Valuations ALWAYS matter - warning

Investment Analysis Clubs Saul’s Investing Discussions
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I’ve been following this board for a few weeks now and come to the realisation that the type of momentum investing which is being advocated here is dangerous!

Yes, the markets have been going up for the past few years and valuations are now very stretched in the tech space (especially, anything to do with the cloud). Thus, many of these tech stocks have risen at a rapid pace. However, history has shown time and time again, that over the full stock market cycle; valuations always revert to the mean - they always do.

For a while; giddy-eyed investors pay up for never ending growth and in the process; they bid up the values of the related companies; but eventually, growth slows down, competition comes along and these investors learn a painful lesson.

Yes, Saul and others have made a lot of cash over the past 18 months or so and over this period, their portfolios have appreciated by around 80% per annum - but those who accept this as a long-term trend or ‘new normal’ will be sorely disappointed!

In fact, I can bet anybody anything they want that if these guys keep holding the same stocks for the next 4-5 years; their returns will be sub-par at best and if a bear-market comes along, then these high growth, richly valued stocks will tank 50% or more.

Of course, if these guys are fortunate and bail out in time; they will still come out ahead but the chances of catching bull market tops is never easy.

Sure, many of these high flying tech stocks are now growing sales at 40-70% per year and this is all well and good; but investors must keep in mind the fact that most of these securities are already priced for perfection (the future growth has already been discounted). How else do you explain Price to Sales multiples of 10, 15 or even 20!?

If you take a compound growth calculator and plug in even reasonably high rate of sales growth going out 10 years and then slap on a 5-6X sales multiple on these stocks; they will NOT offer a high shareholder return from these valuations. It is simple maths and the way markets have worked since the beginning of time.

Finally, if you look at the long-term track record of some of the best investors in the world (Buffett, Lynch, Sequioa, Anthony Bolton, Walter Schloss, Munger etc.) you will quickly realise that even these guys were only able to compound wealth at 20-22% per annum. Buffett did manage to compound capital at 29% per annum over a 12 year period; but he is Buffett and now one of the richest guys on the planet.

So, investing in a bunch of high-growth, momentum stocks without any regard to valuation is not investing, it is speculation.

In his long career; even Saul has been able to compound his capital at around 20% per annum and if you look closely, you will realise that his performance was much better before 2008. From what I can tell, back then, he was running a portfolio of 25-28 companies and was paying attention to valuations. Today, he is running a very concentrated book and totally disregarding valuations.

The purpose of this post is not to criticise Saul and the other guys who are running this type of portfolio - they are doing remarkably well and I respect their performance.

The reason why I am writing this is to forewarn others on this board; who may get tempted by this strategy and abandon their investment styles; quite late in a 9 year bull-market.

As I wrote in an earlier post; an investor’s return depends on two things -

a. Growth rate of the business and longevity of such growth
b. Valuation at the time of entry into the business

Today, the valuations of some of these tech darlings are sky high and when the next recession comes along (whenever that might be) and enterprise IT spending slows down, these stocks will probably get creamed. No, if fact, I guarantee you that they will get creamed and the bag holders will learn an invaluable lesson - trees, no matter how pretty, don’t grow to the heavens.

Good luck to all,

GM

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Hey,

Thanks for the write up.

What would your suggested strategy be going forward?

Br MK

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Still can’t edit :slight_smile:

Anyway, i have a rather binary question.

Which would you prfer:

Growing at 5% per year for 10 years and then loosing 3% of portfolio?

or

Growing at 35% per year for 4 years and then loosing 50% of portfolio?

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I’m not here to give investment advice to anybody and can only tell you what I have learnt and do from over 20 years experience.

First and foremost, I have no issue with a high-growth concentrated portfolio of dominant companies. If an investor does his/her homework, there is no need for more than 10 institutional type dominant growth stocks. However, I personally don’t trust any company 100% so in my own portfolio, I keep 25-27 growth companies. But this a question of personal preference, so each to their own.

In terms of diversification, I do not allocate more than roughly 20% of my portfolio to one sector (i.e cloud, digital payments, banking, footwear etc) and think that putting all your eggs in one industry (i.e. cloud or technology) is asking for trouble. The future is unknowable and anything can go wrong at any point in time - there are no guarantees in the investment business.

Most important of all; I always pay attention to a businesses valuation when I evaluate a business.
Unless you are speculating over a period of few weeks to months, an investor’s return is determined by (i) growth of the business and (ii) valuation of the business at the time of entry.

For example - if company A is growing at 30% per year and continues to do so for 10 years; your return as an investor will be a lot higher if you paid 5X sales for it; than 10X of 15X sales at the time of your investment. This is due to the fact that valuations always compress as any business matures and slows; so the cheaper the valuation at the time of entry; the better for long-term investors.

