Buy the Dip or Sell the Rip?
Given the poor performance of equities so far this year, I wanted to take a quick high level look at valuations of a number of stocks that have been under severe pressure over the last few weeks. By “high level”, I mean that this work is purely numerical / quantitative, not a deep dive into the qualitative metrics of each company which are also extremely important when determining the fair-value of a company’s stock price.
Tech companies are generally believed to be the most sensitive and vulnerable to higher interest rates, a concern for the sector since the Federal Reserve has decisively tilted hawkish in order to address inflation. Better late than never I suppose, although it seemed to take investors longer than it should had to realise that the party is about over. In spite of yesterday’s rally, the current sell-off in equities had been broad, involving nearly all sectors, not just technology. Recall that the S&P 500 reached an all-time closing high of 4,796.56 on January 3rd of this year, just over three weeks ago, but has declined 9.3% since then based on yesterday’s (Jan 26th) close. However, technology stocks – especially the ones that had very high valuations – have been under severe pressure for much longer. The NASDAQ 100 peaked at 16,573.34 on November 19th 2021, and since then, is down 14.6% (based on yesterday’s close of 14,150.75). Drilling even deeper into the so-called “high-flyers” and using the ARK Innovation ETF (ARKK) as a proxy, this ETF is down over 55% based on yesterday’s close (69.03) vis-à-vis its 52-week high of 155.30 on February 12th 2021.
For this analysis, I looked at 33 stocks which I have divided into four categories.
The largest and strongest companies in the list above are the FAMAG companies. I have included NFLX, the name that was used in the old FAANG acronym, even though NFLX is substantially smaller than its peers in this grouping. However, I have also presented averages for the FAMAG only in some of the tables, since NFLX has had some company-specific turbulence recently after its recent quarterly results (because of disappointing subscriber growth).
The next three companies in the list - TSLA, NVDA and SHOP – are considered “established tech” and all have market caps of more than $100 billion (at close Jan 26th). In some respects, they have similar characteristics as the FAANG+M stocks. They are generally considered to be great companies and solid stocks to have in one’s portfolio, but they are clearly much more expensive than the FAANG+M stocks. All are profitable and have had steep growth trajectories, with more “sizzle” in this respect than the larger FAANG+M companies because of their growth.
The third category of companies in the list – the so called “high-flyers” – have been under severe pressure for many months and clearly remain so, if for no other reason than their valuations got completely out of hand. This seemed to be finally recognised by investors starting around 11 months ago, in February 2021. Many of these companies are favourites of Cathie Wood / ARK Invest, and also favourites of stock picking services like Motley Fool. These are exciting young companies in fast-growing sectors (cloud, security, ”sharing” economy, etc.), often quite-rightly labelled as disrupters. A parallel sort of company / situation of the past would be Amazon, which first disrupted retail books stores, and then more traditional “bricks & mortar” retailers starting in the late 1990s. Even though these high-flyers are exciting, dynamic companies, and most will likely be successful in their business, the price of most of their stocks had reached nose-bleed levels by mid-February 2021, well above what could be supported by even the most optimistic expectations. Since then, the prices of most of these stocks have moved down rather substantially as investors have realised the degree of over-valuation. The main issue I have with ARK and with stock picking services like Motley Fool is that they completely ignore value in the short-run. If they like the company, they will buy or recommend it at almost any price. Having said this, I have little doubt that at some point we will overshoot on the downside. In fact, it might very well be that some of the high-flyers will be the first to find levels of support once their valuations adjust appropriately downwards and the broader market stabilises. For investors with the time and interest in doing the proper analysis and with a longer-term investment horizon, the stock price of at least some of companies might fall enough to be deemed attractive entry points. Even with this sliver of optimism, it is hard for me to predict how much prices will have to fall first because – as you will see below – most valuations remain inflated even though some of the high-flyer stock prices are now at 50% or less of their 52-week highs.
Lastly, to ensure I have captured the meme trend of the past year or so, I have included two of the so-called meme stocks - GME and AMC – in a fourth and final category. Some might consider the inclusion of these two names as a distraction and folly, but rest-assured that both GameStop and AMC grabbed a lot of retail and institutional interest during their respective runs, not only because of their price action, but also because they represented an attempt by (mainly new) retail investors – meaning the “Reddit crowd” – to go head-to-head with professional short sellers.
