Deciphering The Reflation Hype For Long-Term Growth Investors

Summary

• Expectations of a strong economic recovery have led to fears of inflation. Higher inflation inevitably leads to higher interest rates, which dent growth companies' valuations.
• Generally, a reflation trade entails rotation from growth stocks to value (defensive and cyclical) stocks. However, timing is critical if one intends to make money from such a trade.
• After the violent sell-off in high-growth stocks, the reflation hype has taken over the investment media. As value stocks climb higher, analysts appear eager to recommend overpriced value stocks.
• Assets are priced approximately based on what reality will look like 12 months in the future. This is key to understanding where to allocate capital today.
• The sell-off in high-growth tech stocks and rapid run-up in value stocks is an excellent opportunity for investors to sell their "overpriced" value stocks and switch to "reasonably-priced" growth stocks.
• This idea was discussed in more depth with members of my private investing community, Beating the Market. Learn More »

Photo by Fokusiert/iStock via Getty Images

Co-produced with Ahan Vashi, Lead Research Associate at Beating The Market & L.A. Stevens Investments, LLC

Introduction

The reflation trade is probably the most discussed investing strategy in the market these days. Most long-term investors know what reflation trade means, but for those who don't, it essentially is a bet that the economy will rebound (from a recessionary/deflationary environment), and that rebound will lead to higher interest rates, higher commodities prices, and higher inflation rates.

Such a macroeconomic environment is most notably beneficial to economically sensitive value stocks and commodities, such as cyclicals, industrials, and traditional financials. Although technology companies are relatively insulated from economic cycles, and reflation is not necessarily bad for high-growth names, high growth tech (trading at ultra-high valuations) has been crushed by the narrative that higher yields in response to higher inflation will reduce valuations (in accordance with theory/logic related to discounted cash flow modeling).

Within our little corner of the universe, we became incredibly concerned over a market that seemed to believe valuations didn't matter in early 2021. Today, after a rather violent correction for much of our coverage universe, we're more sanguine.

That said, as of today, if you are heavily invested in high-growth companies as we are, you might be wondering, "Do I stay the course and hold onto my growth-heavy portfolio, or should I join the reflation trade bandwagon and rotate into cyclical value stocks?"

In this article, we will assess the ongoing reflation trade and evaluate the merits of rotating into value stocks or holding onto growth stocks. I will showcase why many "reopening" value stocks are actually value traps. Lastly, I will share a glimpse into my investing strategy for these volatile times.

Understanding The Reflation-Mania

In 2020, the global economy suffered a deflationary shock, i.e., the coronavirus pandemic. Here in the US, real GDP declined by 3.5%, and the economy entered deflation. To prevent the country's economy from entering into a vicious deflationary cycle (prolonged recessionary environment), the federal reserve cut interest rates to zero and created trillions of dollars in new monetary base. To help millions of Americans hit by the pandemic, the federal government also provided fiscal stimulus worth trillions of dollars, and the Biden administration just added another $1.9T to the rescue effort. Other countries have followed suit and taken similar monetary and fiscal actions.

Although the US economy continues to struggle (evidenced by high unemployment), investors are already looking ahead to reflation as the massive rescue efforts by governments and central banks are gaining traction.

As I mentioned in the bullet points, this is normal: the market is pricing assets based on reality in the future, not reality today.

The rapid rise in bond-yields (US long-term treasury) and commodity prices are pointing towards reflation (adjustment back to long-term inflation trends) by early 2022.

That said, reflation is good for the economy; however, if inflation overshoots, then the Fed may be forced to allow rates to rise, which in turn would further depress asset prices, especially those that are rapidly growing and light in terms of actual earnings.

Yield Panic

The following video does a great job of summarizing the undercurrents of the stock market at the moment and contextualizes the recent rise in interest rates.

Source: 'Reflation-mania' sweeps the stock market | Charts that Count

When the economic environment is recessionary, investors prefer bonds. However, a sharp bounce back in US GDP (expectation of 6-8% growth in 2021) implies assets should be priced such that we are not in recessionary conditions. Hence, investors have been selling (low-interest rate) bonds and moving into other asset classes, namely cyclical, banks, and other stocks known as value traditionally. As the bond supply increases, bond prices go down, and yields trend upward.

In early March, we saw a sharp uptick in US 10-yr Treasury yield; however, as we know by now, yields are still very low compared to historical levels. Although bond yields are low, a sharp rise in these yields could start a rotation from stocks to bonds. The following chart illustrates why:

Source: yardeni.com

The risk of the economy overheating due to very accommodative monetary and fiscal policy looms heavy over markets presently, and if it leads to high inflation (Fed target rate for inflation is 2%), then bond yields could soar higher, further extending the current (in our opinion overdone) reflation trade.

