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Jan 19, 2020

Don’t bet on more Amazons – these valuations are fuelled by hype

written by Lisa Eason

These are strange times for investors — especially in American equities. US stock indices are at all-time highs: over the past 10 years, the total return from the Nasdaq index is almost 350% and the S&P 500 250%. And as with culture, we have copied our friends across the Atlantic — at least to a degree.

These astronomic valuations — in a lowish-growth economic environment — are especially bizarre given that 40% of US public companies were loss-making in their previous 12-month reporting period. Many of the forces driving up the prices of financial assets are technical, not based on fundamentals.

Easily the largest factor has been sheer weight of money — the vast torrent of liquidity unleashed across all leading economies after the 2008 financial crisis by central banks printing money — or variations on that theme. Interest rates are down to all-time lows, which means savers are desperately searching for returns and are tolerating terms that would once have been unthinkable.

Another ingredient is the reduction in the number of public companies — in the US and UK, the total has roughly halved over the past two decades. This is because companies have been going private, merging, or simply not going public in the first place.

As a result of the mergers, the average public company is much larger than used to be the case. Unfortunately, the transition to fewer, larger companies has fostered oligopolies, and mostly acted against consumers’ interests.

Moreover, US public companies have been buying back stock at record levels — “de-equitising” the capital markets.

AIM in London is suffering acutely, with the number of floats on the junior market falling last year by nearly 70% and the number of companies listed on AIM declining to a 10-year low.

Institutional investors are being obliged by compliance to dump illiquid holdings, inevitably including smaller companies. Overall, fund managers see little upside in buying micro- capitalisation stocks, which will always tend to offer potentially higher rewards but also higher risks.

Meanwhile, the companies that do go public, especially in the US, tend to be loss-makers. All the high-profile floats of last year on Wall Street — Uber, Lyft, Slack and Peloton — lose money. They must keep growing in order to become profitable. These new-age public companies are more akin to venture capital investing, with all the accompanying complications.

Venture capital investing needs to be hands-on and intensive, and investors require subscription agreements with powerful rights and board representation. I struggle to see how fund managers with portfolios of perhaps 100 quoted companies can supervise holdings in these types of businesses. It is a different skill set and would tend to deliver much more erratic and lumpy returns.

Business models have moved a long way from classic stock market investing, when companies could typically boast material profits, net tangible assets and a cash dividend. Of course there are such quoted companies around, but they appear to be going out of fashion. Almost no investors now look for income from equities — they want capital growth.

Investors can point to Amazon to justify this philosophy. The online retail giant has broken all the rules: it was persistently loss-making until recently and focused on top-line growth, not cash generation or, indeed, return on capital. However, since its float in 1997, the stock is up 1,000-fold, and it remains perhaps the most successful public company in performance terms in the past 25 years. Nevertheless, it won’t necessarily be possible to replicate this gargantuan achievement.

A further influence is the rise of socially conscious investing. Projects that emphasise their environmental, social and governance credentials are more likely to receive funding — even if the financial aspects of their operations are highly speculative.

So ventures such as Beyond Meat, which produces plant-based meat substitutes for burgers, has a market value of almost $6.6bn (£5bn) despite projected revenues for 2019 of just $275m and a first quarterly profit announced in October.

Tesla is valued at $95bn — more than Ford and General Motors combined — and yet it has only $25bn in revenue, against their total revenue of nearly $300bn. Sometimes it is hard not to suspect that hype has replaced reality in the investing universe.