellent business models, exceptionally competent management, yet unfortunately, are only available at spectacularly high prices. While we agree that quality will always demand a premium it would seem that many valuations exceed even the most optimistic assumptions on valuation fundamentals.

Strange things do tend to happen when the cost of money gets really low. Every investor (ranging from the disciplined professional to the unsophisticated retiree) start to notice that the rewards for staying in low-risk cash deposits are diluting their efforts to cover costs and increase wealth. As money starts to move (some would say put to work harder) it cascades out of term deposits into increasingly riskier asset classes in search of income/yield/return (essentially taking more risk for more return, hopefully).

Good businesses with good management generally produce good results. Good results drive share prices higher. If a company is already on a very high multiple, attempts to assess the required lift in the share price based on the latest good news becomes an extremely subjective calculation. In layman’s terms, once a company is on a multiple of 100 times next year’s earnings, determining whether 75 v 125 times is the correct number is “difficult”.

High growth businesses investing heavily for their future create an additional challenge, namely the lack of earnings can be interpreted as management’s ability to deploy ever-larger amounts of money into driving future value. While I have no doubt that this will be held true in some cases, my experience has been that the execution risks are more often than not underestimated. Growing earnings from loss positions to justify multi-billion valuations usually requires non-trivial execution, substantial capital and a fair amount of good luck.

Investor return envy (otherwise known as FOMO) has created a collection of companies meeting the above description: Good businesses on flabbergasting multiples. We have compiled a list of 8 companies with a combined value of $65 billion with an average price to earnings multiple in excess of 150 times (Market weighted). These are not small companies.

So, in response to the question of what is 'the one thing investors just can’t ignore in 2020', we ask: can we afford to ignore the recent volatility demonstrated by the share prices of companies with exceptionally high investor expectations?   

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This wire is part of the ‘One thing investors can’t ignore in 2020’ series. To download the full ebook please click here.