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Is Value Dead?

The turnaround in equity markets globally has been nothing short of astonishing and something that has taken a lot of seasoned investment professionals by surprise. The composition of the recovery has been surprising also, rather than a flight to quality there has been a flight to tech and growth stocks with little or no earnings, which presents a challenge in itself as to how you value these companies. To justify the valuations, you really have to be confident that the business model is a long-term viable proposition. For those of us old enough to remember the Tech Boom, many of those companies had huge revenues but little if any profit and many didn’t survive. Of those that did survive and are still operating some have been great success stories.

The following two charts show that divergence quite clearly. The first chart shows the Russell 2000 growth index versus the Russell 200 Value Index.

Russell 200 Growth v Russell 2000 Value

Value companies are trading at a 25% discount to where they were 12 months ago. Some of this is justified as the COVID-19 virus will impact many of these businesses more than it will a growing online business.

This can also be seen in the very clear underperformance of the Dow Jones Industrial Index versus the NASDAQ in the chart below. This divergence started in March 2017 as can be seen below.

Disjoin between Tech & Industrial businesses (NASDAQ v DJIA)

New Paradigm or Detachment from Fundamentals?

I recall in the Tech Boom in the late Nineties getting detailed research reports from broking analysts with massive valuations on tech stocks all based on a multiple of revenue, in the hope that the business will one day stop consuming cash and in the longer term deliver eventual profits to shareholders. Fundamentally the new (old) way of valuing companies on multiples of revenue is back and it will end in tears for a lot of people who don’t know what they are buying or what they are paying for.

We are familiar with the process for these types of valuations. As some of you will recall, we had a $48 valuation on Afterpay when the shares were trading below $20. The problem with that valuation was that it wasn’t risk-weighted or discounted for any of the potential problems that could pop up along the way. Things like larger than expected costs of collection of bad debts, regulatory issues, and competitive threats. But if you take the most bullish non-risk adjusted valuation and assume the company gets strong penetration in the US, Europe and other countries, you could be a bull on the stock. You could argue that Afterpay could become a long-term viable business similar to American Express in which case a valuation of over $100 is justified. Pricing that in now is just blue sky and anyone arguing that case now is taking a pretty big leap of faith that there will not be competitive threats, new entrants and or a better product in 12 months’ time. I hope as an Australian that Afterpay achieves all of this and it becomes a great Australian success story, but a lot has to go right and nothing wrong to justify the current valuation.

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