To whet your appetite, here’s a preview of the categories before getting into more detail.
Based on this summary view, I will draw several conclusions before digging deeper into the numbers.
Size matters: Larger and more diversified companies – meaning those offering multiple products and services with diversified revenue streams, customers and suppliers – are generally safer than smaller and early-stage mono-product/service companies, even those that are recognised disrupters. Compare the size – and by proxy, the resources and business risk – of both the FAANG+M and next tier technology categories, to the high-flyers and memes. The larger and more established tech giants have a long history of developing dominant businesses across diverse activities. They have top-drawer management teams and dominant global market positions. Many of the high-flyers offer one product or service and are therefore more at risk of being disrupted themselves by new competitors.
Access to capital: The size and strong investment grade credit ratings of the FAANG+M companies (note: FB and GOOG do not borrow but are implied IG) afford these companies ready access to the debt and equity capital markets. Of course, the reality is that every one of these companies is profitable and generates positive cash flow anyhow. The situation could not be more different for the high-flyers, as most lose money and have a very high cash burn rate. Because they are small companies with negative cash flow, most are not rated, and this means that they are unable to access the debt capital markets to fund their growth. Fortunately, most have been prudent enough during the times of inflated stock prices to raise equity and set aside cash, although whether there will be sufficient cash to get to break-even without accessing the capital markets will vary from company to company.
Growth: There is a narrative often espoused which states that high growth companies merit higher multiples of earnings and sales. I subscribe to this because it is simple mathematics, but an investor must recognise that high growth requires generous amounts of funding because in many cases, exceptional top-line growth and net earnings do not go hand-in-hand. As you probably know, most of the high-flyers and both meme stocks I have included in my dataset lose money, and this means they are burning through their available liquidity. Many investors refer back to the early days of Amazon, as the founder Mr Bezos has been clear on many occasions that the company would be willing to sacrifice margins and bottom-line profitability to gain market share faster, meaning that revenue growth would be robust but profits less so. Investors have generally recognised this fact by valuing AMZN at a higher-than-average P/E ratio, but at the same time, at a lower-than-average price-to-sales ratio (also reflective of thin margins in retail).
Valuations: It makes little sense to me to have ridiculously high valuations based on both multiples of earnings and revenues, a characteristic of many of the high-flyers. In fact, P/E ratios for many of the high-flyers, even using forward earnings, are irrelevant because these companies lose money. Valuations are imperfect and can vary wildly, but generally, history has provided both upper and lower bounds. When either is breached, investors tend to buy or sell accordingly to return the stock to the fair value range. The unusually generous pandemic stimulus from the Federal Reserve and the US government stoked unbridled enthusiasm for risk assets across the board, artificially inflating prices well above fair value. Although the writing has been on the wall for some months now as inflation has increased to levels not seen in 40 years, it was the most recent even more hawkish tilt by the Fed that seemed to rattle markets, bringing stock valuations back to reality. I would be remiss not to say that as ridiculous as some of the valuations remain for the high-flyers and memes, the FAANG+M and new larger new (profitable) technology stocks are far from cheap, at least based on historical valuation multiples. This puts even the stocks of these mega-tech companies at risk of multiple compression should markets continue to deflate. This would not be surprising to me and makes me tilt more towards selling the rip than buying the dip, although this is name specific.
With this backdrop, I will now drill deeper into the numbers by looking at the categories and specific stocks in the dataset based on several important – and I believe – relevant metrics. Let’s start with the most obvious thing first – which companies are profitable, and which ones are not, based on trailing earnings (last 4 quarters rolling)?
Of the 19 companies listed in the table above that are not profitable, seven are in fact expected to be profitable in the next year (even though were unprofitable in the last four quarters): DOCU, CRWD, PATH, SNOW, LYFT, TWLO and ABNB.
I alluded to the importance of size of a company earlier, and the two tables below list the largest and smallest companies by revenues and EBITDA. EBITDA can be viewed as a proxy albeit imperfect for cash flow.