If treasury bond yields reach higher levels than S&P 500 earnings yield, investors could get more earnings (than S&P 500) without taking on any risk by buying treasury bonds. Therefore, the equity markets could take a tumble as investors flee. However, we are currently experiencing reflation and not high-inflation, and there's a very high likelihood that inflation moderates without any significant intervention by the Fed (in the form of raising their target rate).

Stocks Remain Undervalued (Relative to Bonds)

Source: yardeni.com

The "Specter" Of Reflation Is Bursting The Bond Market Bubble

Now, the Federal Reserve could very well step in and control yields if it feels the need to do so. However, Jerome Powell's recent commentary indicated that the Fed is unlikely to intervene at this moment.

Higher bond yields reflect a stronger economy; however, if reflationary dynamics overshoot, we could have inflation, and high inflation in an overheating economy is dangerous for asset prices. The Fed would be forced to increase the risk-free interest rates in order to stem inflation, and that could lead to a decline in asset prices. As the risk-free rate goes up, the discount rate (used to value stocks) goes up too. This is the reason behind the current struggles of high-growth stocks.

Our view is that the powerful deflationary effects of technological innovation will offset these inflationary effects, and high-growth tech companies will continue to do well. And Cathie Wood seems to agree:

Source: Market Liquidity, Inflation, & Financial System | ITK with Cathie Wood

My team and I prefer to invest in monopolistic businesses (these are often hidden from the casual observer's view) that operate at the heart of secular growth trends for the very long-term, but many of our subscribers have been asking about diversifying into value stocks. I am not going to argue against reflation because it is already underway. However, in our eyes, inflation fears are overblown.

And the time to ask whether to buy value stocks was 6 months ago when they were cheap. Today, they are much more expensive. The trade is vastly overextended already, as I will illustrate in a moment.

And history shows that retail investors who stay the course accumulate more wealth than those that trade in and out of stocks. Furthermore, value stocks are not necessarily value. Let's explore this idea:

Beware Of "Value" Traps

Market consensus is that the reflation and higher rates are inevitable (I agree), and the early signs (viz. sharp rise in long-term treasury yields, value outperforming growth in the last few months, higher commodity prices (oil, copper, zinc, etc.)) do support the thesis. I, too, agree that the unprecedented monetary and fiscal stimulus will lead to reflation of the economy; however, I do not think the economic reopening will benefit the "value" stocks as much as most investors (traders) are hoping for at this point.

In the last few months, re-opening stocks like airlines, cruise lines, and restaurants have been on a rampage higher. Investors are playing the reflation trade by switching from growth stocks to value stocks; however, this shift has been going on for the last six to eight months, and numbers show that the reflation trade might have gotten way ahead of itself.

Airlines are trading at much higher multiples than pre-COVID levels, even though a sizable portion of business travel will never return due to cost-benefit to companies from virtual work. With higher oil prices, questionable demand, higher debt loads, and massive stock dilution, the airline industry has shakier long-term fundamentals. We are never going back to a pre-COVID world. And although airline stock prices portray a future where demand reaches pre-pandemic levels over the next 12 months, it is only a mirage.

Now, I am not against value investing (this would require a chapter of a book to really elaborate and explore as it's our opinion that value investing has been bastardized relative to its truest meaning popularized by Graham, Dodd, and Buffett 70 years ago). However, the stock market is full of value traps at the moment.

I will be using Carnival Corporation (CCL) to illustrate what a value trap looks like and highlight the characteristics one should look for if they are about to buy value stocks to participate in the reflation trade.

Observing The Value Trap In Its Natural Habitat

Source: carnival.com

Carnival is one of the world's largest cruise lines, and with travel demand expected to come back in the second half of 2021 (due to COVID-19 vaccination and pent-up travel demand), its business could start to recover from the doldrums (all cruises are currently docked and are not operational). Although CCL's stock price is still below its pre-pandemic levels ($40s), its market capitalization is now slightly higher than where it was back in February 2020 (before the pandemic hit). The market is telling us that, "All is good with Carnival's business"; however, this is far from reality.

Carnival's Market Cap

Source: YCharts

Since the pandemic started, Carnival's revenue has dropped from ~$5B per quarter to $740M (Q2 2020), $31M (Q3 2020), and $33M (Q4 2020) in the last three quarters, which is a drop of more than 99% in sales. Furthermore, Carnival's negative quarterly EBITDA of -$2.5B means the company is losing a lot of money every single day its cruises remain dormant.

