A divestment from valuation fundamentals can, in part, explain the correction occurring in financial markets.
Dan Brocklebank, UK head of Orbis Investments said that when markets move away from clear signals of value – instead following hype or a certain story – mispricing occurs.
“It’s an exciting time in the market,” he said. “We’re seeing after a few years, a return to valuation really mattering again.”
These market cycles are unsustainable and investors have endured a rude wake up call. He said: “For a while, investors were focused on stories and buying companies regardless of valuations,”
He added that what we want is a more rational stock market, not one driven by stories and hype.
History doesn’t repeat, but certainly rhymes
Valuations soared in the pandemic, especially for growth companies and people would bend different metrics to make stocks look cheap, justify wild estimates, or fit a certain narrative.
“We drift further away from the financials when an investment thesis or argument is built around a story rather than hard valuation data,” said Brocklebank.
He gave the example that at the height of the dot.com bubble, the number of eyeballs on a website was often used as an indication of a company’s value – even being referenced in prospectuses.
“History never repeats itself perfectly but things rhyme, and the catchphrase this time around was to focus on TAM, or total addressable market.”
The argument with TAM was that internet companies were able to scale much more rapidly, and Amazon would be cited as the benchmark example of rapid growth without making an accounting profit.
“This becomes self-fulfilling and feeds off itself, but at some point, that does run out and you need to generate profits,” he added.
A good example of this would be Zoom which was trading at lofty valuations during the pandemic. It’s market capitalization in October 2020 was roughly $160bn, as of 12 July 2022 it is at $32bn.
Brocklebank said to justify its market cap in 2020 Zoom would have needed to generate $10bn of profit, wherein actuality revenues before cost were only around $4bn.
“The momentum built into these stocks has deflated massively,” he added. “If you’re making these huge growth assumptions, it’s really difficult to make the math work.”
Where it becomes difficult for advisers
When stocks are on a bull run, advisers can find it hard to promote the merits of diversification. Indeed, the most unpopular people in a bull market are those that voice concern over pockets of overvaluation and speculation.
“We tend to look at what has performed well,” he said. “Human nature is that we like the comfort of crowds.
“I think, what’s challenging for advisers, is that we’ve had such strong trending in markets around this idea of growth and high-quality companies.”
Even if someone had started investing five years ago, with a relatively diversified portfolio, the performance of just those areas has probably meant that they’ve grown as a percentage of overall portfolios.
“The pressure to remove underperforming funds has become so strong, that anything that wasn’t growth and high-quality has probably been booted out of most people’s portfolios.”
Heavily concentrated
It’s difficult too to sell the merits of building in defensive protection when markets are going up, but Brocklebank argued that even in seemingly diversified areas – this could be an illusion.
“There’s often a high correlation between funds in a portfolio,” he said. The whole purpose of having a diversified portfolio is to ride out volatility.
“I would think people need to be checking the cross-correlation of their core holdings and making sure they’re not suffering from an illusion of diversification.”
He said that we are likely in a regime change and the tactics that worked over the last 10 years are not going to work over the next decade.
“Investing is a weird pursuit whereby the rules of the game depend on what everyone else on the pitch is doing,” he added.
Indeed, when investors piled into tech stocks, that changed the rules of the game for everyone as the starting price soared.
“When market and investors actions become more and more diverse from the fundamental valuations mispricing occurs,” said Brocklebank. “It’s the battle between psychology and economics.”
