Keep connected
Our investment management team is made up of engaged thought leaders. Get their latest commentary and stay informed of their frequent media interviews, all delivered to your inbox.
But low interest rates, stronger growth in the major economies and continued support from ongoing stimulus programs should support the global expansion. That, in turn, will mean more growth for corporate profits. Ultimately, even if the general investing public doesn’t immediately rush back into stocks, prices should start to head higher again. They will be supported by higher levels of corporate activity (companies will find that the easiest way to grow is by buying competitors in their industry or ‘vertically integrating’ with suppliers and/or customers). This corporate activity has not occurred yet since companies have been as reticent to spend as investors, but the ‘valuation scales’ have already moved so far that most companies will soon find the ‘value added’ from corporate acquisitions too attractive to ignore. We expect that the resource sector should see most of this corporate activity with stocks trading substantially below net asset values and most acquisitions being ‘self-financing’ due to the cash flows of the target companies. The attractiveness of valuations and the expectation of further growth underlies our continued overweighting of the Basic Materials, Energy and Industrial sectors in both the U.S. and Canada. Our view that the financial industry will remain in a longer-term consolidation and shrinkage supports our continued underweight of the Financial sector.
One of the few areas of the market where we have said that valuations were already too excessive was in the social networking space. This was brought to a head in the past few weeks with the IPO (Initial Public Offering) of shares in Facebook, the fastest growing and largest of the social networkers, with over 900 million users worldwide. Given the huge interest and high valuations of prior public offerings in this area (Zynga, Linked In), it was expected by many that the Facebook IPO would be a major success. But the underwriters increased the size of the offering by over 25% in the final week and then moved the price range from $28-35 up to $34-38 and then priced the deal right at the high end of that range. Add to that the substantial amount of selling from insiders and early investors on the deal as well as the poor management of the first day of trading by NASDAQ, the issue traded above the offering price for only the first few hours and, one week later, had dropped more than 20% below that initial level. However, the fact that a company with less than $4 billion in revenue and under $1 billion in annual profits could not sustain a market valuation of over $100 billion made investors like us who have avoided the space for some time feel like logic had finally returned to the market. Particularly since we also found out after the deal that Morgan Stanley and some of the other dealers involved had recently downgraded growth for Facebook as their migration to mobile users is going more slowly and costing more money that initially expected.
The Facebook issue brought out some interesting analysis from various sources. One that we find most interesting and a concept that we have focused on for some time is what growth rates are needed by individual companies to justify their current valuations. The analysis below, courtesy of Byron Capital, shows the required growth rates for each of the next five years, followed by an average growth rate for years six through 10, and then a P/E ratio that the stock should be trading at a decade from now as a more mature company. Facebook: needs to achieve 30% – 40% growth rates in the first few years and maintain 15% – 20% growth for at least 10 years and would still be trading at 19x earnings 10 years from now to justify its stock price today. With 900 million users there is still lots of potential growth, but to be paying for the next 10 year’s growth today is quite a stretch given that the company didn’t even exist 10 years ago and has an ‘as yet unproven’ business strategy for making profits in mobile.
Contrast this with Google, which only needs to achieve single-digit growth for the next few years and GDP like growth thereafter, as well as only a 13x earnings multiple after 10 years to make today’s price look fair. With the fact that Google also owns the Android operating system, from which it currently receives no income flow, the stock looks like a bargain. Apple, Microsoft and Intel all look interesting as well since their valuations assume very little growth ahead. This probably makes Apple the best of the bunch since it still has the highest growth rate ahead of the three. Amazon makes Facebook look cheap by comparison and remains the most over-valued stock in the S&P500 in our view
No analysis of tech stocks is complete though without including Research in Motion (RIM; creator of the Blackberry). Quite the opposite force is at work here as the current valuation of the stock assumes that earnings will fall by almost 50% this year and continue to fall at least 20% a year over the entire period. If the company can do anything to reverse their market share losses of the past few years, or at least just stabilize at lower levels, then the stock could see a substantial return from current levels.