Burry v. Wood

by Justin Lowry, President & CIO, Global Beta Advisors, LLC

Recently, Michael Burry, who famously took short positions in mortgage-backed securities in 2007 while he was running Scion Capital, announced that he recently opened short positions on the Ark Innovation ETF (“ARKK”). His thesis is that the fund represents the unsustainable and frothy valuations that have been observed in the market over the past 12+ months. Of course, this elicited a retort from Ark Invests’ founder and CEO, Cathie Wood. Her contention is that disruptive technology, which may provide generational advances, cannot be measured by traditional valuation metrics, and therefore, his thesis against ARKK is off base.


10-Year Forward Looking (1/1/1985-12/31/2020)

10 Year Forward Returns

Source: Data from FactSet Research Systems


This begs the question: who is right? Well, time will ultimately tell who is making the correct assumption. However, this debate raises the question as to whether all companies should be valued the same way. It is Global Beta’s opinion that most companies with frothy valuations will ultimately collapse under their own weight, however, that should not necessarily dissuade investors from companies that may evolve into a generational company such as Amazon or Apple. As is the case with all investments, investors must keep in mind that for every Apple, there are 1000s of AOLs. To examine this perspective further, let’s look at how the broad market reacts over time to valuations. The previous chart is a regression analysis of the S&P 500 Index, plotting out the index’s monthly price-to-sales ratio from January 1985 through December 2020 and measuring the corresponding forward 10-year return.

As you can see, there is an 86% correlation between the price-to-sales of the S&P 500 Index and its 10-year return horizon. What we glean from this chart is that the periods when the price-to-sales of the S&P 500 are on the lower end of the spectrum, the index has achieved higher returns and vice-versa. Where do we currently sit and how far off the spectrum are we?

As you can see, valuations have now exceeded levels observed in the “tech bubble” era of the late 90s into early 00s.  As you can see, the price-to-sales mutliple in the S&P 500 peaked at nearly 2.5 during the tech bubble.  As of 07/31/21, valuations are nearly a full point beyond the peak of the tech bubble.


Historical Monthly P/S of the S&P 500 Index

Historical Monthly P/S of the S&P 500 Index

Source: Data from FactSet Research Systems. January 1985 through July 2021.



10-Year Forward Looking Returns – Invesco Nasdaq 100 ETF (March 1999 – July 2021)

10-Year Forward Looking Returns - Invesco Nasdaq 100 ETF (March 1999 - July 2021)

Source: Data from FactSet Research Systems


As of 07/31/21, the S&P 500 was sitting on its highest price-to-sales multiple going back to January 1985 at 3.34.  By this analysis, the point goes to Burry as the broad market (defined as the S&P 500 Index) is realizing extraordinary valuations relative to historic norms, and that has historically been negative for the index’s return outlook.  However, Cathie makes a good point – disruptive technology may provide growth rates that would justify today’s valuations.  Therefore, simply looking at the market on a broad scale through the lens of the S&P 500 Index may not provide us with a full picture.  Therefore, we would want to proxy the disruptive technology segment of the market to provide us an indication on how it responds to growing valuations over time.  The Nasdaq 100 Index provides the best representation of disruptive technology on a historical basis.  The previous chart is the same analysis we did with the S&P 500 Index but applied to the Invesco Nasdaq 100 ETF (“QQQ”).

While the bounds of valuation are higher and wider with the Invesco Nasdaq 100 ETF than the S&P 500 Index, the relationship is similar.  Although the history is shorter than what is available for the S&P 500 Index, we still see a roughly 89% relationship between the price-to-sales multiple of the Invesco Nasdaq 100 ETF and its forward 10-year returns; indicating better performance when valuations are on the lower end of the spectrum and vice-versa.  To be more specific, as you will see, every period that the Invesco Nasdaq 100 ETF has a price-to-sales multiple above 6 ended with a negative forward 10-year return.  This would also favor Burry’s contention that valuations and mean reversion do apply, even for technology companies.  Based on our research, there is a point where stocks of any kind become too rich for investors, which is difficult for investors to conceptualize in the current environment as investors have seemingly become captivated with the euphoria of exponential growth.  Where does the current multiple for the fund lie today and how does it stack up with its history?


