8/22/24 Thoughts on Financial Markets
A thread on some of my recent thoughts on financial markets.
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I haven’t published too many pieces specifically focused on financial markets over the last couple of years largely because, while I was in school, I wasn’t spending too much time studying markets in detail. I invested all of my money in the S&P 500, enjoyed school, and, two years later, the market is up 38%. Not bad!
However, now that studying markets is a large part of my day job, I want to occasionally log my thoughts concerning valuations, opportunities, investor behavior, etc. I don’t have a set cadence for these pieces, maybe once a month? Maybe less? We’ll see. Anyway, that’s enough context. Let’s get to it.
Passive investing, multiples expansion, and more
A couple of years ago, researchers from Baruch College’s Zicklin School of Business and Harvard Business School estimated that at at least 38% of markets are now passive. That’s a low bar by their own observation, considering that their study only includes “strict end-of-day indexers who are benchmarked to either the S&P 500 or the Russell 1000/2000.” If you include other index funds such as the Nasdaq 100, and other passive vehicles such as dividend-focused ETFs, small cap, mid cap, and large cap ETFs, sector-specific ETFs, and value/growth ETFs, the percent of stocks owned by passive investors could easily be greater than 50%. Of course, this isn’t a bad thing. The S&P 500 outperformed most actively managed large cap stock funds for the 14th year in a row in 2023, after all.
But the rise of passive funds has also introduced new inefficiencies to markets.
Think about it like this: when half of the money flowing into stocks is determined by index inclusion and factor values instead of valuation analysis, stock prices can easily become (temporarily) dislocated from company valuations. Combine these passive flows with algorithmic trading that can accelerate price momentum, and stocks can quickly become detached from their fair value on both the high and low side.
The efficient market hypothesis states that asset prices reflect all available information, and the underlying assumption of the efficient market hypothesis is that one can’t possibly outperform the market because all information is already incorporated into a stock’s price. But when so much of the market’s buying and selling activity is determined by information irrelevant to a stock’s value, it feels like the inefficient market hypothesis is a more accurate description. And inefficiencies create opportunities.
I believe there are a lot of inefficiencies in the market today, both on the high end and the low end.
Market pundits often talk about the price and valuation multiples of the S&P 500, claiming that it’s undervalued or overvalued from time to time. In aggregate, that information is helpful to contextualize the market as a whole, but it’s important to remember that the “S&P 500” isn’t a standalone entity. It’s a collection of companies that each have their own revenues, expenses, earnings, multiples, and growth rates. And the price of the S&P 500 says little about the state of its individual components. Let’s look at some of those larger components.
Over the last couple of years, the “Magnificent Seven,” aka Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla, have done quite well:
Apple: 33%
Amazon: 30%
Alphabet: 42%
Meta: 220%
Microsoft: 51%
Nvidia: 621%
Tesla: -25% (though, if you bought in January 2023, you’d be up 81%. Timing matters!)
And now, the “Mag 7” makes up 31% of the S&P 500 index. I don’t think concentration, by itself, is a bad thing. And these companies earned their concentration by outperforming the market. But some of these valuations are beginning to look pricy.
Let’s look at Apple, the world’s biggest company, as an example. Apple is up 33% since August 2022, and 75%, or $1.5 trillion in market capitalization, since January 2023. However, Apple has also experienced two years of declining sales, flat net income, and declining free cash flow. Its entire stock price increase since 2022 has been valuation expansion, and the company is now trading at 34x earnings (compared to a median PE ratio of 18.6x over the last decade) and 32x free cash flow despite no growth for two years. I realize that, yes, it’s Apple, and everyone owns an iPhone and the company deserves to be worth $10 trillion or whatever, but at some point, valuation does matter.
I’m not a multiples maximalist by any means, and I don’t think “low P/E ratio” should be one’s north star for evaluating stock picks (Google “value trap” for examples as to why), but valuation does matter, because lower valuations creates a lot of room for upside.
In 2018, for example, Apple traded at 12x free cash flow. Apple’s free cash flow per share is up ~110% since then (that’s great!), but it’s also trading at 32x free cash flow now. Yes, Apple has crushed it as a company, but its stock price benefited more from multiples expansion than it did from company performance. This is, of course, the ideal scenario: the company starts clicking, the market rerates it at a higher valuation, and the stock outperforms. And a lot of stocks have done well over the last couple of years thanks to a combination of strong execution and multiples expansion. But many of these stocks are now priced to perfection, trading at 40x, 50x, and 60x earnings, and high earnings multiples come with high investor expectations. If expectations aren’t met, multiples can contract.
Steve Ballmer gets a lot of flack for Microsoft’s stock price generating negative returns during his tenure as CEO from 2000 to 2014, but Ballmer grew revenue by 230% and earnings by 135% during that time. Not a bad performance! His issue was that Microsoft traded at ~70x earnings in January 2000 and 18x earnings in September 2014. Valuation compression 101.
I’m not saying that high multiple = bad stock, or that you should dump your big tech stocks, (Nvidia’s P/E ratio is 74, but its earnings are up 10x over the last year. That’s just absurd execution), but high multiple does = high expectations, and it’s something to keep in mind when looking at the market today. Back to my first point: when so much of the market’s trading activity is passive and algorithmic, stock prices and company valuations can easily diverge, and a little valuation work can go a long way.
