“This time is different” is a phrase that describes the (misguided) belief that investment paradigms have somehow changed. This statement is most often heard when traditional ways of valuing stocks or the broad market suggest a bubble valuation, but bulls want to seek arguments about why the current valuation is still reasonable or too low. The phrase has recently shown up in a rising amount of comments I am reading on a range of articles, and I believe that at least some parts of the market are overvalued right here. This does not necessarily mean that all stocks, or even the average stock, must be trading above fair value, but things look bubbly in some market segments right now.
In the above chart, we see a couple of stocks that look severely overvalued today. Many of these companies are not even profitable on an EBITDA basis, which already excludes depreciation, amortization, as well as interest and tax expenses. They trade at high multiples of revenues as well – in fact, the EV to sales multiples many of these stocks are trading at would be quite high, even if they were price to earnings multiples. On average, these stocks also trade at a very high multiple of their reported book value. Before we delve more into the pockets of the market that seem overvalued, let’s first take a look at the this time is different phrase.
Bubbles Have Occurred Again And Again, For Centuries
Carmen M. Reinhart and Kenneth S. Rogoff have written a book about the phrase and how it connects to the history of market bubbles, with the subheading reading “Eight Centuries of Financial Folly”. This already shows that speculation, and speculation-driven exuberance, is a very old tale. Historic market bubbles include the famed tulip mania that occurred in the Dutch Republic in the 17th century, the South Sea bubble that occurred during the 18th century, and many more.
In the more recent past, we have seen irrational exuberance play out during the dot.com bubble around 20 years ago and during the housing market bubble that preceded the Great Recession.
During the dot.com bubble, the Nasdaq index (QQQ) rose by around 100% in around 1.5 years, which is an upwards explosion in share prices that can’t be explained by the underlying performance of the companies that make up the index. Large companies, including Cisco (CSCO), have seen their share prices rise by 120%+ in a little over a year. To this day, the company’s share price has not risen back to the levels that were hit in early 2000 – despite the fact that the company continued to grow its revenues, earnings, and cash flows over the years.
Looking at the US house price index between 1995 and 2007, we see that prices rose slowly in the beginning before prices started to accelerate more and more:
The graph shows a clear upwards bend in the years preceding the crash, which was the result of more and more investors rushing into the market at any price in order to participate in the presumably easy gains.
In both cases, during the dot.com bubble and during the housing market bubble, many stated at the time that this time [was] different. This included very smart and knowledgeable people, including regulators, investment bankers, Federal Reserve personnel, etc. Many didn’t want to see what seems quite obvious in retrospect – prices were not driven by fundamentals or the macro environment, but rather by speculation.
Is The Market As A Whole Overvalued?
We believe that the answer to this question is no. There are pockets that seem overvalued, and this may include large companies with a heavy weight in broad indices. Recently, I published an article arguing that Apple (NASDAQ:AAPL) seems to be trading above fair value right now. I released a similar article arguing that Tesla (NASDAQ:TSLA) seems to be trading above fair value. At the same time, however, there are many stocks that trade at reasonable valuations.
Sam Kovacs wrote an article recently in which he has shown that, contrary to what many believe, many stocks are trading at quite reasonable valuations. According to that article, 50% of stocks are trading at price to earnings multiples of 20 or lower, i.e. at earnings yields of at least 5%. Compared to the yields investors can get from treasuries (well below 1%), this does not seem unreasonable at all. 30%, or about one-third of the market, trades at an earnings multiple of 13 or less, which surely is not a high valuation. This includes major companies such as AT&T (NYSE:T), Pfizer (NYSE:PFE), etc.
Even high-quality companies such as Johnson & Johnson (NYSE:JNJ), one of just two companies with a triple-A rating, are trading at very reasonable, or possibly even low valuations. Johnson & Johnson trades at just 16 times next year’s expected profits, for example.
Then, again, the S&P 500 index (SPY) is valued at a whopping 29 times net profits right now, which equates to an earnings yield of 3.5%. Compared to how the index was valued over the last 120+ years, this is a quite high valuation:
The high valuation of the index, compared to the fact that half of US stocks trade at 20 times profits or less, can be explained by the heavy weighing towards tech companies that have high market capitalizations and high valuations.
Over the last year alone, the valuations (P/E multiple) of companies such as Apple, Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) have risen by 30%-80%. This means that a large portion of the share price growth these companies experienced was not based on the operating performance of the company (e.g. EPS growth). Instead, the market somehow believes that the multiple that Apple should trade at needs to be 80% higher than the multiple the same company, with the same products, traded at one year ago.
