Nvidia: Irrational Market At Work - Bezek's Daily Briefing

| About: NVIDIA Corporation (NVDA)
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Nvidia is one of the year's biggest winners.

The stock is going up more now simply because it's already up so much.

A classic demonstration of irrational market forces.

An investment in the sector that I prefer.

Last week, we discussed the tax loss selling phenomenon, and specifically, the opportunities it leads to as people dump stocks for reasons not directly connected to the company's intrinsic worth. See: Treat Yourself: 3 Tax Loss Selling Gifts.

There's another irrational behavior on the other side of that coin. For stocks that rally, many active fund managers feel compelled to buy the stock to appear not to be "missing out" when revealing their holdings to shareholders. Exhibit A, Nvidia (NASDAQ:NVDA):

NVDA Chart

NVDA data by YCharts

This is a classic exponential chart. The word bubble is overused, but in cases where a bubble does occur, the chart often looks like this.

Why is Nvidia soaring? Sure, the company has put up strong results in 2016. The most recent quarterly earnings report was outstanding. The stock's proponents have developed a robust and persuasive narrative that favors NVDA stock. And that's all fine.

However, what you're seeing now - yesterday's 7% no news run during a dead holiday market - is classic end of year move chasing. Just since November, the stock is up from 70 to 117. It's up 260% on the year now, and is by far the biggest winner in the Nasdaq 100 Index (NASDAQ:QQQ).

For fund managers - particularly ones trailing the market on the year - they have to justify their performance to clients. If their list of top holdings shows a bunch of losers - say biotech or solar stocks this year - and they lack big winners, the client may think the manager is a fool.

Thus, the manager sells their underperformers, and uses the money to bulk up on positions that performed well during the year. That way, their portfolio looks better when clients see a list of latest holdings. It's a classic case of buying high (and quite possibly later selling low), but managers feel compelled to play anyway since they get paid based on how many assets they manage. Image is everything.

This mechanism combines with another one, called tape painting. In this, managers buy more stocks they already own large positions in right before the quarter or year ends. This allows the stock in question to close at a higher point than it would have otherwise, making the manager show stronger returns for the period.

It's a form of taking performance from future quarters and moving it into the current one - seemingly irrational - but more logical once you consider that quarterly returns are all important for attracting new money into a fund.

Throw in some exuberant analyst recommendations - Goldman just upgraded Nvidia to a conviction buy despite the huge rally over the past six weeks - and you get freight train action in NVDA stock.

NVDA stock also comes with a sizable short interest, making it a particularly attractive target for managers who want to run the stock up into year-end, since they know the short sellers are suffering profound emotional distress watching their 2016 results get wrecked by this runaway stock.

Can It Go On?

Nvidia is wildly overpriced by any traditional valuation metric. GuruFocus assigns price targets to companies on a variety of greatly varying valuation models. Its current table for Nvidia shows a large range of potential valuations - unfortunately, all results come in around the $10-25/share level:

Note how the current price is a different zip code from all the various valuations the different models arrived at.

There's a great growth story around Nvidia. Note the word story. Huge stock market runs always require there to be a prevailing idea that is so powerful that longs feel compelled to jump on board, and "conventional wisdom" makes it difficult to be bearish on the stock. You know such a narrative is at work when prominent influential investors are writing stuff like this:

For stocks to make magical runs, you need that sort of emotional connection that compels people into the stock. He got off his bike and straight bought it - no cool purchase after hours of diligent research, as would happen with more rational purchases. Efficient market theorists wept.

I'm not here to weigh in on Nvidia's fundamentals. There's plenty of places to read or listen to Nvidia's story. It's pretty exciting indeed, virtual reality, data centers, self-driving cars, and so on. If it all comes true, Nvidia stock can continue to be a star performer in 2017. For a decent bear case, see the recent, Fault Lines In The Nvidia Story here at Seeking Alpha.

Personally, I'm never going to buy a stock at 36x EV/EBITDA, 61x earnings, 40x forward earnings, and 12x book value. I might be able to forgive one or two of those, but all four in concert are too disconcerting. And it's not like Nvidia was a hot growth story prior to this year, earnings and revenues weren't doing much. Nvidia's 10-year compounded revenue growth rate is under 6%.

Nvidia's story could well come true. But at today's prices, you need earnings to double. And then they need to almost double again. At that point, today's valuation would be justified.

A company like Texas Instruments (NYSE:TXN) may not have as flashy of a story, but it's still heavily exposed to the self-driving automotive space, and shares are at a more reasonable valuation. Net income is up 50% over the past three years, and the company pays a decent dividend with a huge growth rate. The stock, while not going stratospheric, has been a strong performer:

TXN Chart

TXN data by YCharts

It's certainly not as exciting as Nvidia, but there's little risk of the stock price cratering either. I know which sort of stock is likely to lead to greater wealth over the course of an investing lifetime.

Disclosure: I am/we are long TXN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.