The technology-led sell-off of growth stocks is buffeting global stock markets. The Nasdaq Composite fell as much as 11% from its all-time high (at the point of writing), a mark it hit barely a month back, and is sitting on a loss of 2.1% for 2021. By comparison, the broader Standard & Poor’s 500 index is holding up better, down only 3.3% from recent highs and up 2.3% year to date.
The Dow Jones Industrial Average, on the other hand, is just a hair’s breadth away from record-high levels and is up 2.9% so far this year. This is a reversal of what transpired last year, when the Nasdaq gained 43.6%, well ahead of the DJIA’s 7.3% increase and the S&P 500’s 16.3% advance.
What we are now seeing is a massive market rotation, from growth and tech stocks — that were the big gainers during the Covid-19 pandemic — to cyclical and value stocks that will benefit from normalisation of economic activities and whose outlooks are further boosted by the passage of the US$1.9 trillion (S$2.56 trillion) fiscal stimulus package. A case in point: Stocks such as The Walt Disney Co and JPMorgan Chase & Co have gained in this current selldown (see Chart).
As we said, investing is about relatives, a continuous weighing of the prospects of all alternatives. Right now, the imminent economic recovery is seen to be more positive for cyclicals. And it has renewed inflationary expectations — resulting in the steep spike in US Treasury yields and triggering the current tech-growth sell-off.
The yield curve has steepened very quickly, with yields on the benchmark 10- year Treasury currently hovering around 1.6%. While prevailing yields remain very low from the long-term historical perspective — in fact, still the lowest since 1960, save for the past one year — it is nonetheless a hefty 71% jump from where it started the year, at 0.93%.
We explained some weeks back why high-growth stocks have outperformed in recent years against the backdrop of consistently falling interest rates, all the way to historic lows. The opposite is happening right now. Growth stocks are bearing the brunt of the sell-off. This is because a significant proportion of their earnings-cash flows is in the future, and higher interest rates mean lower present values (share prices).
If you recall, the fair value (price) of a company is equal to the sum of its discounted future cash flows. In formula terms, P = Earnings/(r-g) where g is the expected growth rate of earnings and r is the expected cost of capital over the future period when these earnings are accrued.
We have demonstrated before how it works, mathematically (see Table). The higher the long-term expected growth rate, the more sensitive its price to changes in interest rates (discount rates).
For instance, a company that is expected to grow by 2% will only see its fair value fall from 11 to 10 times for each dollar of earnings when the interest rates increase by 1%, from 11% to 12%. On the other hand, the fair price for a company that is expected to grow by 10% will drop by half — from 100 to just 50 times for each dollar of earnings for the exact same increase in interest rates.
This explains why stocks with very high growth expectations (g) — that we think, are also unrealistic — such as Tesla, SunPower and Peloton Interactive have fallen far more than stocks with lower growth expectations, the likes of Adobe and Apple. The compression in their fair valuations is much steeper (see Chart).
Additionally, not all tech stocks are equal, even when they have the same growth expectations (g) — due to differences in the discount rates (r).
The discount rate, typically the company’s weighted average cost of capital, is made up of two components — the risk-free rate plus a risk premium. The risk-free rate is a common denominator, usually the yield on government bonds. The risk premium — to compensate investors for holding a risky asset — reflects the risks specific to the company. It is determined by the level of business and industry risks, management and shareholder governance, liquidity risk, country and forex risks and so on. In short, it reflects the uncertainties of future earnings-cash flows.
For instance, the risk premium for Microsoft would be much lower than that for Tesla. Why? Because we are reasonably confident about Microsoft’s future earnings growth, based on its existing positioning in the software, gaming and cloud computing markets. We have a good grasp of its margins, including taking into account its historical track record — for instance, earnings per share have risen at a compound annual growth rate of nearly 30% in the past five years.
Conversely, there are significant uncertainties as to Tesla’s future market share and pricing and thus, profitability. We are highly doubtful that it can sell more electric vehicles than all the major carmakers combined, as its market valuations would suggest. Its competitive edge in the industry is unproven and, in truth, genuine competition is only just starting to emerge. In other words, Tesla’s first-mover advantage is, we think, not as enduring as its ardent fans would like to believe.
The rise in Treasury yields is not unexpected, though it happened a little sooner and faster than we thought. In fact, we have articulated this in recent articles — inflation will tick higher in the months ahead, driven by the reopening of economies and low base effect from last year. That said, we are still convinced that inflationary pressures will be modest beyond 2021 and that interest rates will stay low for longer.
Yields will stabilise and tech stocks such as Microsoft, Adobe, Alphabet and Taiwan Semiconductor Manufacturing Co will continue to gain from the accelerated global digital transformation. Anecdotal evidence suggests that stocks generally outperform during periods of strong economic recovery, high liquidity and low interest rates (from the historical perspective). Hence, our strategy is still to stay with companies with sustainable high growth.
Don’t distribute treasury shares as dividends
Last week, we discussed at length why we think companies and regulators should embrace the practice of share buybacks. Share buybacks are extremely popular in the US as a means to reward shareholders, more so than dividend payments. And we have demonstrated the positive and outsized impact of each dollar spent on share buybacks on market valuations.
The thing is, the majority of Malaysian companies that do share buybacks then choose to distribute these treasury shares as dividend in specie to shareholders. We think this sends the wrong message to the market — that the buybacks are opportunistic and non-strategic. And it negates the positive impact of the share buybacks on valuations.
Distributing treasury shares as dividends in specie does not benefit shareholders — especially since most will end up with fractional shares (less than board lots) that they will sell for cash, which is the preferred form of dividends (for income). Worse, odd-lot shares are usually sold at below market prices.
If the company wants to give dividends to shareholders, it is preferable that it places out or sell the treasury shares at market price and then pays out the proceeds as cash dividend. In fact, this is the more common practice in Singapore, where companies tend to buy back shares when prices fall and resell them in the market when prices recover.
The Global Portfolio closed 2% lower for the week ended March 10, paring total returns to 52.6% since inception. Nonetheless, this portfolio continues to outperform the MSCI World Net Return index, which is up 39.7% over the same period.
The top three gainers were Builders FirstSource (+8.9%), Home Depot (+3.5%) and Vertex Pharmaceuticals (+2.8%). On the other hand, Geely Automobile Holdings (-11.9%), Rio Tinto (-11.7%) and ServiceNow (-8.1%) were among the biggest losers.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
