Price is what you pay, value is what you get.
“Price is what you pay. Value is what you get”, a quote uttered famously by Warren Buffett in his 2008 annual letter to Berkshire Hathaway’s shareholders. Price and value are two sides of the same coin. Understanding the difference between price and value is the core principle of value investing. It is also core to KeyStone’s hybrid strategy which involves buying growth & dividend growth stocks that offer GARP or growth at a reasonable price. We are not always looking for the cheapest stocks on the market, nor will we pay anything for a business – we look for a reasonable price, for a good business.
Unfortunately, particularly in the technology sector, that principle has been largely ignored over the past 12-18 months by investors chasing growth at any price and it is coming home to roost.
Let’s take a quick look at investor sentiment that has led us to where we are today. Under-communicated by the broader indexes has been the stealth crash in growth tech and risk-oriented stocks.
This chart authors an alarming story. While the NASDAQ index itself rose to the end of 2021, by the start of 2022, over 40% of NASDAQ stocks were down 50% from their highs on the year.
How can this happen? Two things are at play. Number one being the dominance of the “MegaCap-8”, Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, NVIDIA, and Tesla. The combined market cap of these tech behemoths has surged over the past 10 years (including in 2021) to just under $11 trillion, giving them incredible influence on the broader indexes.
Chart created by: Yardeni Research Inc.
The MegaCap-8 now make up almost one-quarter of the entire S&P 500 and over half the NASDAQ 100.
Chart created by: Yardeni Research Inc.
As the result, a strong year of gains (as we saw in 2021) can mask losses, even significant losses, elsewhere in the index.
But why are over 40% of Nasdaq stocks down over 50% from their 2021 high?
A major theme heading up to the pandemic and immediately following has been massive capital inflow into “disruptors or innovation stocks” – stocks that promise to change the world and become the next Google, Microsoft, or Apple. The problem is, while a number are excellent growth businesses, including the likes of CrowdStrike Holdings Inc. (CRWD: NASDAQ) and DocuSign Inc. (DOCU: NASDAQ), the multiples investors were willing to pay to sales and cash flow (if present) were historically high. In other names such as EV hopeful, Rivian Automotive Inc. (RIVN:NASDAQ), and, in Canada, e-commerce payment enabler Lightspeed Commerce Inc. (LSPD: TSX), cash flow was negative, and price-to-sales multiples were 50-150 times plus.
Perhaps the poster child for the euphoric buying in tech disruptors is the Ark Innovation Fund, run by recent market darling, Cathie Wood. Outside of Tesla, the fund does not own the Mega-Cap-8 but rather a basket of disruptor and innovation stocks. As such, it is a decent proxy for the stealth crash. To be clear, the fund performed very well for a 3-4 year run as money piled into these stocks. But the Ark ETF has lost billions with its unit price down 38% in the last 3 months and approximately 50% over the past year.
We took a quick look at the current valuations (post stealth crash) of the top holdings in the Ark Innovation Fund removing Tesla (as one of the MegaCap-8) from the equation. To give readers context, the average market PE is 22.5 at present. Only one of the fund’s top 12 holdings has a PE of under 30. Seven of the 12 companies do not appear to report current earnings or even adjusted earnings and while the price-to-sales multiples have decreased, historically they remain high.
Investors were buying stocks symbols (price) with little consideration for value. Remember, price is what you pay, value is what you get. Euphoric buying in these disruptor hopefuls fueled by cheap money, record stimulus and low rates has led to little value in this space over the past year and a significant correction, however stealthy it may be, is not surprising.
The market tends to remind you, that one cannot just pay any price for most stocks.
To give you an idea of how overvalued many of these disruptor hopefuls were trading at 50-150 times sales below is a quick breakdown of the peak valuations on some of the best true disruptive tech companies over the past couple of decades.
Even in this list of true once-in-a-lifetime investments, not one came close to a price-to-sales multiple of even 45.
It appears value is beginning to matter once again.
With that in mind, while we have continued to recommend long-term holding such as Microsoft and Alphabet, which remain at relatively reasonable valuations, we are keeping a keen eye on around 30 cash flow positive mid-to-large-cap US SaaS technology names. Stocks which have dropped in value in sympathy with the sector and may finally fall within our GARP model.
To that end, we are hard at work on a US technology stock special report designed to take advantage of the recent correction in this sector with a focus on where some of these great businesses can be 2-3 years from today.