I was around in the tech bubble of 1999; and remember all of the tech stocks trading at absurd valuations (because of anticipated future growth; which did materialise in some cases); yet investors lost 70-99% of their capital in the bear-market and many stocks only broke out to new highs 10-15 years later! This is due to the fact the stocks had run way ahead of the business fundamentals and it took 10-15 years for the operating results to catch up with the valuations.

Personally; I prefer companies which are profitable now as opposed to businesses which are burning cash for future growth; so most of my portfolio is invested in the former category. Having said this; I do also own shares in SHOP, SPLK and WDAY because I feel they have a ‘moat’; a long runway of growth and over the next decade; I can still expect to make 15-17% CAGR from these holdings. Note that over the next decade, all of these three companies will probably grow at a much faster pace than 15-17% per annum; but because their current valuations are so high; I am not expecting to translate all that business growth into shareholder returns (due to future valuation compression).

The vast majority of my own portfolio is invested in dominant companies which are profitable now; and my portfolio is expected to increase EPS by around 20% CAGR over the next 5 years. Again, this is not a guarantee; just the consensus estimate from Wall Street analysts.

Unlike many people on this board; I do not trade in an out of stocks often and ONLY sell under the following conditions:

i. If I’ve made a mistake and the business turns out to be a dud
ii. If the growth rate is slowing down or new management is questionable
iii. If I come across another high-growth multi-year ‘moaty’ opporunity available at a fair price

Otherwise; I sit tight and let the power of long-term compounding work its magic.

In terms of bear-market protection; I use a trend filter and look at the yield curve; and when both signal trouble; I protect my bull-market gains by hedging my book (shorting RSP by a factor 1.3X my long exposure). This way; I don’t give back most of my bull-market gains.

In summary; I focus on dominant long-term profitable compounders which are expected to grow their earnings by at least 20% pa over the next 4-5 years and only invest in these companies when they are trading at a PEG ratio of under 1.6 or a sensible price/sales ratio. With my method; I deliberately pass on some big winners (eg: Square); but this is a price I am willing to pay for my peace of mind.

If you are speculating and willing to exit at the first sign of trouble; you can make money by speculating in the high-flying momo stocks but this is a risky proposition and a game which I’m not very good at. So, I stick to what works for me and allows me to sleep well at night.

Hope this helps.

Best,

GM

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My goal is to compound my capital at 15-17% per annum for 20 years and not blow up. Although this is my objective; I have been compounding at nearly 19% per annum.

No guarantees that this will continue in the future; but no good reason to believe it won’t.

As long as I keep buying stakes in excellent businesses at sensible valuations and sit tight; the companies’ progress/growth will take care of me.

Best,

GM

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GM,

Valid points and if I was glued to an investment forever, your points would be 100% applicable.

However, owning 10 companies lets me focus on them intensely. With the help of this board, I pick up on things that I don’t think the scatter-brained market does.

i.e. stealth growth for Pivotal and Nutanix. Their low margin rev is shrinking while high margin, subscription revenue increases. Eventually this will provide a jump in overall rev growth.

The beauty is if our companies’ growth begins to slow down or for me, their P/S gets too high compared to other fast revenue growers, then I can move fast and invest in a company I like better.

Saul’s portfolio is a beautiful example of the decisiveness to act fast and adjust when stories change.

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If we are discussing the changing business models of NTNX and PVTL on this board; you can be sure this has been discussed at length at many of the institutions which manage billions of dollars.

Best,

GM

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"No. of Recommendations: 0
If we are discussing the changing business models of NTNX and PVTL on this board; you can be sure this has been discussed at length at many of the institutions which manage billions of dollars.
"

This i do not agree with. Just because something is big with a lot of people does not mean it is all seeing and all knowing.

Br MK

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Q1) Who asks questions during earnings calls?

A) Analysts who work for the big brokerage houses and banks

Q2) Who subscribes to Wall Street research?

A) Mutual funds, hedge funds, very large private investors

By the time any ‘secret’ corporate news gets to these boards; you can be sure that is already in the price.

Information first goes to the connected/big players; then it trickles down to us mere mortals.

Do you seriously think that just a few of us on these boards know what is going on with NTNX and PVTL?

Best,

GM

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That would imply that Wall Street could never make a mistake because they have ultimate knowledge AND money.

Or am i missing something :slight_smile:

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Q1) Who asks questions during earnings calls?
A) Analysts who work for the big brokerage houses and banks

Q2) Who subscribes to Wall Street research?
A) Mutual funds, hedge funds, very large private investors

By the time any ‘secret’ corporate news gets to these boards; you can be sure that is already in the price. Information first goes to the connected/big players;

Just curious GM. With that reasoning we should all just put our money in ETFs or Mutual Funds.

How do you explain that the analysts are so often completely wrong? Could it be because they are trying to keep track of 50 or 100 stocks and just don’t have the time to understand each one?

And how do you explain that we on the board are doing so incredibly better than the ETF’s, Hedge Funds, and Mutual Funds? Not just gaining a reasonably higher percentage than them, but gaining several or many TIMES more than they have.

