Growth Bubble Bursts: All Good Things Come To An End

Mar. 06, 2021 8:00 AM ETABBV, ABNB, ARKF, ARKK, ARKQ, ARKW, BHP, CNQ, DASH, DIA, EPD, ET, HT, IGV, IYM, LI, NIO, NVDA, PLTR, PLUG, IGPT, PTON, PYPL, QQQ, SNOW, TLRY, TSLA, UBER, WKHS, XLE, XLF, XLK, XPEV, ZM, CNQ:CA, TLRY:CA378 Comments

Jonathan Weber

Investing Group Leader

Summary

Growth names profited from ultra-lose monetary policy and massive stimulus spending.
With rising rates, that tailwind has ceased to exist.
Valuations were very high across many growth names, and now they are coming back down to earth.
Value has easily outperformed growth over the last month, and more of the same could be coming, as growth names continue to underperform.
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Article Thesis

During 2020, and into early 2021, high-flying trendy stocks that belonged to companies with a strong growth outlook were a solid play, generating attractive returns in many cases. The gains enjoyed by many of these stocks were driven by multiple expansion in many cases, however. That can't go on forever, of course, and we are witnessing in many growth stocks that multiples are compressing, even if underlying results are strong.

Not all growth stocks are trading at bubble-like valuations, but it looks like the recent growth underperformance could persist as multiples come back to earth. This is an especially pronounced headwind for stocks trading at extremely high valuations, and for funds that invest in such stocks, such as the ARK family. Many of these stocks and funds have already hit bear market territory, and more could come in the coming weeks.

Source: unsplash.com

A Solid Trade Thanks To Ultra-Lose Monetary Policies

About a year ago, when the pandemic gained strength around the globe, equity markets started to decline. There was a quick and violent sell-off, but stock markets bottomed out in late March and have risen to new all-time highs since then. Gains in stocks from the nadir were not created equal, however, as some stocks performed much better than others.

Among the best performers, there were many companies that had a strong underlying growth outlook or at least a strong perceived growth outlook. Valuations didn't matter too much to the market, and stocks that were already expensive rode the fiscal and monetary stimulus wave to even higher valuations.

Source: Fed website

As central banks were printing trillions of dollars, while governments provided additional stimulus to companies and consumers, there was a flood of ultra-cheap money that had to be deployed somewhere. Some of that money was finding its way into stocks such as Tesla (TSLA), Zoom Video (ZM), or the ARK funds, such as ARK Innovation (ARKK) and ARK Next Generation Internet (ARKW). Those that bought into these stocks and funds early on enjoyed strong gains over the next couple of months:

The two ARK funds that were mentioned delivered returns of at least 240% between April 1, 2020, and January 31, 2021. Work-from-home favorite Zoom Video returned 180%, home fitness beneficiary Peloton (PTON) saw its shares rise by 430%, and gains in the EV space were even stronger. Tesla delivered an outstanding 770% return over those nine months, and other EV plays such as NIO (NIO), Plug Power (PLUG), and Workhorse (WKHS) saw gains of around 2,000%, respectively.

To those that bought these stocks early on and that timed their exit perfectly, I say congrats - increasing your investment by up to 20x in one single year is outstanding for sure. However, the number of investors that entered at the bottom and that sold at the top is likely minuscule compared to the many investors that have bought on the way up, or even at the top. For those, the returns do not look like what we see in the above chart.

Share Price Gains Were Primarily Driven By Multiple Expansion In Many Cases

If a stock rises by hundreds of percentage points in a single year, then it is highly unlikely that this is happening without multiple expansion, as this would require massive underlying business growth. Banking on multiple expansion must not, per se, be a bad idea, we believe. If, for example, you decided to buy AbbVie (ABBV) in March at $60 because you assumed that it would not trade at ~6 times earnings forever, then you essentially invested assuming that multiple expansion would be a factor for your returns. You bought something that was ultra-cheap and expected that it would get closer to its historic valuation eventually, which it did over the following weeks and months.

Buying something like Nvidia (NVDA) at $500 in August of last year was a different type of investment. You would have bought an attractive company at a quite high valuation of 70-80 times net earnings. Compared to Nvidia's historic valuation, that was already an ultra-high valuation:

Investing in an already very expensive stock with the goal of benefitting if it gets even more expensive can work, as it did for Nvidia. Buying at $500 allowed investors to exit at ~$600 with perfect timing, as Nvidia's valuation rose to an earnings multiple of 100 at the peak. However, these investment strategies only work until they don't, and it looks like that has happened for Nvidia already. The company delivers strong results, but its multiple has started to compress over the last couple of months, which is why Nvidia is now trading below $500 per share.