Which brings me to my next point:
There are a lot of stocks hiding below the surface
Hidden below the surface of the S&P 500’s big tech-led ~40% gain over the last two years are a slew of companies that got crushed in 2021 and 2022 are still well below their pandemic peaks. Some of these companies were just plain bad businesses plagued by unprofitable growth, outrageous stock-based compensation, and “adjusted EBITDA” metrics that would make Adam Neumann smile (long-live “community adjusted EBITDA”), and investors grew tired of paying top-dollar for them when interest rates rose.
Others, however, were overpriced, but good businesses that continued to execute at a high level as their stock prices collapsed, or they were broken growth stocks who have since cleaned up their act, but the market is still overlooking them.
Take PayPal (full disclosure: I bought some shares this week), for example. PayPal was trading at 11x last year’s free cash flow earlier this week, despite growing revenues at 9% annually, expanding profit margins, and announcing a $6 billion share buyback. Here is its stock chart over the last five years compared to its annual and quarterly revenue:
No, it’s no longer generating pandemic-era 20%+ annual revenue growth, but the business looks… fine? PayPal’s problem was that investor expectations reached a fever pitch in 2021 when the stock was trading at 71x earnings, it didn’t have a chance to match those expectations, and the stock collapsed.
Shopify is another example. It was trading at 50x sales in 2020 and 2021, which is just an insane multiple for any company that isn’t an AI startup raising hundreds of millions of dollars on like $100k of revenue. That being said, its sales have doubled since then, and it’s now trading at a (still pricy, but more digestible) 12x revenue, and the company is profitable thanks to some heavy cost cutting initiatives in 2022 and 2023.
These are just two examples, but there are dozens of otherwise-functional companies that were priced to perfection three years ago, that are doing just fine now, that are still trading well-below their pre-pandemic highs.
China stocks
Another fun trend to look at: Chinese stocks. At the beginning of this year, Chinese stocks were trading at their greatest-ever discount to US stocks, and despite a slight recovery, the valuation gap is still massive. Don’t get me wrong, I get why:
The Chinese economy is struggling, the US economy is booming.
China literally kidnapped one of its best businessmen for being critical of the government.
The US keeps threatening to delist Chinese ADRs.
But still… the Chinese internet ETF, whose biggest holdings include Tencent (revenue up 8x in the last decade), Alibaba (revenue up 10x in the last decade), PDD Holdings (revenue up 20x since 2018, though to be fair, this stock has done pretty well lately), and JD.com (revenue up 10x in the last decade), is basically flat since 2014.
And any piece of bad news still sends all Chinese stocks down. Walmart offloaded its stake in JD.com earlier this week, and Alibaba, which is an entirely different company, briefly fell after hours because… China? I get the delisting risk and geopolitical risk and economic risk. But also… from a valuation standpoint, the risk with Chinese stocks was much, much higher in 2020 than it is now. All of those “risks” existed when KWEB traded at $100, and it exists with KWEB trading at $30. Chinese stocks could flounder at this level for years, but the “risk” associated with owning them is far lower now than it was four years ago, even if it doesn’t feel like it. Which brings me to my last point:
Rethinking Risk
One thing that makes investing hard is how price movement affects us psychologically. High prices (or prices going up) are self-affirming, leading investors who are holding these stocks to think, “Yes, I’m right! This stock is great! It’s going to keep climbing and climbing.” well past the point of any reasonable valuation. And as the price climbs, investors who did not invest begin to sweat.
“Oh it’s pricy, I’ll wait for it to come down."
“Maybe I should buy, but I still don’t know if I can pull trigger yet.”
And then, after a 200% melt up, they capitulate:
“I can’t take it anymore, I need to invest!”
And then the stock peaks, and begins to collapse, and the whole process plays out in reverse. Some investors get scared and sell immediately. The stock recovers for a bit, then resumes its trend down. More investors sell, and the decline accelerates. Investors waiting on the sideline are terrified to invest, even when the stock is well within their valuation parameters, because they worry that it will keep going down. Those holding the stock will sell it well-below a reasonable level because the pain of losing money overpowers rationality, and they just want to get out.
You can see this in the KWEB chart: brief panic in March 2020 due to the pandemic, then the index soared by 150% in a matter of months as investor FOMO’d into Chinese tech stocks, then it collapsed, falling more than 80% over the next two years.
Tell me, was it riskier to invest before the collapse, or after? Reality doesn’t match the feelings we experience.
Prices going up feel safe because price increases 1) confirm that we’re right and 2) signal that we’re making money. So when we find an investment that works, we don’t want to sell, even when our brains know that we should, because the stock has done so well for so long that we trust it.
Prices going down feel dangerous because when you hold a stock that’s declining, you lose money. Losing money hurts, and no one wants to get hurt, so we typically sell or avoid stocks that are falling/have fallen. But cheaper stocks are (at least from a valuation perspective) safer than expensive stocks. Much of the risk is priced in. It’s already happened.
That’s enough market musings from me today, happy Thursday.
- Jack
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Jack's Picks
A fun piece in Semafor covering The New York Times’ complicated relationship with Ezra Klein.
Wild story about two New Zealand brothers who turned a $10 million family inheritance into billions by trading across various international markets.
Bought KWEB about 3 months ago!
Super insightful article. Especially the piece on psychology of profits and losses.