Valuation is coming up increasingly in conversations and not in a good way. It comes up in a “this is crazy” but “I have to participate” kind of way. The Beyond Meat IPO might have been the catalyst for taking a high level of concern present in the past decade higher. But the Uber and Lyft IPOs with their testimonials that they never plan to make a profit played a part too. At least in the past, there was a path to intended profitability.
Valuing financial assets is incredibly important to a well-functioning economy if it hopes to properly allocate capital, control risk and allow its citizens to save for things like education, healthcare, houses and retirement. The focus of financial asset valuation for most readers is the stock portfolios they manage for clients. But from a societal viewpoint, it goes far beyond. Venture capital investments need to be valued and VC valuation contributes importantly to whether or not new investments are made and therefore meters the pace of innovation. Nothing spoils the mood for further investment than a fundraising round with a big markdown. Similarly, valuing family, small businesses, apartments, offices and industrial space is essential to spreading risk, raising capital and funding growth.
So we ask is today’s valuation rational or delusional? The answers? Yes. And Yes. Let me unpack my thoughts a bit by discussing how I think about public equity valuation generally.
Financial markets are by and large rational and priced according to a series of relationships and input factors. When it comes to valuing publicly traded equities, rational and somewhat measurable inputs include interest rates, sales and earnings growth, inflation, innovation, operating leverage (the degree to which an incremental revenue dollar creates a dollar of operating income) and strategic call-option value. We are not arguing markets don’t periodically make mistakes.
Less seemingly rational and measurable, but no less important inputs for valuing public equities include scarcity value (or not), sentiment, money flows into or out of the stock market/sector/industry, anticipated industry disruption, fear, greed and portfolio risk mitigation.
Implicit in what I have written so far is that the valuation accorded to other assets is integral to determining equities’ valuations. The importance of other asset values cannot be underestimated. It determines flows inside of various parts of the economy. Many stock market bears cite high valuation as the key reason they are bearish. I always ask the question, expensive relative to what asset? Today, stocks valued at 25X trailing earnings growing three to five percent annually when the 10-year US government risk free rate is 2.2% are inexpensive, in our view, if the forward environment is similar to the past. The term structure of interest rates can argue that it will be.
Government policy makers have a large role in determining how stocks will be valued. Ignoring their role and goals is dangerous. If the US central bank wants to create a wealth effect and raise the price of financial assets either by lowering rates or keeping existing rates low for an extended period, it is hard to argue multiple compression will occur for macro-reasons. Similarly, if the Fed desires to slow the economy and reduce inflation, it pays to understand that financial assets will face downward valuation pressure.
The Fed’s input to public equity valuation can be made almost ridiculously and powerfully simple. If the Fed is providing more/less liquidity than the economy requires for working capital and capital spending, money will flow into/out of financial assets and there will be an upward/downward bias if one holds inflation and interest rate assumptions constant.
The key determinant is whether stocks are inexpensive or cheap compared to other assets, especially risk bonds like High Yield, but also corporate and government bonds of all risk profiles and income producing real estate. The Fed Model (earnings yield versus interest rates) is used to make these determinations. Absent entering or exiting recession, the Fed Model is a reliable indicator to evaluate stocks’ attractiveness.
Government input to valuation doesn’t end with central bank policy. The trajectory of regulatory and tax policies plays a large role because it influences growth rates by impacting available markets, sentiment, timelines, merger and strategic values, after tax and free cash flows and capital availability.
I understand you may be getting itchy for an answer to our question. So, are publicly traded equities rational? We cannot answer that question quite yet.
One must evaluate the impacts of innovation on growth, inflation, interest rates, sentiment and strategic value. Innovation impacts these key valuation factor inputs strongly. Periods of high innovation like that we are experiencing bring different effects to the economy, its policy makers, companies and investors. We argue they come together via central bank policies and financial asset valuation by influencing inflation and growth.
The most important effect of high innovation is the production of a deflationary vector as costs get lowered by superior solutions. High innovation also brings disruption to existing industries and companies. This has the effect of allowing interest rates to stay low because inflation is not seen as a great a threat as it would be in a period lacking innovation. This has a positive effect on valuation by keeping interest rates low. Innovation also boosts the valuation of companies leading innovation.
