Revisiting the Wisdom of Buying Absurdly Expensive Stocks

In December 2020, Growth stock mania was at its peak. Fourteen months on, what has happened to those eye-wateringly expensive multiples?

FAANGM stocks are trading at extraordinary multiples, leading some investors to suggest they have hit bubble territory. What has happened historically when stocks reached these stretched valuations?
 
Read Article

Introduction

In December 2020, we published a piece titled ‘The Wisdom of Buying Absurdly Expensive Stocks’. At the time, our motivation for writing the article was driven by the furious multiple expansion in hyper-growth tech and related industries in the wake of the first waves of Covid-19, which had pushed the number of stocks with an EV/Sales ratio above 10x in the Russell 1000 to the highest since the peak of the dotcom mania, and those in the MSCI World to their highest ever.

Our conclusion at the time was that history suggested forward returns after crossing this threshold were not great: the median Russell 1000 and MSCI World stocks underperformed cumulatively by 65% and 33%, respectively, after five years; and the mean performance was a bit better at 28% and 7% underperformance, respectively, reflecting the impact that a few extraordinary successes can have on the sample.

Raising the bar to an EV/Sales ratio of more than 20x resulted in future prospects that were even dimmer: cumulative median underperformance for Russell 1000 and MSCI World was 73% and 50%, respectively, after five years; and cumulative mean underperformance was 42% and 22%, respectively.

These findings were a timely reminder of the power of mean reversion. Market participants have a tendency to focus on errors of omission during bull markets, whereas in the long-run, errors of commission are powerful determinants of long-run performance. For all the endless searching for ‘the next Amazon’, scant attention is paid to the risks of being the bagholder in ‘the next Webvan’, a USD3-billion market cap online grocery delivery company that peaked at c. 40x sales, and subsequently went to zero.

Fourteen Months On…

Fourteen months on, what has happened to the universe of exorbitantly expensive companies?

Well, perhaps to the surprise of no one, the number of these companies has continued to increase. This is most evident in the number of Russell 1000 stocks with an EV/Sales ratio of more than 10x comfortably exceeding the 2000 peak, and the number of MSCI World stocks above this threshold peaking about 40% above the levels in our original analysis (Figure 1).

Figure 1. Number of Stocks With an EV/Sales Ratio of More Than 10x

Problems loading this infographic? - Please click here

Source: Man Numeric; as of 31 January 2022.

For all the headlines grabbed by Rivian and Lucid Motors1 (pre-revenue companies capitalised at tens of billions of dollars at IPO), the reality is that the total number of Russell 1000 stocks in the more extreme 20x EV/Sales cohort has undershot the 2000 peak. In essence, we can observe that while expensive valuation has become more commonplace, eye wateringly expensive valuation has occurred with less frequency than in the past (Figure 2). However, at an MSCI World level, the end of 2021 was uncharted territory.

Figure 2. Number of Stocks With an EV/Sales Ratio of More Than 20x

Problems loading this infographic? - Please click here

Source: Man Numeric; as of 31 January 2022.

Our original analysis went up to the end of August 2020. In the 17 months since then (until the end of January 2022), the performance of the cohort with an EV/Sales ratio of more than 20x gives a pretty clear picture of egregiously expensive stocks coming back to earth.

Figure 3 shows how all but the top quartile of Russell 1000 stocks has underperformed the market (in terms of excess returns) in the months subsequent to crossing the 20x EV/Sales threshold. Indeed, the worst quartile has underperformed by more than 60% since August 2020. And it’s a similar story in the MSCI World.

Figure 3. Excess Returns of Stocks With an EV/Sales Ratio of More Than 20x (Since September 2020)

Problems loading this infographic? - Please click here

Source: Man Numeric; Between 1 September 2020 and as of 31 January 2022.

Of course, there are those who argue that the collapse in the returns is due to disappointments in the stocks’ fundamentals. Our data suggest the exact opposite: those expensive stocks, in fact, far outgrew the overall market, just not far enough to cope with the absurd multiples.

Figure 4 shows how the expensive cohorts in the Russell 1000 and MSCI World Indexes have delivered average excess top-line growth rates of about 60% and 40%, respectively. Indeed, all of them seemed to have reported a considerable increase in sales around the beginning of 2021.

Figure 4. Excess Sales Growth of Stocks With an EV/Sales Ratio of More Than 20x (Since September 2020)

Problems loading this infographic? - Please click here

Source: Man Numeric; Between 1 September 2020 and as of 31 January 2022.

So, yes – if we don’t look at the returns, one may say that their fundamentals look rather dreamier. Yet, the reality is, when it is absurdly expensive, it is … absurdly expensive.

 

1. See, for example, www.bloomberg.com/news/articles/2022-02-02/ev-startups-are-wilting-under-harsh-light-as-public-companies?sref=Arnx08gV

User Country: United States (237)
User Role: Public (Guest) (1)
User Access Groups:
Node Access Groups: 1