- The high-beta tech group has been slaughtered, even though the major indices have held up well.
- Many investors are hoping for a comeback in these names.
- Beyond a certain valuation level, the growth story itself no longer matters. Only capital flows matter — which are a function of the macro picture.
This article is a friendly wake-up call of sorts for investors in high-beta social media, cloud, biotech and e-commerce plays. You know, the stuff with triple-digit P/E ratios (if profits even existed), trading at nutty price-to-sales, and so on.
First of all let's establish, for the sake of the record, that this "high-beta" group has been slaughtered. The major indices have held up well, as we observed in "Boring is the New Sexy." But high-beta has basically entered a full-on bear market. Consider the following as of this writing (May 6th intraday):
- Amazon (NASDAQ:AMZN) is more than 26% off its January highs.
- Yelp (NYSE:YELP) is more than 45% off its March highs.
- Salesforce.com (NYSE:CRM) is more than 22% off its March highs.
- Twitter (NYSE:TWTR), which we remain short, is more than 55% off its December highs.
- IBB, the biotech ETF (we're short), is 18% off Feb highs after a large dead cat bounce.
Those are bear market numbers. You can quibble over what a bear market is or isn't, but the generally accepted rule of thumb is a greater than 20% decline from highs.
Many investors are hoping for a comeback in these names. We recently read of a prominent Wall Street analyst calling YELP a buy because, having fallen 40%, it was now attractively valued based on the growth story and what have you.
Our two cents: Forget the growth story angle. Realize that the growth story is not what drove these stocks in the first place. Oh, it made a difference absolutely. The growth story always serves as optimism rocket fuel, whether justified or non-justified, helping to inflate bubble-like valuations.
But here is the bottom line. If you were heavily long high-beta and are now wondering what the heck happened, guess what: You were making a big macro bet. You were playing the macro and just didn't know it.
You probably thought the "bottom up" analysis is what mattered. As such you were focused on stuff like:
- the future of social media
- incredible growth rates and user uptake
- metrics of user engagement
- the "new sharing economy"
- the ability to monetize mobile
- etc., etc., and so on
But you know what? All that stuff was a red herring relative to the real drivers of the crazy valuations now being relentlessly deflated. All these stocks were simply vehicles - Uber black sedans if you will - for a game of macro musical chairs.
Fred Wilson, a legendary venture capitalist, provides the key to understanding this in a recent blog post:
…the moral of this story is that you can push valuations when you have investors knocking down your door, but unless you are cash flow positive and expect to remain so for the foreseeable future, you do that at your own risk. You will need to find someone to top that price down the road and that person may not be there.
- A VC, The Valuation Trap
Wilson was talking about pre-IPO companies in that post, and the danger of taking a pre-IPO valuation so high that the hurdle becomes a point of no return. This is the predicament Box now finds itself in.
But the same logic further applies to already public companies. When you take valuation too high, relative to rationality or sense, the problem is that no future growth can justify it beyond a certain point.
Amazon and Twitter are classic examples. How much is the future growth of AMZN worth? How much is the future growth of TWTR worth? Nobody knows. Nobody can really say. Both of these companies have great stories though. And so the power of the story itself was used to justify multiples detached from any semblance of reality.
And this is where we get into the "macro" aspect of all these high-beta names. Beyond a certain point, aggressively inflated growth company valuations are no longer about growth. They are simply about greater fool theory (GFT), in the sense of valuation tethered to nothing, expanding or contracting solely on capital flows.
Let us hypothetically say that XYZ is a hot new social media stock. XYZ's prospects are so hot, in fact, that the company's stock trades at 600 times earnings.
Given this state of affairs, what is to prevent XYZ from trading at 900 times earnings? Nothing really - any growth projection that can justify 600x earnings can also justify 900x earnings.
But at the same time, what is to prevent XYZ from falling to 300x earnings? Again, nothing really - a deceleration of capital flows can cut the multiple in half…and at 300x earnings it is still priced for super-growth.
And thus, when the valuation gets "silly" enough, the actual stock price could rise or decline by 50%…with no change to the underlying story at all!
This is why, beyond a certain valuation level, the growth story itself no longer matters. Only capital flows matter - which are a function of the macro picture.
Markets are best understood through the lens of game theory. GFT (Greater Fool Theory) is a major aspect of that. It helps us see how seemingly irrational price moves can be driven, at least in part, by rational bets. Or rather, an irrational move can be driven in part by dummies (investors whose analysis is outright bad, faulty, or non-existent) and driven in part by sharp-eyed operators who know the stock is a dog, but also know there is "momo" for the taking.
- Strategic Intelligence Report #29, 03-29-14
In the quote above, the "dog" stock we referred to was King Digital (NYSE:KING), for which we joked the symbol should have been KNGA to better rhyme with ZNGA. In that issue we previewed the bad omens of the Candy Crush IPO and predicted that the Box IPO would either be delayed or come off badly if at all.
Why? Again, because of the macro. Not all high-beta stocks are dogs, but again, when the valuation becomes untethered from reality, there is so much two-way flexibility - either up OR down - that capital flows matter far more than the actual growth story itself.
Live by the sword, die by the sword. If your favorite long-term investment has such a bright future it can trade at twice the current valuation without making anyone blink, it can also probably trade at half that valuation - or a third or a quarter - entirely dependent on big picture drivers such as what central banks and hedge fund managers are doing, independent of the story so beloved of analysts and true believers.
And this is why we say, beyond a certain threshold of valuation irrationality - which was delivered to us via Ben Bernanke, momo hedge fund managers, and so on - all these stocks had become "macro bets." As we outlined in Tiger Soup and further elaborated on via Death of the OCBN and Boring is the New Sexy, the math of near-zero interest rates coupled with the rocket fuel of silicon valley optimism to create a giant momentum basket for which capital flows are now reversing… and for which the pain is likely to continue.