Carnival's Revenue

Source: YCharts

Even though Carnival's stock might point to a quick recovery in sales, the near-term demand remains questionable, and even if the sales do return to pre-pandemic levels by say 2023, longer-term profitability levels of Carnival will never come back due to the massive expansion in Carnival's financial debt load and the resulting rise in interest expenses as well as its share dilution.

Carnival's Debt

Source: YCharts

Carnival's free cash flows were dropping for years before the pandemic hit, but projections suggest that Carnival will burn $11B (negative FCF) in a year post the beginning of the pandemic. Woof! That’s brutal. Assuming Carnival's sales do come back and the company manages to deliver long-term growth rates of 5%, it will still not reach pre-pandemic FCF per share within the next decade.

Carnival's Free Cash Flow

Source: YCharts

Due to the added burden of higher interest expense, Carnival's long-term free cash flow margins will contract from ~10% ($2B) to ~5% ($1B). Assuming Carnival doubles its revenue by 2030, that would put Carnival's free cash flow at $2B (levels last recorded in 2017-18). However, the shareholder dilution Carnival had to undergo to stay afloat in 2020 means that the company's free cash flow per share will not reach pre-pandemic levels throughout the 2020s and possibly ever.

Source: YCharts

Also, it looks like the dilution is not quite done yet as the company just raised another $1B by issuing common stock in the last month, and further dilution is not off the table. Carnival will continue to lose cash (negative FCF) for the next few months at least as the business will only return in phases, and the company will need to spend a lot of money to get its cruises operational again, and so most of the cash on its balance sheet will be gone by the end of 2021.

Source: YCharts

The image above summarizes our entire discussion on Carnival Corp, and it is easy to say that we are looking at two completely different companies: the pre-COVID Carnival Corp and the post-COVID Carnival Corp.

Comparison Table: Pre-COVID CCL vs. Post-COVID CCL

	Pre-COVID CCL	Post-COVID CCL
2022E Revenue [A]	$23B	$18B
FCF Margin [B]	10%	5% (due to higher interest)
Average Diluted Shares Outstanding [C]	681M	919M
Free Cash Flow Per Share [D] = ([A]*[B])/[C]	$3.37	$0.98
Long-term FCF Growth Rate	5%	5%
Terminal Growth Rate	2%	2%
Future Dilution (Assuming no black swan events like COVID)	-10%	-10%
Assumed Price to FCF (yr-10)	15x	15x
Current Stock Price	$29.63	$29.63
LA Stevens Valuation Model Results:
Fair Value	$59.34	$17.26
Projected 10-year CAGR return	11.93%	-1.07%

Click to enlarge

Source: Author

As you can see in the table above, without COVID's deleterious long-term impact on Carnival, it would have been worth ~$59.34 (market cap: $40B). However, investors must realize that they are looking at a completely different company: one with a massive debt burden that has the potential to send Carnival into a death spiral. Furthermore, even if Carnival manages to generate pre-COVID level free cash flow, each shareholder’s cut of that FCF is now lower due to massive shareholder dilution. Every asset's value is the discounted value of the free cash flow it will generate in its remaining lifetime, and since each Carnival stock is expected to generate lower free cash flow, its value is now lower. According to my estimates, the post-COVID Carnival is worth only $17.26, i.e., it is currently overvalued by 71%. Furthermore, the expected 10-year CAGR return for the post-COVID Carnival is negative (yes negative) -1.07%. Hence, Carnival Corp. is a value trap and potentially a terrible bet for long-term investors.

If you are looking to play the reflation trade, I think commodities might be a better place to be than value stocks. However, if you do opt to buy value stocks, make sure that the business you are buying has solid fundamentals (low-cost structure, robust liquidity) that remain undistorted due to the pandemic (and after the pandemic is gone). Massive increases in debt and outstanding shares are two big red flags to look for when buying any reopening stocks.

High-Growth Tech Stocks Have Consolidated For A While Now, And The Recent Sell-Off Has Created Some Great Buying Opportunities

The "FAANG" stocks combined with Microsoft (MSFT) and Tesla (TSLA) form nearly 40% of Nasdaq's (tech index) total market capitalization. Since these six companies contribute so heavily to the market cap of technology stocks, they are looked upon for market direction. From the start of 2020, these stocks have returned between 30-70% each, with Tesla being the only outlier with 750% growth in the share price.

