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09/10/20203 mins

‘Growth’ has ruled the recovery. What next for investors?

Aside from some recent missteps, stockmarkets have made a swift recovery from their lockdown-induced lows. So much so that despite the economy remaining in a precarious state, equity markets have recorded new all-time highs. But this apparent return to health is deceptive – a large proportion of stocks, particularly those exposed to the real economy, remain well below pre-lockdown levels.

The recovery has been concentrated around a small number of US technology and internet stocks – including the FAANGs which have come to epitomise the markets’ hunger for growth at any price.

Huge stimulus packages from central banks and governments, and a view that the tech ‘working from home’ stocks have become safe havens during the pandemic, have driven another surge for these ’growth’ companies, pushing overextended valuations to levels last seen at the dotcom boom. Price as a multiple of sales is more than 10x for some of the popular technology high-flyers, such as Microsoft. In fact, more US stocks are valued this way now than at the height of the dotcom era.

US software company Sun Microsystems, hit this level during dotcom mania. Reflecting on the extraordinary valuation a couple of years later, the company’s CEO Scott McNealy famously asked investors: ‘what were you thinking?’

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realise how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

New stockmarket listings are often a good indicator of investor euphoria. Naturally, owners of private companies are inclined to sell their shares on public markets when they believe they can take advantage of overblown prices. The recent flurry of listings suggests that is exactly what they see now.

Although there have been many ‘hot’ technology companies coming to market, this trend is not confined to Silicon Valley darlings. A recent IPO of a bottled water company, Nongfu Spring, is a notable example, having made its founder the richest man in China. The IPO was oversubscribed by 1,148 times.

The willingness of investors to look far into the future for growth – something that is enabled by interest rates and yields that look set to stay low for years to come – is exemplified by electric vehicle company Nikola. The company reached a market value of over $30bn, surpassing that of Ford, despite generating no profit, no revenue, and having no production. Recent suggestions of fraud imply investors’ enthusiasm may also be causing some to discount serious risks in search of growth.

What could trigger a revival in ‘value’?

The contrasting fortunes of ‘growth’ and ‘value’ investments have reached new extremes, with ‘value’ lagging to an even greater degree than at the dotcom bubble. History suggests that such extremes do not endure indefinitely, however. As contrarian investors, we look for situations that have left certain companies out of favour, and where we see a likelihood of change.

Inflation could be the trigger that sparks a rotation from overextended technology to areas of better value. The extraordinary stimulus measures to combat the effects of Covid-19 may prove inflationary in the longer term – something the US Federal Reserve has expressed an increased willingness to tolerate. Historically, ‘value’ stocks have often performed better during periods of elevated inflation, while ‘growth’ stocks have tended to find more fertile ground in lower inflation environments.

As contrarians, we steer clear from the excessively popular and overvalued areas of the market. It is impossible to say when the bubble is finally pricked, only that it always is in the end. Meanwhile, we prepare for change by investing in the areas that we believe will be the next winners – the unloved, but robust, companies that can suddenly become fashionable again.

Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations.

The Scottish Investment Trust PLC has a long-term policy of borrowing money to invest in equities in the expectation that this will improve returns for shareholders. However, should markets fall these borrowings would magnify any losses on these investments. This may mean you get back nothing at all.

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