Of Narratives and Fundamentals

In December 2021, we wrote a blog post on frothy valuations in the stock market. Since then, the stock market has indeed declined with technology stocks leading on the downside. Many high growth stocks have retraced most of their Covid gains and are down 50-80% from the highs.

We now believe it is time to buy these disruptive and innovative businesses.

We are almost at the two year anniversary of the Covid market bottom. The stock market bottomed on the 23rd of March 2020 and then went on a tear led by central bank intervention. This bull market and the accompanying market speculation were led by growth companies; many of which produced awe-inspiring returns for investors (at least for a while…).

“The intelligent investor is a realist who sells to optimists and buys from pessimists.”

- Benjamin Graham

These have been very difficult markets to navigate for most value investors. They watched in awe as companies such as Zoom, Peloton and others rose to eye-popping levels led by narratives such as ‘covid beneficiaries’ or ‘disruptive tech’. It was also perceived a lot ‘cooler’ to own these high flyers vs. something like Berkshire Hathaway. The value investor's horror was further exacerbated by the fact that all this made a lot of sense! These companies are in fact very disruptive and have long runways of growth.

Value investors are typically diligent and deliberate. From their perspective, there were two big problems with these growth stocks. First, it takes some time to ascertain if the business has a durable competitive advantage. During Covid, it was difficult to truly understand if a company was benefitting from temporary or permanent factors. Without a durable competitive advantage the company's future prospects are vulnerable to competitive attacks by other well funded players. Second, valuation for these businesses was very high. Mr. Market had, in fact, determined that these companies will experience high and durable growth for many years into the future and reasoned that it was appropriate to pay up for this growth.

“Many mistakes have been made in buying growth stocks on the theory that the future will duplicate the past.”

-Benjamin Graham

Lets see how these stocks have done in the last two years compared to Berkshire Hathaway:

We see that since the 1st of April 2020, Berkshire has appreciated 97% compared to 58% for ARKK ETF, 50% for Shopify, and -20% for Zoom. One would have been better off just investing in Berkshire Hathaway!

What are our lessons from this saga?

First, narratives matter in the short term but fundamentals matter in the long term. These narratives often lead to short term flows and momentum that further intensify these moves. Without a deep understanding of the business, its quality and valuation, these markets can easily whipsaw an investor.

Second, Covid has indeed accelerated a lot of trends. The fact is that technology has increasingly become a bigger part of our lives. Businesses do need to modernize and increase efficiency in order to stay competitive. Software, as they say, is eating the world. We believe these trends are real and will provide a nice tailwind for these businesses for many years to come.

Third, and most important, valuations matter! Do not chase stocks!

Today, value investors are rejoicing as they escaped the worst of the growth stock declines. They feel much like they did after the tech bubble burst in 2000 when they were proven right and rewarded for ignoring tech stocks. Surprisingly, many value investors never made the effort to understand these businesses.

We, at White Falcon, disagree with this stance.

We believe that, as long as the business is in our circle of competence, it does not matter if the business is tech or non-tech or if the business has low P/E or high P/E or even if the business is currently profitable. In each situation, we look to understand the business, its unit economics, its competitive advantages and its valuation based on the cash flow this business will produce in perpetuity.

“Growth and value investing are joined at the hip”

-Warren Buffett

Let us give you an (extreme) example: Tesla.

Tesla is a controversial company that is disdained by both value investors as well as short sellers. Perhaps for good reason! We don’t have a view on the stock or an opinion on the business. But, here is a thought exercise: in 2018 Tesla had a stock price of $65 per share, a market capitalization of $53 bn and an enterprise value (includes debt) of $63 bn. In 2021 - three years later - Tesla produced an operating profit of $6.5 bn and an earnings per share (GAAP EPS) of $4.90. This means that in 2018, Tesla was trading at EV/Op Profit of 9.7x and a P/E of 13.2x three year forward earnings.

Was Tesla not a value stock in 2018?

Similarly, there are many other businesses that are operating in industries with secular tailwinds run by savvy founders. Some of these businesses produce very little current earnings due to which they are called ‘profitless tech’ companies. It is important to understand that these companies choose not to turn a profit today in order to invest in growth. Some of them, unlike Tesla, are less controversial and easier to understand.

We believe some of these growth companies are finally available at reasonable valuations. The average multiples have come down from the very high levels of 2021 and is closer to their 5 year averages. Today, an investor does not need to make very aggressive assumptions in order to get an estimate of intrinsic value that is close to their market price.

But, what about interest rates? Surely, increasing interest rates is bad for growth stocks? Overall, we believe it is real rates (nominal rates minus inflation) that matter and these rates are still deeply negative. While many lower quality growth companies will indeed have trouble staying afloat, the market is painting all growth companies with a broad brush. Hedge funds that owned these companies have been forced to divest of their stakes at any price due to de-leveraging and redemptions.

In this environment, White Falcon has been finding higher quality growth companies that meet our quality and valuation criteria. We may be early in our endeavor but we believe that these businesses, if held for 3-5 years, will produce superior risk adjusted returns.