Why Valuation Still Matters
As we close out the year of 2021, we have gone through one of the most rewarding periods in the equity markets’ history. Since the COVID sell off bottomed in March of 2020, the S&P 500 is up over 100% and the NASDAQ is up even further. This rally has been pretty relentless on the surface, but overall, the average stock has not performed as well. This means that there is less “participation” on the upside (less companies participating). With the overall index’s showing higher highs goes to show how much the largest companies in the US dictate the movements of those indices. This is not a new occurrence; it has happened in the past like in the early 1900’s with the Railroads dominating the index. Later on, you would see the Communications & Computer/Technology companies like IBM etc. Now though, we have 5 companies dictating over 20% of the S&P 500’s daily change. By what I have found, this could be the most top-heavy the S&P 500 has been historically (sources 1 & 2). This isn’t a bad thing overall, because those companies are helping change the future! One thing though needs to be considered, and that it’s not what you own but how much you paid for it.
In my opinion, the markets have developed the top-heavy weight not only because of how the companies have evolved over the past 20 years but also the growth of passive investing. What is passive considered you may ask? Well, these are usually within something called an ETF (Exchange Traded Fund). The simple way to think of these is when you purchase an ETF, you are buying the S&P 500 as it is weighted that day. As the days go on, the ETF buys and sells those securities to try to imitate the index’s returns. They are popular because they are usually lower cost than either buying all the stocks or owning a Mutual Fund that picks and chooses which companies to own. Over the past decade, this area of the market has expanded immensely. I think this could be a good thing, but eventually there will be too much money in the passive side leading to less discovery of a stock’s valuation based on the business. But instead, it’s based on the market sentiment at the current time for ALL STOCKS in an increasingly equal manner.
In my personal opinion, this has contributed to the active investor underperforming. Also, when people have been making their decisions, they are tending to look even more at cost than net performance. This isn’t bad until it is. Meaning once enough money is passively invested, it potentially could move all companies good/bad/or indifferent in a similar manner. Eventually I think it could create the buying opportunity of a lifetime, but I also think it is going to take time (potentially a long time) to play out.
Also, people have been getting excited about companies that have come public recently with little to no earnings. This is because people become invested in the dream of the future business. Overall, some of these will be huge winners. Although, there is potential for a large portion to become a “pipe dream”. As of now, I think it is irresponsible to try to value a business based on its “estimated revenues” in 2027. What happens if the company never turns a profit or their research into their future tech turns sour? Or, what if a competitor leap frogs them prior to the year they are estimating their valuation on? Or even what about inflation devaluing those future earnings by 2027? Well, it could turn out to be pretty rough for the owners (aka the stockholder). If you are looking at investing into these companies, you should be aware of the potential risks and only allocate a small portion of your portfolio. I think this could be food for thought for many of you out there.
Then what should you look at if valuation matters? I would say to look at businesses that actually make solid profits today, have stable cash flows and are seemingly ignored by the market. They are ignored because they are boring. In my opinion, boring is a very good place to be. How would you know if they are ignored? If you barely hear about the stock around the people you know, that would be a good starting indication.
Basically, I want you readers to know that it is true when investment firms state “past performance does NOT dictate future returns”. Drawing out past performance into the future can be a very dangerous practice. The winners eventually become over owned and when there is even a sign of weakness, those areas people find safe can become the most dangerous. Remember it works until it doesn’t, and I am NOT a crystal ball so I have no clue on when it will take place. If I did “know”, I hope you would run as far away as you can. All I know is that someday it will take place. History doesn’t repeat itself, but it tends to rhyme. Feel free to reach out to me if you have a comment on the article or just want to learn more. I am always here to help.
Riley Sisson
Branch Manager, RJFS
(1) https://www.garycarmell.com/sp-500-top-heavy/
(2) https://www.slickcharts.com/sp500
Any opinions are those of Riley Sisson and not necessarily those of Raymond James.
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