When it comes to single stocks, it’s important to assess where your returns will come from. Past returns are, at best, only an indication of how things might turn out. If you don’t do the detailed work on the prospects vs the track record, as well as the valuation, you’re looking for trouble. Ignoring what the market has previously told you about a company is equally dangerous.
The share price return is a function of two things: growth in earnings per share and changes in the valuation multiple. The former is based on management’s efforts and the latter on the market’s response to those efforts.
If earnings are flat but the multiple expands, you get a positive return. If earnings are flat and the multiple decreases, often because investors feel they can get better returns elsewhere, the share price will drop. There have been many such examples of this in value stocks in the past couple of years, as fixed-income investments started offering proper yields and traditional dividend-focused stocks needed to become cheaper to compensate investors for taking equity risk.
Particularly in growth stocks at high multiples, you can easily end up in a scenario where earnings growth is positive but the unwind in the valuation multiple is so significant that the net move in the share price is negative. This happens frequently in the magnificent seven technology stocks, or other growth stock darlings such as Lululemon (a dip I recently bought).
In those stocks, I increasingly find myself watching the movement in the revenue multiple as a simple test of whether the valuation is too high or too low relative to where it has been trading. This is where I believe that listening to the market is really helpful. Instead of getting the textbook out and fighting with people about whether three, four or five is the right multiple, why not look at what a liquid market of buyers and sellers has been saying about a company? In other words, look at where the multiple has historically traded and why.
This approach I’m taking assumes a base case of mean reversion in the multiple. Simply, if the multiple historically traded at, say, five and the multiple is now eight, there needs to be an exceptionally good reason that each dollar or rand of earnings is suddenly worth 60% more than before.
Another example of the importance of listening to the market can be found in South Africa, where quality stocks trade at stubbornly high multiples despite the country’s clear challenges
Sometimes we see strong, sustainable reasons for this, such as the manner in which Ferrari’s earnings multiple has left most luxury stocks for dead and traded up to where you’ll find ultra-luxe player Hermès. There are sensible reasons that Ferrari’s business model can be compared to that of Hermès rather than LVMH or Richemont. In most cases though, the multiple moves based on broader market movements, with corrections and even overcorrections as part of that journey.
It’s not about buying every dip. It’s about buying the right dips. Applying a mean reversion lens is one way I try to sort the good dips from the bad.
Closer to home
Another example of the importance of listening to the market can be found right here in South Africa, where quality stocks (the likes of Clicks, Shoprite, PSG Financial Services and Capitec) trade at stubbornly high multiples despite the country’s clear challenges. Part of this may well be that there are South Africa-focused equity funds chasing a small pool of very high-quality assets, which naturally drives up prices. This doesn’t explain Clicks, though, which is well known for having a high foreign ownership percentage.
Trying to have a philosophical debate on why a group such as Capitec trades on a high price-to-book compared with, say, Standard Bank is pointless. The recent market response to strong earnings at Capitec proves it. Despite clearly being priced for growth, the news of mid-teens earnings growth at Capitec drove the share price higher anyway. Instead of the multiple unwinding, the share price rallied off the increased earnings base and the multiple remained elevated.
This is maddening for those with short positions based on the valuation alone. The local market has shown that valuation shorts with no reference to mean reversion are dangerous things, as the highest-quality stocks trade at stubbornly high multiples even when growth isn’t fantastic. The US market seems to be more willing to punish a slowdown, which is how we see moves of 20% or more in a single day, even on the world’s largest tech companies.
On both long and short positions, listen to the market.
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