OB Report
July 2017
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Will Investors Party Like it's 1999?

Steven ZichermanBy Steven Zicherman
MBA, CFA, Equity Analyst
Murray Leith

By Murray Leith
CFA, Executive Vice President and Director,
Investment Research

ResearchWho has not heard of FANG stocks? The media can’t stop talking about them because they are currently the driving force behind stock market returns.

FANG is an acronym coined by the host of CNBC’s Mad Money, Jim Cramer, and it originally referred to four technology-driven growth stocks: Facebook, Amazon, Netflix and Google (now called Alphabet). Since then, the term has evolved to include other technology titans. According to Goldman Sachs’ definition, which includes Apple and Microsoft but excludes Netflix, the so-called FANG stocks have generated roughly 40% of the gains in the S&P 500 Index this year.

Cynics believe that these stocks are overvalued and that investors are buying them because of a fear of missing out, or FOMO – yet another acronym! They point to narrow stock leadership, wherein overall market returns are too dependent on the performance of these few FANG stocks, to make their case.

Market returns are often dominated by the performance of a few stocks, and there is little historical evidence to suggest that market breadth and returns are correlated. We are agnostic on the matter and prefer to focus on economic conditions, company fundamentals and valuations.

We constantly ask questions and perform sanity checks with respect to our holdings. When stocks are down, we wonder if the assumptions underlying our investments still hold true. When stocks are up, we question whether share prices reflect reasonable forward expectations. A healthy level of anxiety permeates all good financial analysis. Based on our assessment of the fundamental factors that drive company and stock performance, we don’t believe we are in another technology bubble. In fact, there are some major differences between the mania of 1999/2000 and now.

Back then, the tech sector was full of early-stage, concept-driven companies. Remember e-Toys and Pets.com? Just before the March 2000 bust, Barron’s published an article that listed unprofitable Internet companies and highlighted the short amount of time they had left before they ran out of cash. In addition to this general lack of profits, the technology sector traded at an eye-popping valuation of almost 70 times earnings.

Today’s tech sector looks and feels different. FANG stocks are some of the largest companies in the world. They are far more mature than the dot-com tech companies and are led by impressive owner-operators like Amazon’s Jeff Bezos. These tech giants generate lots of cash and require little capital to grow. As a result, key operating metrics such as profit margins are relatively higher. Most importantly, the sector trades at 24 times earnings, which seems reasonable given the quality of the underlying businesses.

Back in 1999/2000, the makeup of the technology sector was skewed toward hardware and equipment companies. Those types of businesses tend to be more sensitive to the business cycle. Today, the technology sector is dominated by software and services companies, which are far better businesses thanks to their subscription-based recurring revenues and the mission-critical nature of their offerings. Companies like Amazon, Alphabet and Microsoft are better equipped to withstand competitive threats and economic uncertainty because they benefit from high switching costs and barriers to entry.

The media loves to invoke fear to sell news, and on Friday, June 9, they warned of a “bloodbath” in technology. That day, the technology sector declined by roughly 3%, and the selling continued into the following week with another 1% drop on Monday, June 12.

Four percentage points is hardly a bloodbath, and the sector remains up close to 20% for the year. What the financial media failed to recognize is that the market sell-off was not exclusive to the tech sector. Growth-oriented stocks across various industries were also down, indicating that the selling was much broader than what was being portrayed. A J.P. Morgan report suggested that the sell-off was triggered by a computer-driven, algorithmic trading strategy. The same report noted that traditional, fundamentals-based human investors were responsible for only 10% of the volume traded in the equity markets.

In our opinion, the robots were wrong to sell growth stocks. Higher growth companies have outperformed since the 2008/2009 financial crisis, and we think that will continue to be the case for a long time. In fact, if valuation didn’t matter, that would always be the case. But price does matter!

Around the turn of the century, the price of technology firms, and “growth” stocks in general, became way too high. Not only did technology stocks crash and burn, but the biggest blue chips also performed poorly because they too were grossly overpriced.

Today the S&P 500 group of companies are priced at about 22 times earnings, far from the more than 30 times multiple reached at the peak in early 2000. Moreover, considerably lower bond yields should justify higher stock valuations. With the yield on long-term government bonds close to 2% today versus roughly 6% at the turn of the century, there is an argument for significantly higher valuations.

The Odlum Brown Model Portfolio has been focused on higher-quality, higher-growth businesses since the mid-2000s. That is when we made a big push outside of Canada and started buying big U.S. companies. At the time, we declared “growth” the new “value” because the price of growth had come down from the stratosphere and become reasonable. It’s a strategy that has served us well. Over the last five years, the Model has grown at a compound annual rate of 17.5% versus 8.9% for the benchmark S&P/TSX Total Return Index.Model

We are sticking with our game plan. The rationale for favouring growth-oriented businesses has strengthened in recent years. Not only is the price of growth still reasonable, but there are fewer businesses that can deliver decent growth in a slow-growth world. Those that can will likely become more popular, which should help drive valuation multiples higher. Truth be told, it’s possible that investors could “party like it’s 1999” and drive the valuations of growth companies to much higher levels. Perhaps then talk of a bubble may be justified.

The Odlum Brown Model Portfolio was established by the Research Department in December 1994, with a hypothetical investment of $250,000. These are gross figures before fees. Past performance is not indicative of future performance. Trades are made using the closing price on the day a change is announced.

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The Odlum Brown Model Portfolio was established by the Research Department in December 1994, with a hypothetical investment of $250,000. These are gross figures before fees. Past performance is not indicative of future performance. Trades are made using the closing price on the day a change is announced.

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