Source: YCharts

However, since Sep 2, 2020, these tech-leaders have entered a sideways consolidation. Interestingly, the data on Price to Free Cash Flow multiple shows that Apple (AAPL), Microsoft, Facebook (FB), and Alphabet (GOOG) (GOOGL) have very little multiple expansion. As you know, the world has changed, and these technology giants have seen massive growth acceleration with greater future prospects in store for each of these companies. We won't be talking about the long-term secular growth trends supporting these businesses, but we know for a fact that these stocks have already grown into their valuations, and they are trading at pre-pandemic levels with better future prospects. If you were wondering why these big-tech stocks didn't budge during the sell-off in early March, I hope the following chart and the above discussion answered your query.

Source: YCharts

Ok, maybe the big-tech stocks (other than Tesla) are fairly valued. But what about the big winners from the pandemic, the likes of Zoom (ZM), Peloton (PTON), DocuSign (DOCU), and Teladoc (TDOC)? Aren’t these stocks overpriced and ripe for a big crash?

The simple answer is no.

Looking at their dizzyingly high stock prices, one may assume that most of the above mentioned stocks saw a multiple expansion; however, each of the four companies I just mentioned experienced multiple (Price to FCF) compression from their pre-pandemic levels. Hence, it is clear that the market is paying less for the free cash flows generated by these companies than it was paying a year ago. In other words, the Zooms and Teladocs of this world are cheaper in post-pandemic times. However, the digital transformation trends accelerated by many years, and these empowerment platforms should be costlier than before as they are now essential to both consumers and enterprises.

Source: YCharts

The notion that tech stocks are highly overpriced is false as of today, and fear in the market surrounding high-growth tech stocks should be capitalized on by each and every investor. Of course, you have to be very selective to differentiate winners from losers in order to outperform the market in the long-run.

Growth investing demands patience and courage to hold on and buy more during rapid sell-offs in volatile times. Most investors tend to sell right at the bottom of a correction and buy back at the peak. The simplest solution to tackle volatility is to do nothing. When you have high conviction on the businesses (stocks) you own, just let your money ride (even when the stocks go down 30-50% in two weeks). If you don't believe my words, take it from one of the best growth investors that ever lived:

Source: How to BUY Stocks During A STOCK MARKET CRASH by Peter Lynch | Volatility Interview

I am always fully invested (with incremental new cash finding a home within a few months); however, I do like to use market volatility to my advantage. During this latest tech sell-off, I sold some of my low-beta stocks, like Apple (AAPL) which has been a very long-term hold of mine, to buy some of my favorite high-growth tech stocks that I believe will turn into multi-bagger investments over the next decade, such as Twilio (TWLO), to which you may know I am quite partial.

Here's An Example Of What We Bought In The Sell-Off

While investors and traders were panic-selling during the last couple of weeks, we were buying the businesses we love at 30-50% off their all-time highs. Volatility is a double-edged sword for high-growth investors. On one side, it could deeply hurt portfolio values; but on the other side, it creates an opportunity for greater wealth creation.

During the recent sell-off, some high growth tech stocks fell by as much as 50% from their highs. Now, some tech stocks were (and are) trading at frothy valuations and deserved to be sold-off, but others were just fine. However, during sell-offs, Mr. Market behaves like a drunken man and tends to sell off every asset in sight without regard for its quality or true value. The current sell-off was limited to high-growth tech stocks due to fears of reflation (and consequent inflation), and a lot of froth was eliminated, but it also created incredible buying opportunities in reasonably-valued growth stocks like Hims & Hers (HIMS).

Source: YCharts

HIMS stock is still some way off its all-time highs and way below its long-term fair value. Investors should capitalize on this sell-off so as to generate outsized returns over the next decade.

Short And Sweet Investment Thesis For Hims & Hers

• Hims & Hers is truly the embodiment of the consumerization of healthcare. It sells B2B (Hims & Hers for Enterprise, as they call it) but is primarily focused on its consumer-oriented business, which sells telehealth services, and also consumer-oriented products in places like all 1,800 Target (TGT) stores nationwide in the US.

• Hims & Hers is a rapidly growing multi-specialty telehealth platform that aims to modernize the $4T healthcare industry. The pandemic exposed the flaws in our healthcare systems and has accelerated the rate at which Hims & Hers could further consumerize healthcare.

• Telehealth companies like Hims & Hers, Teladoc (TDOC), and many others are focused on delivering value-based healthcare through advanced technology with unique approaches that consumers love in the 21st century.

• Teladoc is already one of our most prominent positions at Beating The Market, as has been for the last 8 months or so (have personally owned it for the last 3-4 years) due to its market leadership and platform capabilities. However, as you may know, the telehealth market is still a very nascent industry. Therefore, we should expect to see multiple winners in this space, and Hims & Hers has massive momentum and a demonstrated successful business model. It also appears to be achieving what Teladoc has dreamed of achieving: consumerizing healthcare in a way its users not just like, but adore.