Those that bought at a too-high valuation have seen negative returns since their purchase, despite the fact that underlying business growth is very strong. The dangerous thing about investing in these high-flyers thus isn't that the company will suddenly perform badly, but rather that even ongoing business growth can't protect you from potentially steep losses.

The same can be said about many other stocks that performed well in 2020, especially from industries such as e-commerce, software, cloud computing, electric vehicles and related technology, green energy, and so on.

Rising Interest Rates Lead To Multiple Compression

In general, investing in these very expensive high-growth names did go well up to a couple of weeks ago. Then, interest rates suddenly started to rise considerably, which meant that money was suddenly more expensive and less abundant. With rising bond rates being available for investors, there suddenly was less of a need to invest in stocks at multiples of 50x, 100x, or even 1,000x their respective net earnings.

We have seen a considerable downwards move in many of these stocks over the last couple of weeks, showcased by the following chart:

Over the last month alone, names such as Tesla, NIO, Plug Power, Zoom Video, Palantir (PLTR), Peloton, ARK Innovation, and PayPal (PYPL) have all lost at least 20% and up to 40% in some cases. For those that bought in early this year, close to the top, the last couple of weeks have thus been quite disastrous, especially since these companies don't even pay any meaningful dividends that could ease the pain.

And yet, despite the steep losses, none of these companies are inexpensive yet:

PayPal, the cheapest among these companies by far, is still trading at more than 40 times 2022's net profits right now, which isn't a low valuation at all. Looking at the others, we see that they are all way more expensive still, which means that there is still a lot of downside potential left. Who says that Peloton can't trade for 55 times net profits in 2022? Or for 40 times net profits? That cannot at all be ruled out, which shows that there is potential for shares to lose another 50% or even more.

I wouldn't bet on that by shorting any of these names, but I still think that longs should consider these facts. Shares have lost substantially over the last couple of weeks, growth seems to be out of favor right now, the trend has been towards value names, and yet these growth names trade at ultra-high valuations that could easily be cut in half during another sell-off.

Looking at the performance of growth versus value over the last couple of weeks, we see that rising rates aren't necessarily a problem for all companies:

Over the last month, the Dow Jones (DIA) is essentially flat, the S&P 500 (SPY) has lost just 2%, whereas the NASDAQ (QQQ) has quadrupled those losses, being down 8% in just one month. As shown above, those losses are even more pronounced in some specific growth names. There are even entire industries that performed quite well over the last month, such as energy (XLE) and basic materials (IYM), which both delivered a positive performance thanks to rising commodity prices.

Being long value names such as Canadian Natural Resources (CNQ), Enterprise Products (EPD), Energy Transfer (ET), Hersha Hospitality (HT), and mining giant BHP (BHP) has worked very well for us over the last month:

Thanks to reopening efforts around the country and recovering energy markets, it wouldn't be a very large surprise if these names continued to do well going forward. The troubles that growth investors did experience over the last couple of weeks are thus not necessarily representative of what equity markets do overall. Instead, it may just be the unwinding of a period of exuberance where valuations were ignored for too long.

Takeaway

The growth trade was great for those that entered at the right time, i.e. in spring 2020, and that exited at the top early this year. But for those that bought at or close to the top, this could prove to be a very costly error. The growth trade has been good for some investors - but all good things come to an end, eventually.

Reopening and vaccination progress favor many value names over the tech-heavy growth stocks, and since valuations across many growth names are still very stretched, it wouldn't be a very large surprise to see value continue to outperform growth over the coming months. Please share your opinion on the macro nature of the article and/or on specific names in the comment section if you want to!

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This article was written by

Jonathan Weber

49.29K Followers

Jonathan Weber holds an engineering degree and has been active in the stock market and as a freelance analyst for many years. He is an active author on Seeking Alpha since 2014.
According to Tipranks, Jonathan is among the top 1% of bloggers (as of August 1, 2023).

Jonathan is interested in income stocks and value stocks primarily but does also follow some growth stocks.

If you want to reach out to Jonathan, you can send a direct message here on Seeking Alpha.

Disclosure:

I work together with Darren McCammon on his Marketplace Service Cash Flow Club.

Analyst’s Disclosure: I am/we are long ABBV, ET, EPD, BHP, HT, CNQ. 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.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (378)

Hender

09 Mar. 2021

Comments (3.14K)

net present value and PE compression would apply to all stocks, not just growth stocks.

gpiazza

08 Mar. 2021

Premium Investing Group

Comments (189)

How about the 1.9 Trillion stimulus? Seems to me the market has a way to go yet on all that funny money.

Bikerron1

08 Mar. 2021

Premium

Comments (1.61K)

Enjoyed your article very much. Also enjoyed reading other peoples comments. This isn’t investing anymore it’s nothing more than gaining. Been doing it for more than 45 years and it’s getting harder and harder each year to make a good decision.

Jonathan Weber

08 Mar. 2021