I initially built Screener.co to help me identify value opportunities based on valuation metrics relative to both past company performance and analyst expectations for future performance. In the past few months, I have noticed fewer and fewer companies coming up my value screens, many of which I have previously published on Seeking Alpha. The few that do appear are of markedly lower quality, on average, that what I have seen in the recent past. This could be the result of one or more of the following:
- We are in the midst of a sustainable economic recovery that is being correctly predicted by the market, in advance of being reflected in analyst estimates or backward-looking performance metrics.
- The market is priced to reflect a sustainable economic recovery even though we are not in one.
- Market efficiency has improved, as more participants and capital flow back into stocks, and fewer companies are hitting the aggressive filter criteria that I use for value stock selection.
- Valuation has become decoupled from the underlying fundamentals; speculation and the "bubble mentality" have taken over.
- In a low interest rate environment, investors are increasingly chasing returns wherever they can find them, driving up demand for previously overlooked investment opportunities.
It is rational for valuations to increase relative to fundamental metrics if the market believes that future performance is likely to improve materially relative to past performance. Much has been written about organic revenue growth, among large-cap companies, being anemic in recent years. Nevertheless, margins and earnings have expanded disproportionately. That trend is unsustainable over the long term, as there are upper bounds to how much earnings growth can be squeezed out of operating efficiencies in the absence of top-line growth. However, if we are in the early stages of a sustainable economic recovery, one should be willing to pay a higher multiple of past revenue/earnings given the higher expectations for future performance.
I do not believe that the market has become more efficient over the last year or so. If the limited universe of value opportunities were coupled with a lack of speculative behavior driving growth stock valuations sky-high, that might be a possibility. However, I see more and more growth companies with Revenue > $100M hitting my EV/Revenue > 10 filter even as fewer companies are hitting my value screens. The wide open IPO window, that has seen companies routinely open for well above their initial pricing on the first day of trading, also suggests that we are seeing more speculative activity rather than greater efficiency. In addition to the talk of a robust IPO pipeline of late-stage venture-funded tech companies, the following recent IPOs (across multiple sectors) have all closed at >50% above their offering price (with $1B+ market caps) on their first days of trading:
Sprouts Farmers Market (SFM)
Noodles and Company (NDLS)
Tableau Software (DATA)
Despite the evidence of speculative activity in the markets, I also do not believe that the "bubble mentality" is the primary factor that is driving US stocks higher and yielding fewer value opportunities. Market sentiment still seems mixed. As somebody who lived through the original "dot-com" bubbles and recalls talk of a "new economy" and "an end to the business cycle," the current environment seems markedly different. Today, you are as likely to read an article about affluent investors hording cash, or about "bubble 2.0", as you are to read about rampant speculation, day-trading, or fear of missing out on the "next big thing." This split in market sentiment is also evidenced by the high short interest in some of the companies above (i.e. FUEL has >20% of its public float short as of 12/29/2013, according to Yahoo Finance).
I also do not think that investors "chasing returns" adequately explains the lack of value opportunities. There is still no evidence of large funds flows into value-focused equity investment vehicles. Though I have heard some people say that "long-only" funds are regaining some of the popularity that they have lost in recent years, the greatest increase in ETF fund inflows have been into new "long-short" or "alternative" ETFs.
Given the facts enumerated above, it would seem that the activity and sentiment in the current market reflects the uncertainty around whether we are finally headed for a sustainable economic recovery that will finally yield top-line growth. Given that investors seem willing to pay premium multiples for business that would otherwise have been overlooked, I believe that the consensus is that we are in the midst of a sustainable recovery. Though I have my doubts, I hope the market is right!