It is almost by definition that the largest companies are the established technology companies, and the smallest are mainly high-flyers. As you will see later, it is the largest companies that have been hit the least by recent unsettled market conditions, although these companies have also seen their shares decline in January. 18 of the 33 stocks in the dataset (16 high flyers and both meme stocks) are EBITDA negative, meaning these companies are not able to support their ongoing businesses from cash flow. This is less concerning to investors when investor sentiment is positive but can become an important issue – in fact a matter of survival – if these companies run out of liquidity and are unable to access capital in the equity or debt capital markets, or from banks.
The following two tables look at valuation metrics. To provide some context, the price-to-sales of the S&P 500 index is 2.77x, and the price-to-sales of the NASDAQ 100 is 4.97x. Similarly, the price-to-forward earnings ratios of the S&P 500 and the NASDAQ 100, respectively, are 19.6x and 34.3x.
The first table above looks at the companies with the highest and the lowest price-to-sales ratios. Both NVDA and SHOP have very high price-to-sales ratios, much higher than the average for example of the FAMAG stocks (average 7.6x). Both stocks have also moved down sharply since the start of the year, which was inevitable given their rich valuations. Alongside high price-to-sales ratios, both NVDA and SHOP have high price-to-earnings (forward) ratios, reflecting optimism regarding future growth, but also making them vulnerable to downdrafts even at current levels well off of their 52-week highs. This does not mean that these are not excellent companies and could be buys even now at these price levels based on your ability to withstand a further move down, should it occur, before they eventually grow into these lofty multiples.
As far as price-to-forward earnings, as I mention in the footnote, 11 of the companies in the dataset have negative earnings expected for next year, according to analysts’ consensus expectations. The ones listed in the table have the worst such ratios, and for reasons I will not drift into in this article, I do not really like any of them. As far as the lowest price-to-earnings, I like the stories behind GOOG and – should you have the stomach – COIN. In fact, COIN is highly profitable and has very reasonable valuation multiples but will be highly correlated with the volume and direction of movements in cryptocurrencies, a correlation that will undoubtedly exacerbate its volatility.
Let’s turn now to two other important technical metrics – the price now as a % of 52-week high (to show how much the stock price has declined since its 52-week high), and the short interest.
The top part of this table show the stocks that have declined the least on the left side, and the ones that have declined the most on the right side. Supporting my thesis that size matters – along with being a dominant and established business – the five stocks that have been least affected so far by the January sell-off are perhaps not surprisingly the FAMAG stocks. Those stocks that have been hammered the hardest (right side) include four high flyers and one meme stock. In fact, as you can see in the table showing the stratification, 19 of the stocks that are currently worth 50% or less of their 52-week high are either high-flyers (17) or meme (two) stocks. Of the five worst performers, all have had various problems in addition to simply being over-valued, and this has compounded their decline. Different from the recent declines in the FAMAG stocks, most of the worst performers have seen their prices trend lower now for many months although the recent sell-off has accelerated their declines.
The table below summarises short interest of each stock as a percent of its float.
Interpretation of this table by name (top portion) can cut both ways. On one hand, it clearly provides picture of the least favourite stocks by the short position (right side of table), meaning that investors have sold borrowed shares in anticipation of buying the shares back (i.e. “covering their short”) at lower prices. Not surprisingly, the two meme stocks are amongst the five with the highest short interest. I do not know a lot about DKNG, but I am also not surprised to see LMND and TDOC on this list because I believe that both have operating / competitive issues beyond simply the numbers. The reason the short interest can cut both ways is that if any of the most shorted stocks start to get upward momentum, it can force short sellers to cover their position by buying shares in the market, fuelling an upward spiral. We have seen this play out in the past on both AMC and GME, as short sellers found themselves victims of social media-inspired (generally Reddit) retail day-traders.
Let me finish with a more comprehensive table of the companies in the dataset, ranked by largest to smallest as far as market cap. This data, as it all the data in this article, uses prices as of the close on January 26th 2022.
Now you decide – buy the dip or sell the rip? It's not as easy to decide as it used to be!