It is time to shift focus back to free cash flow, valuation, independent research, and risk management.
In the age of TINA (there is no alternative), market participants were piling into stocks with valuations that didn’t make sense. It was painful to watch because the endgame always is the same: many of the hottest performers during the hype become the biggest losers during the crash, and many people get burned financially.
Attitudes change after such an experience. Folks typically take time to return to the most speculative pockets of the market. Many never return. Focus shifts back to basics: fundamentals, valuation, doing your research, and risk management.
Until next time, that is, when a new generation eagerly repeats the same mistakes. While knowledge in hard sciences accumulates over time, in financial markets, it doesn’t. No real progress is made. The market pendulum ensures that disciplined investors cumulate wealth, while gamblers and bettors, as a group, lose money.
The tide has turned
Going into 2021–2022, so-called ‘growth’ or ‘glamour’ stocks had stunning 10-year returns and sky-high valuations. That sets up for disappointment. And it did. From tech to SPACs to cryptos and meme stocks, the dominoes have fallen since autumn of 2020.
Over the past two years, there has been a trend change that favors the value-driven investor. Stocks with low valuation multiples have outperformed growth stocks globally. And value cycles can be multi-year phenomena.
On some measures, the valuation differential between growth and value stocks is still at extreme levels, even at dot.com bubble levels. It leaves ample room for further mean reversion going forward.
Regime shift
A regime shift towards company fundamentals and valuation discipline is healthy. It is how rational investors are supposed to behave. Market participants are finally returning to free cash flow, as stipulated by the basic pricing equation of finance, instead of relying on performance charts, salesmanship, or innovative metrics that try to conceal that stock prices are based on unrealistic assumptions about future profitability and revenue growth.
CEOs are also taking notice. According to CNBC, in May 2022, after “super clarifying” meetings with investors, Uber’s CEO sent an email to personnel stating, among other things: “It’s clear that the market is experiencing a seismic shift, and we need to react accordingly… We have made a ton of progress in terms of profitability, setting a target for $5 billion in Adjusted EBITDA in 2024, but the goalposts have changed… Now it’s about free cash flow.”
Structural macro tailwinds
Economist John Kenneth Galbraith had a maxim: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” Although I’m firmly in the first camp, it doesn’t always stop me from hypothesizing about future macroeconomic developments. I’d assign a significant probability to a long-term capex boom in the West.
Take two examples, the climate emergency and de-globalization (a.k.a. the re-establishment of friendly supply chains). The West doesn’t have enough energy assets or manufacturing capacity to solve these problems.
The next decade isn’t only about eyeballs or apps; it is about building electricity grids, chip fabrication plants, and manufacturing capacity. Smaller domestic companies and industries such as materials, energy, machinery, manufacturing, and construction will likely benefit. And while startups may innovate, established firms build. In the spirit of Mark Twain: in a gold rush, it pays to sell shovels.
Neglect valuation at your peril
The trend change in stock prices in favor of value investing is already in its third year. With a high growth-to-value-spread leaving ample room for further mean reversion, a regime shift towards free cash flow, and a potential capex boom that benefits traditional industries, valuation discipline is a habit you neglect at your peril.
Hans-Kristian Sjöholm