That’s a real paradox.:grinning:

Saul

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Saul; you have done way better than the broad market because you are obviously very good at what you do. As I wrote in my earlier post; I respect your performance.

Wall Street doesn’t give a damn about investor returns; its only interest is to generate a return from investor’s capital (i.e. commissions etc.)

Most mutual fund managers underperform because they are closet indexers (too much career risk by deviating too much from the index) and by the time management fee, commissions etc are paid from the funds; they end up lagging the index. Plus, most managers feel they need to act (trade) to justify their active management fees; so they create unnecessary activity which hurts performance.

I know this because I was in the money management business for 20 years and only retired 2 years ago.

Best,

GM

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Wall Street analysts get it wrong because they are also human and nobody can predict the future consistently and accurately all the time.

You and others on this board have done significantly better than the broad markets because you run very concentrated portfolios; ride momentum; trade frequently and exit. Your strategy is momentum trading; not long-term investing AND not many are good at it.

For long-term investors; valuation at the time of entry always matters and that is the point I’m trying to make.

Best,

GM

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GM,

Not to pile on, but you contradicted your earlier statements. First, you said if we are talking about something here, then all the big firms and Wall Street traders already know and have that it is already factored into the price.

Then you said, pro investors are closet indexers, don’t care about investor returns, but instead care about making money from investors.

Those two ideas are opposite of each other.

I agree more with your second statement and that’s why with our intense focus and deep concern about our own skin in the game, we can do more than just analyze the numbers. We can actually understand vision, business strategy, and invest in “expensive” companies with only 20-30% revenue growth (Pivotal) knowing that when their low margin service revenue goes away, it will be replaced by higher quality, higher margin software subscription revenue.

And you’re right, there are many analysts on the calls and some of their questions are key indicators that they don’t understand the business models or strategies of some of the companies. They can’t when they are focused on entire sectors or 20-50 companies.

Also, I have a friend who works at Pivotal and doesn’t understand the dynamics of how their shrinking services revenues hides their growing subscription revs. He just loves working there and is good at his job.

Point being, all of this is not known or if it is, Wall Street’s short term focus allows us long term thinkers to capitalize on it.

I appreciate your contrarian thinking on this board, but in a way, that type of thinking is what this board uses to our benefit. That way of thinking is in line with the general market and Wall Street pros which is why we are able to be successful with our concentrated and contrarian approach.

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P.S. we aren’t just a buncha crazies who think “price doesn’t matter” David Gardner is a strong proponent of ignoring price, in fact he searches for “over valued” companies as part of his Rule Breaker criteria which has served The Motley Fool and many subscribers very well.

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Saul, the reply to your ‘real paradox’ question is that, so far as I know, there is no ETF, hedge-fund or mutual fund extant which does what you and others here do: invest all available investable capital in about 10 companies which are all in the sub-sub-sector of a sub-sector of a sector with an emphasis on high annual turnover and an absolute requirement for bull-market momentum. No paradox there!

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How many of their highly valued recommendations have bombed out badly?

You can say what you like; valuation ALWAYS matters in the end and after the end of the next bear-market/recession; you will begin to agree with me.

All the best,

GM

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US tech stocks and the broad indices went nowhere for 13 years (2000-2013) because valuations were very high in 1999. It took 13 years for operating results to catch up with valuations.

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GM, what puzzles me is how you can think that the information is always factored into the current price so that the current price is correct. If so, why bother picking stocks at all? Anyone who listens to the conference calls will realize that the analysts often don’t understand what the company does. It’s just a series of letters that makes up its ticker to them.

And how could Shopify have been correctly priced just 2 years ago and be up 500% from there? And how could all of the analysts so missed what was going on with Twilio (up 118% or so since January, when the analysts were so down on Twilio being commoditized, and about Uber leaving), when what was really going on was so clear to us? Or Nutanix, up 140% in nine months? How could the initial price have had all the facts factored in? I think you are over generalizing a bit.

And how could you think what we are doing is trading? Traders go broke, they don’t make 80% a year. We buy and hold until the story has changed, or until we realize that we have made a mistake. That’s totally different than trading.

Best,

Saul

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If you take a compound growth calculator and plug in even reasonably high rate of sales growth going out 10 years and then slap on a 5-6X sales multiple on these stocks; they will NOT offer a high shareholder return from these valuations.

Alright, let’s do that with SHOP, the most ridiculously priced stock here at the moment.

TTM Revenue is $760 mil.
MC is $15,5 bil.

If we take a high rate of sales growth - 25% p.a. for 10 years, we get a revenue of 1.25^10*0,76 = $7 bil.

Then we’ll take your multiple of 5,5 *$7 bil. = $38,5 bil.
Compared to our current valuation of $15,5 bil. we would gain 250% in 10 years, or about 10% per year compounded without leverage.

That’s not bad even compared to Buffet (who needed leverage to achieve higher numbers)…

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