The reasoning for why this happens is not very convincing, at least to me – after all, not much has changed at Apple and the other tech mega-caps. Apple already had a growing services business one year ago (in fact, growth has slowed down), yet its valuation was way lower back then, it was already known that new 5G phones would be coming, etc. Pressed on why they believe that Apple is still fairly valued right here, some investors state that the “metrics of the past” are not the correct choice to value the stock any longer, i.e. this time is different.
The same can happen when one talks to Tesla bulls. Some of those bulls argue that Tesla is an “exponential company” that can’t be “valued on a linear basis”, which is, at least in my ears, some fluffy way of saying that this time is different:
Over the last year, Tesla was able to grow its revenues by 5%, its cash flows by a little over 20%, but somehow, its share price exploded upwards by 750%. The company offers more or less the same products it offered one year ago, has the same leadership, operates in the same market, etc. One would assume that share price should, at least more or less, follow the trend of revenues, earnings, profits. But, instead, its market capitalization explodes upwards. To me, this screams of a bubble, underlined by the fact that no other company with a market capitalization anywhere close to Tesla’s (~$400 billion) trades at anything close to Tesla’s 230 times forward earnings multiple (1,200 times on a trailing basis).
Getting back to the table featured at the beginning of the article, we also should talk about some of the recent IPOs and high-flyers. Do Lemonade (LMND), Beyond Meat (BYND), Zoom (ZM), Nikola (NKLA), etc. operate in growth markets? Yes. Does this mean that they will likely be able to grow their revenues considerably over the coming years? Yes. Does this justify price to sales multiples of 30, 50, 80? A couple of years ago, a stock would have been called way overvalued if it traded at 50 times net profits, and now, some investors argue that a 50 times sales multiple is justified, or even a great bargain in some of these stocks.
To us, it looks like these companies are trading above fair value and that their massive share price gains this year have been driven by speculation to a significant degree. Something similar happened often enough in the past to know that these things do not end well in many cases. Looking back at Cisco in 2000, the same could be said about the company as is said about Zoom, etc. today. The company was active in a growth market, showcased strong revenue gains, etc. And yet, 20 years later, those that bought back then are still waiting for their shares to break even.
High Valuations Can Amplify Growth
We want to note that high valuations for growth stocks also have a positive side. This makes raising equity much easier, and it allows the company to make accretive acquisitions repeatedly. If, for example, a company’s stock is valued at 50 times net profits and the company issues shares to take over competing companies at a 25 times earnings multiple, this is easily accretive to the acquirer’s EPS. Cisco, before the crash, was pursuing such a strategy, which is one reason why the company was able to achieve a very compelling revenue growth rate in the first place.
We see that Cisco’s share count rose by more than 50% in a couple of years, which helped fuel the growth the company generated at the time.
This strategy only works as long as valuations for the issuer remain high, however. Once valuations come back down to earth, this does not work any longer. This also happened to Cisco, which had to self-fund growth and acquisitions following the bursting of the bubble. Depending on one’s stance regarding this strategy, one could thus either call it a virtuous cycle, or a scheme inspired by the greater fool theory – or anything between the two. In any case, this strategy only works until it doesn’t, which makes it dangerous.
Be Careful Out There
We won’t deny that those that bought Tesla, Zoom, etc. a couple of months ago have enjoyed attractive gains since – but that always holds true during the bubble phase. We believe that, ultimately, much of the gains that these stocks and many more enjoyed over the last year will be given back, or that share prices will move sideways for a very long time until the underlying value of the stock has risen to a level where more share price gains are justified.
Bankruptcy is not a risk for these companies, but a Cisco-style underperformance for a long period of time is, we believe, a very possible scenario, even though these companies will likely continue to grow their businesses – just like Cisco did 20 years ago.
That being said, we also want to point out that we believe that not all of the market is overvalued. We at Cash Flow Kingdom think that there are still attractive investments to be made (select real estate, midstream, and preferred stocks, etc.). It should also be pointed out that the temptation to move to cash seems inadvisable due to the Fed’s clear commitment to keep rates low for years even were it to spur above normal inflation.
Before chasing any recent high-flyer, it may be a good idea to ponder whether the current valuation is justified by the company’s underlying business. In some pockets of the market, this is not the case (opinion). It looks to us like bubbles are building and expanding, which is why we think it is prudent to be careful out there.
One Last Word
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Disclosure: I am/we are long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.