Innovation also stokes M&A as companies seek competitive advantages, to retain leadership positions and to enter new and adjoining markets. The Technology and Healthcare sectors’ outsourced R&D model has been an incredibly efficient model for fueling innovation by driving reward to the innovators directly. But it’s also allocated risk capital decisions incredibly efficiently. Where success and opportunity reside, capital is plentiful. Successful CEOs can pick their next assignments.
Understanding the outsourced R&D model’s design is essential to understanding Technology and Healthcare valuation. So long as there is important innovation that acquirers want, these companies, which we term Public Venture Capital, will be valued by metrics other than their bottom line. They will be valued as a call option whose value is judged by the anticipated mature gross margin achieved in a highly efficient large-cap acquirers’ operations. What multiple do you pay for a public VC firm? It is too nuanced by individual companies, but it is higher, much higher, than one would pay for its incubator stage bottom line.
Innovation’s impact on investors and policy makers is not only about winners. Innovation displaces past industry leaders whose markets and/or market shares decline, sometimes rapidly, if there is an accelerated adoption of a new paradigm (think camera and map makers a decade ago). Their workers need to be re-trained and capital repurposed. This has the effect of lowering valuation on the companies negatively impacted by innovation. It also has a major influence on policy makers and elected politicians. Innovation’s speed and depth determines the policy makers response. It is fair to say that today’s policy makers are terrified of the changing economy’s impact on workers. That fear may be misplaced given rising wages and sub-4% unemployment. But it is present nonetheless, and one need not look beyond the fear over automated cars and trucks displacing drivers to understand it.
We are ready to begin to bring it all together.
The situation investors confront today can be summed up as follows:
- When interest rates are close to zero it is logical to value financial assets highly and to extend durations,
- When growth is scarce, it is logical to highly value those that can grow secularly, as opposed to cyclically,
- When innovation is high, it is logical to highly value the innovators,
- When strategic M&A is robust, it is logical to highly value the potential targets,
- When central bankers are concerned the global and US economy are slowing and therefore likely to pursue easy monetary policy, it is logical to highly value companies that will grow best a year out,
- When the time comes that inflation is viewed as a threat and moving higher, it will make sense to value financial assets lower and to include forecasts of higher interest rates that will shorten preferred durations,
- When the time comes that strategic M&A slows, it is likely to be because innovation has slowed, which will cause an uptick in inflation, which will cause an uptick in interest rates, which will cause a reduction in desired duration.
You may notice I haven’t mentioned the dividend discount model (DDM) valuation yet. Value investors who rely on traditional DDMs are shaking their heads at this market. That is because most of the valuation conversation is over what price to pay for the highest valued stocks, not the cheapest. As we argued above, Growth investors are counting on take-outs to realize their value creation event and DDMs are not helpful when an acquirer will eliminate every expense below the gross margin line.
Low interest rates approaching zero make DDM estimates incredibly difficult to model and sensitive to inputs rendering, to our mind, them ineffective in the near term until rates normalize. The terminal value difference when one uses a 1% risk free rate and a 2% risk free rate is immense. What is the appropriate risk-free rate when half the world’s government bonds carry negative nominal interest rates? What is the appropriate duration of income statement and cash flow DDM modelling when disruption is attacking new industries and firms every day?
There are other major inputs to valuation. They include institutional portfolio management and risk controls, perhaps not in the manner one expects, and money flows and sentiment. Portfolio managers are at various times a victim or beneficiary of client money flows.
Today, Value managers are the victims, feeling the negative reflexive effects of liquidation and their stocks’ absence of relative earnings strength. Their clients are responding to the well-known brew (favoring Growth) of:
- Slow global growth dampening the more cyclical earnings,
- Low interest rates that make capital plentiful and returns on capital low,
- The absence of inflation which keeps interest rates low and favors long duration assets, and
- Innovation leadership disintermediation.
The effect on Value stocks’ valuation via the lens of normalized earnings, which so many Value investors depend upon, is chilling and cheap stocks, by many metrics, keep getting cheaper.
