Back in August I told you I had a thesis I was working on fleshing out about why growth stocks are so loved and why growth has trumped value for years and continues to do. The first post on this is here. But let me provide an update today.
Two things inform my update. One is an interview I did on Real Vision with Ben Inker, who is the head of asset allocation at money manager GMO. The link to that video is here.
And the second is Joe Weisenthal and Tracy Alloway’s latest Odd Lots podcast episode here. In that episode, they explain that “it seems like all financial markets are the same big trade. A gold chart looks like a Tesla chart, which looks like an Ethereum chart, which looks like a chart of a basket of cloud computing stocks. So why is this? And what could cause that to change? On this episode, we speak with Jared Woodard, the head of the Research Investment Committee at Bank of America, who recently published a report on exactly this. As Woodard explains it, the question starts with low growth and inequality, and the premium that investors will pay for certain types of securities in such an environment. ”
The Inker conversation
I spoke to Ben the Friday before last as preparation for our interview. And I told him about my thesis in three parts. First, there is the fact that GDP growth has slowed, both due to a loss of real growth and a slowing of inflation. Second, there’s the fact that low interest rates reflect that slowing, making the present value of distant cash flow streams more valuable.
And third, there’s the optionality that those cash flow streams provide. As in the Internet bubble days, fledgling companies give people upside via an out-of-the-money long-dated call option on their earnings. It’s akin to a lottery ticket, where the payoff is high. And if you invest in enough of these companies, one of those tickets is likely to score big as they did with Amazon, Google, Ebay and Facebook.
On my first characterization, I remember Ben’s saying that much of the price/earnings ratio differential between large-cap stocks and mid-cap stocks can be explained by the differential in growth. Essentially, we are living in a more winner-takes-all world. And the lion’s share of additional revenue growth accrues to the biggest and most dominant companies. Add in operating leverage and share buybacks and you see EPS growing much faster – and sustainably. It’s an oligopoly world in which large-cap stocks can grow earnings per share well in excess of small-cap and mid-cap stocks and above the rate of growth of the overall economy.
Ben was sceptical of the second claim. He sees the long duration aspect as an ex-post explanation of what is happening on the ground with investors. People are not telling themselves they want to invest in Tesla because they need long-duration assets; they buy Tesla because they think that’s where the growth is, because that’s a stock where they can make money. So we can infer that the relative importance of distant cash flows is why stocks like Tesla have captured people’s imagination. But that’s not what’s going through their minds as they make the purchase.
Finally, on the long-dated option view, Inker agreed with the framing and focussed in the taped interview on the high implied volatility aspect of that optionality. He said that this volatility may not last, meaning that, as the company matures, the volatility will diminish and the option value will decrease. That’s going to hit share price. In the real world, that simply means that what seems like limitless possibilities in a company’s growth today will become much more limited five years down the line. And the share price will decline as a result. In the interview, Ben talked about Tesla as a perfect example of how this is likely to shake out.
Odd Lots implications
I love Odd Lots because it delves into quirky, non-mainstream parts of the markets and the economy. It’s a finance geek’s podcast. But, in this case, I won’t steal their thunder and will let you listen to the podcast episode. For me, though it is heartening to see others thinking the same way I am about why growth stocks matter.
There’s an upshot though; and it goes back to Ben Inker’s comments about the call option implied volatility. The market will ‘correct’ as it did in early September when we gain greater insight into the future and that insight shows less growth than anticipated. I have been saying that I see September and October as a make or break for the economy and markets. If the hockey stick style growth upsurge of the early re-opening days continues, share prices can continue to power forward. But, if growth wanes or rolls over, it suggests more pain from the coronavirus recession is to come. And what we’re seeing so far – in the form of several data misses – is more negative data surprises. That acts as a headwind for risk assets.
The question for individual stocks boils down to how this all transmits to earnings. We are still in a winner-take-all environment. Just because growth wanes doesn’t mean it has to wane for Amazon. Just because people and companies are defaulting on loans doesn’t mean Microsoft can’t continue to add to earnings via massive cloud computing revenue growth. But a hit to growth relative to expectations does make it more likely that individual companies take a hit. And at the aggregate level, that is even more true, despite the advantage oligopoly gives large cap stocks over mid-cap and small-cap.
Overall, I am looking at the next few months as pivotal for what comes for the next few years. The coronavirus pandemic is a big economic event. And the contours of the eventual recovery from it are coming into focus now.
What happens now will make plain how we will proceed for months and a few years to come. If growth proceeds at a robust level, the likelihood that we overcome the coronavirus grows a lot. And with the help of stimulus to tide us over, worst case scenarios fade from view.
But if the economy rolls over, we should expect the future growth in the economy to look less robust. And that will feed through to individual companies’ shares. And while growth stocks can weather that storm better, I think this outcome is priced in. Apple at 45 times earnings is more than fully priced for oligopoly-like domination. Anything short of that is bad for Apple, Facebook, Google, Amazon and all the other market darlings like them.