AFR: Is the herd being led into growth purgatory?

This article was written by Jacob Mitchell and published in The Australian Financial Review on August 12, 2020.

We’ve seen it before – growth purgatory. It’s a place, not for investors who back great, growing businesses, but a place for investors who buy those businesses at the wrong price.

It might surprise readers that a quality company such as Microsoft condemned a herd of investors to growth purgatory for almost two decades.

During the dotcom bubble, Microsoft was trading at a peak earnings multiple of about 85 times. It was then, and still is now, a fantastic business but 85 times earnings was not the right price to pay.

Investors who poured into Microsoft at those sky-high multiples (among other tech bubble high-flyers) spent more than a decade in the red and by 2011 it had de-rated to a price-earnings multiple of less than 10 times!

The most important point for investors to remember today is the fact that this was not a result of poor operating performance. Through that period of growth purgatory, Microsoft’s earnings continued to grow. The market, however, de-rated the business and investors who paid the wrong price for a great business were caught out.

So, could today’s markets be leading investors into another period of painful growth purgatory?

Historically, it would appear so. Year-to-date, two-thirds of the move in the S&P 500 can be explained by just five stocks: Facebook, Apple, Amazon, Alphabet and Microsoft. Market leadership has never been this narrow in the US.

Market cap concentration is at a 30-year extreme, as is breadth – currently only 20 per cent of stocks are outperforming the index. These extremes have signalled a turning point in the past.

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Reversals of market extremes

Reversals of market extremes – where less popular, lower multiple stocks begin to outperform the current winners – typically coincide with a cyclical economic rebound, combined with some larger shift in the underlying investment cycle such as when the commodities super-cycle replaced the dotcom bubble.

New European Green Deal anyone?

While we have seen some periodic upswings since the 2008 financial crisis, economically cyclical stocks have underperformed right up to the extreme industrial production collapse that occurred during the COVID-19 outbreak. Cyclicals are now more than two standard deviations cheap versus the defensive and growth parts of the market.

But we are now, for the first time in a decade, witnessing a wave of large-scale fiscal and monetary stimulus across the world in response to the COVID-19 pandemic.

The initial response in 2008 was large fiscal and monetary expansion, but this turned to fiscal austerity in 2010. Central banks were left to stimulate growth in the decade following, but monetary policy alone was not enough to trigger a broader investment cycle.

The liquidity response today is better balanced between the real and financial economies and therefore is more likely to be followed by a cyclical economic rebound.

However, risks such as the uncertain impacts of the virus, a rise in populism, socialist policies, burgeoning fiscal deficits, and the weak quality of corporate debt are all related risks and are risks to equities as an asset class more broadly.

That is, they can affect both higher multiple growth and lower multiple stocks. Providing these risks do not derail the cyclical rebound in activity, and there is evidence of stabilisation in activity, a rotation into lower-multiple (or value) stocks can emerge.

In these uncertain times, what I think is clear is there are just as many growth traps in today’s market as there are value traps.

Investors seeking a smoother journey to achieving their long-term goals may be best served by simply asking: “Am I paying the right price for this great business?” As we saw with Microsoft at the turn of the century, the allure of explosive short-term gains can lead to long-term purgatorial pain.


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27 August 2020