The lower valuation for growth


Volatility in investing is often equated with risk. This is nonsense. For an active investor, volatility is actually an opportunity, namely the possibility to buy low and sell high. The real risk of investing is a permanent loss of wealth, although, with today’s high inflation, that is mainly a permanent loss of purchasing power. However, there is another risk besides permanent capital loss: missed opportunities. The first risk focuses on limiting losses, the other on maximising profits. It may be possible to eliminate one of the risks, but not both at the same time. It is the battle between greed and fear. Greed is a stronger emotion than fear, which is why new bubbles are created time and time again. Greed is an emotion and good investors are usually able to control their emotions. Emotional investors buy mainly at the peak of euphoria when prices are high. The advantage of switching off emotions is that the bottom becomes visible when other investors are depressed. This is also the reason why contrarian investing can produce good results. Those who cannot control their emotions should be very reluctant to invest themselves.

There are, however, some rules of thumb that can also help the average investor achieve better results. Limiting losses is a good starting point. That seems simple, but the average investor prefers to take profits rather than losses. But by limiting losses and keeping the winners in the portfolio, the results improve. Furthermore, buying low, and selling high sounds like a simple rule to remember. The reality is that many investors buy at the top and sell at the bottom. In the real world everyone is used to negotiating, what can be deducted from the price of a new car or where can the new TV be bought with the most discount. Often, people know in advance when something is a good deal. Investors should do the same. If it is not a good deal, then it is not a good deal. Don’t try to come up with excuses why you should pay more. In the long run, overpaying depresses returns. Beware that our minds tend to rationalise things. Cognitively dissonant as we are, we emphasise arguments that fit into our own vision and ignore counterarguments. Those who do pursue these arguments quickly come up with the argument that ‘this time is different’, but remember that history does not repeat itself, but it does rhyme. The good quality of a good investor is also patience, be careful with rash investments. Only when everyone is anxious should there be some haste. Patience is usually a good way to avoid problems. Investors do not look at the prices every day either, they just make a lot of noise. Those who have thought carefully about their investment should try to filter out the noise. The financial news can largely be ignored. Furthermore, taking risks does not determine the ultimate return. Risk only says something about the permanent loss of wealth if the investor has got it wrong. It is not wrong to invest conservatively, because it also means that it is easier to make up interim losses. If you follow these rules, you will probably not beat the stock market in a rising market, but you will in a falling market. It is therefore much easier to make up for a missed opportunity. In investing, it is not possible to make up for the lost time to recover losses. But the biggest problem for any investor and even his or her worst enemy is the investor himself or herself. Investors have nothing against risk, as long as it does not cost them money.

In the stock market, the average investor loses about half of the shares in his portfolio. In order to compensate for these losses, one needs more than 45% of all shares on which a profit is made. Then you are back to square one. The total return on shares is determined by only a few percent of the stock market. These are unique companies that every investor is constantly looking for. Everyone wants to invest in the next Microsoft or Apple. They are growth stocks, but because everyone wants to pay for them, the biggest risk of growth investing is that an investor will pay too much. That is not so easy to determine. Here is an example. Ten years ago, Amazon shares were trading at 120 times earnings, mainly because the entire cash flow was reinvested in the company. Just before that, that company was no more than an online bookstore, but now it also sold third-party products. That organisation required a lot of IT capacity and servers that could respond quickly to customer queries. Because too much server capacity was installed, part of it could be leased to third parties. The cloud was born. But anyone who argued in 2012 that Amazon was cheap because of its prospects for cloud services was looked at with pity. The reproach to Amazon was that they had better stick to the existing business model and not interfere in things they did not understand. The rest is history.

Many of these growth companies are listed on the American Nasdaq. The Nasdaq is now 22% below its all-time high. There are 4,700 stocks listed on the Nasdaq and 61% are down 20%, 43% are down 40% and 29% are down 60%. An important exponent of the latter group is Cathie Wood, whose ARKK is now 68 per cent underwater. Companies like Zoom, Netflix, Peloton, Facebook, Shopify, Square and Spotify have become much cheaper. Now they are all shares that have risen sharply before. In that respect, this group resembles the Nifty Fifty of the 1960s and 1970s. Those were shares like Polaroid, Coca-Cola, IBM, Xerox, and McDonald’s that were just as favoured then as the FANGs or the FAAMGS are now. The valuation of the Nifty Fifty ranged from 50 to as much as 100 times earnings. When the Bear market started, these companies were the main victims. They were losses of 55 to 90 per cent. The IT sector was much smaller then, but it lagged behind the broad stock market by as much as three decades after the Nifty Fifty peak. Nevertheless, many of these investments ultimately proved to be among the few companies on the stock market that determined the total return on equities. Just not all of them.

Now, investing is always easy when you can look back. Again, there are companies listed on the Nasdaq that will never return to the 2021 peak, but there will also be winners with spectacular future returns. Those who select individual stocks have the difficult task of selecting those companies. Then it is not wise to look at the current valuation, but only at the growth prospects. The risk then is that the market will hanker after such high valuations in the short term, but remember that each share ultimately follows the underlying profit development. The advantage of this select group of companies is that they are perfectly able to pass on higher prices to their customers and that they usually have no debts. These companies can therefore weather a recession and, moreover, they also benefit from competitors in the form of zombie companies that get into trouble during a recession. So for such growth companies, a recession is an opportunity rather than a risk.