Historical Monthly P/S of the Invesco Nasdaq 100 ETF

Historical Monthly P/S of the Invesco Nasdaq 100 ETF

Source: Data from FactSet Research Systems


As you can see, the Invesco Nasdaq 100 ETF is currently short of the peak levels observed during the late 1990s, however, it is currently sitting at its highest level since that time and above a price-to-sales multiple of 6.

With that said, just because a stock is nominally expensive today doesn’t mean it cannot grow into its valuation over time.  As St Joseph University professors, Morris Danielson and Amy Lipton, opined in their research paper, “Are Some Stock Prices Destined to Fall?”, there is a growth rate expectation for stocks to achieve if they are to justify their current price-to-sales multiples.  Their model computes the price-to-sales multiple, expected operating margins, and expected dividend payments of a company against an expected rate of return over a defined period time to determine the annualized sales growth needed to justify the company’s multiple.  This is contemplated such that companies with lower price-to-sales multiples, higher margins, higher dividend payments where the expected rate of return is modest do not need to grow their sales as much as a company in the opposite circumstance.  Below is the equation we are referring to:

growth rate expectation equation

Sr+1 = 12-month trailing sales at the end of the terminal period
S0 = Current 12-month trailing sales
P0 = Current price-to-sales
t+1 = Expected Operating Margins at the end of the terminal period
R = expected annualized rate of return
D = dividend yield
T = terminal period

Examining Netflix

As an example of this equation, let’s examine Netflix (“NFLX”).  Below is each metric of the equation for Netflix as of 7/31/21:

Sr+1 (in millions) = $110,588.67
S0 (in millions) = $27,585.14
P0 = 8.94
t+1 (based on current margins) = 63.3%
R = 9%
D = 0
T = 10

Annualized Growth Rate Needed over Terminal Period = 14.90%

Examining Zoom

To bring context to this, let’s evaluate a stock that is considered more of a disruptive technology company, Zoom Video (“ZM”):

Sr+1 (in millions) = $81,188.07
S0 (in millions) = $3,279.44
P0 = 35.21
t+1 (based on current margins) = 31.6%
R = 9%
D = 0
T = 10

Annualized Growth Rate Needed over Terminal Period = 37.84%

Based on the above metrics, Netflix would have to grow its sales annually by about 15% over the next 10 years to justify its current price-to-sales multiple.  Based on Netflix’s historical sales growth rate, 15% year-over-year sales growth seems attainable in our view.

As you can see, based on the above metrics, Zoom would need to grow its revenues by an annual rate of nearly 38% over the next decade.  While Zoom has demonstrated extraordinary growth over the past 12-18 months, we believe that as the pandemic subsides, demand will naturally come down.  The question becomes what does a post pandemic world look like now that it has been demonstrated remote video communications are an efficient and effective way of doing business?  The other variable is Zoom’s competition.  As it stands now, Zoom has very little competition in a space with demand that is certainly calling for more competitors.  We believe a 38% average annualized growth rate may be difficult to achieve over a 10-year period.  In our opinion, betting on Netflix to achieve a 15% annualized growth rate is far more attractive and probable than Zoom achieving a 38% annualized growth rate over the same period.

However, some of the disruptive technology companies that Ark Invest prides their research on are not profitable and have a lot of work ahead to scale their businesses.  Therefore, it is a challenge to measure valuations for those companies, and thus, they become a riskier proposition, particularly for long term investors.

What does this all mean?  Investors certainly can’t discount the value of disruptive technology companies, however, in aggregate, growth companies tend to have very modest outlooks after significant price appreciation, particularly in a short period of time.  It’s important for investors to carefully consider companies with high valuations on a stock-by-stock basis.  Global Beta makes it a point to add inputs in our investment methodology, such as the formula outlined above, to reduce overall portfolio valuation, even in high growth segments of the market.  It’s important to participate in stocks with higher growth prospects, but we believe investors should select companies that they believe can sustain growth rates relative to what the company needs to grow to return shareholder wealth.

 


 

Definitions

Price-to-Sales – the current market capitalization of a company divided by its 12-month trailing sales.

R2 – the proportion of variation between one variable and another.

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