What a run it’s been in the equity markets! Too far, too fast? Possibly. In our view, we need to see solid earnings reports from the 4th quarter 2019 – maybe even some growth – and some enthusiastic guidance for the first quarter of 2020. Frankly, without confirmation from the fundamentals, the tremendous equity performance we’ve seen during the last quarter of 2019 and so far in 2020 would be attributed solely to rosy sentiment, fear-of-missing-out (FOMO) and significant multiple expansion. Coming up short on corporate earnings will likely mean that the market is “over its skis” and could come in for a bumpy landing. We remain cautious for several other reasons:
- Some stocks have taken off like a rocket – mostly for reasons that relates more to how the opportunity is perceived, rather than demonstrated success (in fact, sometimes despite negative actual results). When stocks go parabolic without a specific reason, we grow wary. Sure, in some cases, we can justify the move as part of a “re-rating” by investors (investors reconsidering or re-pricing information that they already knew after time to fully consider its impact). But that’s the exception. What then has followed is a self-fulfilling dance with Wall Street analysts stretching and twisting logic to find rationales for ever higher price targets. Frankly, we understand — it takes a great deal of courage as an analyst to have price targets below the actual price. But, unfortunately, when the music stops, investors are typically often the ones without a seat.
- On a P/E basis, US equity markets are pricey – trading at roughly 19x earnings – roughly, 3-4x above historical averages. As we stated above, if stocks “grow into” these higher valuations with strong fundamentals results, then no problem. However, enter Wall Street strategists, some of whom are now trying to focus investors on other valuation ratios that they claim are more “relevant”, like P/FCF (Price to Free Cash Flow). Could you already guessed that when considered through this new lens, valuations appear more reasonable? We thought you might have.
Netflix (NFLX) is a recent interesting example. NFLX just reported earnings for 4Q 2019. The company beat on revenue and earnings, but missed on US subscriber growth and reduced its guidance for the coming quarter. Analysts scrambled to defend the stock – responsibly conservative, attractive content slate, massive international growth opportunity — they noted. But we noticed (along with some others) something else more troubling in the details – the company changed the way it measures engagement with its content, massively lowering the bar for itself and cleverly altering investors’ perspective of future success. Previously, NFLX reported households viewing a title based on 70% of a single episode of a series or of an entire film. Going forward, NFLX will report on households (accounts) that chose to watch a given title — specifically as indicated in a footnote: “[c]hose to watch and did watch for at least 2 minutes — long enough to indicate the choice was intentional– is the precise definition.” They also noted that “[t]he new metric is about 35% higher on average than the prior metric.”
Of course, there were “legitimate” reasons for the change. “We now have titles with widely varying lengths…this way, short and long titles are treated equally, leveling the playing field for all types of our content including interactive content, which has no fixed length.” And, they pointed out that this methodology is similar to that used by others — BBC, New York Times and YouTube. Yet, in our experience, such moves always raise a red flag with the timing rarely a coincidence. Could it be that with greater competition for consumer eyeballs and dollars with competitors like Disney and Comcast entering the market that Netflix no longer has the subscriber growth trajectory and pricing power it once did? If so, they would need another metric to tout with investors to demonstrate that their content is reaching and retaining its subscribers. Voila – seems to us the problem is solved!
Seems to us that with so many struggling to find ways to suggest that all is OK and the party train will keep running smoothly – in the absence of meaningful fundamental data – prudence and caution is warranted.
The views presented herein are those of Validus Growth Investors, LLC (“Validus”) as of January 2020 and are provided for informational purposes only. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. The information is based on the economic and market conditions as of this date. The information is not intended as a discussion of the merits of a particular offering and should not assume that any discussion or information provided herein serves as the receipt of, or as a substitute for personalized investment advice from Validus or any other investment professional.
This material is provided for informational purposes only and does not constitute a solicitation. The material is not intended to be relied upon as a forecast, research or investment advice and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any forecasts made will come to pass.