Growth managers, in contrast, are the beneficiaries and receiving funds, though nothing like VC firms, and having to allocate money to the names they like fundamentally but may think expensive or allocate to stocks they view less favorably in a time where winners are grabbing a larger and larger percentage of the economic rent and strategic value. Liquidity constraints prevent trading around positions for all but the smallest managers. The portfolios that have ignored valuation and focused upon fundamental and strategic attractiveness have done the best over the last decade.
Then there is sentiment. This brings us to Beyond Meat (BYND). It is forecast to achieve $210mm in ’19 revenues and possesses a $5.8Bn Enterprise Value. That is 27X revenues. Does this make sense? To me the answer is no. But I understand how its valuation gets there. Greed and excitement are at work. Interesting to us is that it brings up another complicating factor to valuation. Newness. When a company invents an industry in investors’ minds and possesses first mover advantages, institutions believe they must own a stake and sentiment is overwhelmingly positive typically as it enters public markets. BYND has invented plant-based protein substitutes that are sure to gain traction. It reinforces in our minds how portfolios managers think and act to mitigate risk. We don’t know. But our assumption is that most small and mid-cap Growth managers feel a need to own at least a starter position in BYND. They have seen what has happened to the cannabis stocks with their strategic appeal and returns.
Stocks’ valuation limits get stretched by portfolio relative performance risk mitigation that encourage investors to own stakes in firms that will need to own and that other Growth managers will feel a need/possess a mandate to own. When one further factors in the shrinking number of public companies, it accentuates the desire for investors to own the good companies that do trade publicly.
How does the current mania for Growth firms end? What forces it to end? Are we there today?
Slow growth, demographic negatives, low interest rates maintained by activist central banks, incredible innovation and disintermediation, high government debt levels and unfunded public safety net obligations and the risk of deflation are the defining characteristics of the current global economy and market structure and driving accommodative policy maker actions that are friendly to stocks’ high valuations being and staying high. It is the expectation that this environment continues and with it the valuation accorded to winners and losers that we have been seeing.
When this powerful, existing environment changes and a new leadership emerges, it will be obvious and show itself in self-reinforcing reflexive actions and outcomes. Think Volcker taking over and saying, “I am going to kick inflation in the teeth. It’s game over.” Something like a Volcker moment will happen, in our view, to signal the turning of the environment.
We think the most likely catalyst to a turn in the environment, if not a central banker or government declaring the end of low inflation by instituting Modern Monetary Theory (MMT) or some such, is likely to begin with a slowing in innovation and a breakdown in the outsourced R&D model in Technology and Healthcare. When this occurs, valuation will be reduced for the firms that are no longer likely take-outs candidates. The tell will likely be a firm or two or three putting themselves up for sale and their failure to receive any offers or offers that measure up to expectations. Something related may be happening in early Uber and Lyft trading and it’s why Uber and Lyft and WeWork’s trading is and will be very important. If the public VC eco-system is to break down perhaps its first breakdown will be in public market exit strategies leading to losses.
When innovation slows, it is likely inflation rises, which in turn will turn central bankers’ moods sour. Higher interest rates will be required to battle the anticipated rising inflation and that in turn will hit the valuation of long duration assets more than it will shorter duration ones. It is directly applicable to Growth versus Value strategies.
Relative earnings strength will be the most likely key change if the environment is to change. If innovation slows, inflation and interest rates rise, then cyclical earnings may increase, especially as capacity leaves industries gradually because the cost of capital is higher. Value industries will face a more favorable nominal and relative earnings outlook when inflation picks up because the inflation beneficiary industries will be apparent and different than the deflationary beneficiaries where market share grabs were the winners.
Perhaps I haven’t answered your question directly yet. I haven’t said that stocks are irrationally expensive or cheap. That is because, as I hope today’s essay shows, valuation is incredibly complicated and reflexive. The current environment, as our Figure 1 shows, remains friendly to valuation for Growth where the supporting wind is from behind and rough for Value where the winds are squarely in the face. Policy makers have shown no desire to change the trajectories in place. We will stay vigilant to the change. But it appears not to be changing today.
We are focused on marginal change occur in innovation, inflation, interest rates, M&A trends, relative earnings strength, and public market exits for VC firms to see when the landscape is changing to tell us when valuation is set to contract meaningfully for Growth and expand for Value.