• Hims & Hers has a business model similar to a few of our favorite stocks: Roku (ROKU) and Square (SQ). By offering streaming hardware at meager gross margins, Roku brings customers into its ecosystem and then makes money through advertising. Hims & Hers is doing something similar. The telehealth company offers primary care service at just $39 per visit and then makes money through subscription-based drug sales, as one example of using this free platform to sell consumers other products. It's like Square and Upstart (UPST) because it has a robust "enterprise/B2B business" as well as a consumer-oriented business. The numbers reflect just how potent this combination has been for the company:

• Hims & Hers recorded a y/y revenue growth rate of 67% and a gross margin of 77% for Q4 2020. In 2021, the company expects to rake in ~$200M on revenue; however, I think they can/likely will do much more than $200M, especially as the pandemic subsides and they continue to expand the three distinct segments of their business. The company was founded and began operations 3 years ago. In 3 years, it has gone from idea to $200M in revenue. This is incredible, and we expect such momentum to carry through into Hims & Hers' next chapter of its journey as a company.

• Andrew Dudum, Hims & Hers' CEO, is a visionary leader who has proven his management pedigree over the last few years. Still just 32 years old, Andrew is poised to lead his company to greater heights for the next 2-3 decades.

• Hims & Hers offers extremely attractive returns at a valuation of about $2.3B, or approximately $12.50/share.

Now, does this mean Hims & Hers is a guaranteed success? No. But we do very much like the company, and it's illustrative of the kind of companies we target within our investment operations.

Concluding Remarks

The violent sell-off shook out many growth investors from their positions over the last month. And indeed, volatility could strike again; we have no idea, nor do we believe it's necessary to have any idea. What we do know is that the stock market is a machine that transfers wealth from impatient to patient investors, and there are always great deals to be found regardless of broad market conditions. I will round up this article by sharing my strategy for long-term growth investors who are looking to build wealth in a sustainable way.

Please remember that this is for educational purposes only.

Situation	Strategy
The portfolio is concentrated on high-growth tech stocks.	Hold onto your high-conviction holdings through the volatility, and buy more on big red days if you have dry powder. Sell overpriced value stocks (if you have any) or low-beta stocks to raise capital, and buy into high-conviction growth companies on heavy discounts (as they will benefit the most from a new business cycle, and the inflationary effects will only be transient). If you don't have any liquidity source, just do nothing, hold tight, don't watch the portfolio every day, and let your money ride.
Blended Portfolio (Value + Growth)	The recent sell-off in high-growth tech names and a huge run-up in value names is a good opportunity to reallocate your portfolio. You may choose to do it by adding capital to your growth stocks or selling value and buying growth to readjust your portfolio to ideal weighting.

Click to enlarge

If reflation does happen (very likely), and the global economy recovers quickly, we would be entering a new business cycle that could invigorate the next leg up in equity markets. In 2021, high-growth tech stocks could underperform their value counterparts. However, long-term, the best stocks to buy in any given environment (reflation, deflation, stagflation) are the stocks of dominant companies that are operating at the heart of secular growth trends.

To be sure, sobriety must be exercised in the fair value assessments of these companies. We cannot stress this enough, and it's a practice we maintain in our own investment operations.

Early 2021 illustrated what a world of "valuations don't matter" begins to look like: it's not a world in which any of us want to live. Valuations matter.

Now, does this mean that I am scouring the investment community for 7x P/E plays? No, but I do my best to instill sobriety into each and every valuation I perform (which emphasizes free cash flow and the long-term potential thereof).

At this juncture, I believe it wise to eliminate all market noises from your investment decision-making process, to invest in great businesses trading at reasonable prices for the long term, and keep HODLing them through volatile times. Use market volatility to your advantage as it gives you an opportunity to buy high-quality businesses at prices lower than the prices where you initially liked them. Wealth creation in the stock market needs research, courage, and most important of all: patience. To create life-changing wealth, all you need to do is "Buy right, sit tight".

We started our discussion to answer this question:

"Do I stay the course and hold onto my tech-heavy growth portfolio, or should I join the reflation trade bandwagon and rotate into cyclical value stocks?"

Answer: Stay the course and buy more of your high-conviction stocks.

Thank you for reading, and happy investing. If you liked this article, follow me to get updates on my future articles directly in your email. And please feel free to share your thoughts, questions, and/or concerns in the comments section below.

Analyst’s Disclosure: I am/we are long ZM, ROKU, SQ, TDOC, HIMS, HIMSW, TWLO, AAPL, PTON. 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.