Time to WAAAX off?

Sentiment and emotion play a huge role in the short-term pricing of equity markets, however the way to compound returns in equities over the long run is to invest with a margin of safety, in companies that consistently grow their earnings and dividends

As Benjamin Graham said, in the short run, the equity market is a voting machine, but in the long run, it’s a weighing machine. That remains accurate today.

The hardest aspect of investing is remaining patient and unemotional. It’s hard to retain discipline when you see others making money in stocks you don’t own and sectors you don’t understand.

My advice is to resist “FOMO”, the fear of missing out. This is not the time in the equity market cycle or economic cycle to give into FOMO.

While the biggest capital gains have been made in profitless new technology stocks, I believe global equity markets are starting to behave more like a weighing machine. That is NOT good for profitless, expensive, new technology stocks. Equity investors are more discerning and are simply not paying the lofty “valuations” that private investors were happy to subscribe in the private equity market.

We saw evidence of this when WeWork cancelled their IPO process this week. WeWork was “valued” at $47billion after the last round of investment from Japan’s Softbank Vision Fund. The IPO process appeared unable to even get a valuation of one third the previous round “valuation”. No wonder the vendors pulled it, particularly the highly geared Softbank Vision Fund which needs high exit prices to justify their entire investment strategy. This is a reminder of the potential dangers of pre-IPO unlisted investments that mark their “performance” to “valuations” based off the last round of equity invested. Illiquidity works both ways and there are attributes of a Ponzi scheme about many of these unlisted investment funds. Just remember, lobster pots are very easy to get into, but almost impossible to get out of…

The WeWork IPO cancellation shouldn’t have been a big surprise. The post IPO performance of UBER (UBER.US) and Lyft (LYFT.US) is evidence that the equity markets have become more discerning than the private markets in valuing still unprofitable technology stocks. The chart below confirms UBER is -30% since IPO and Lyft -42%.

Source: Bloomberg

This de-rating trend is spreading further to profitless food delivery stocks such as Grubhub (GRUB.US) which is down -61%, online real estate portal Zillow (Z.US) -53%, EV and battery manufacturer Tesla (TSLA) -25% and music streaming business Spotify (SPOT.US) -38% over the last 12 months to name a few examples.  Last night fitness start-up Peloton Interactive (PTON.US) closed down over 10% on its first day of trading to become the third worst unicorn debut since 2008 according to Bloomberg.

These may well prove to be good businesses, but they were clearly trading without a margin of safety. Even after recent falls, it’s impossible to argue any offer clear “value” yet.

The US equity market appears to be pivoting away from unprofitable technology stocks in favour of profitable and cash generative established platform stocks such as Microsoft (MSFT), Apple (APPL), Alphabet (GOOG) and Facebook (FB) to name a few. I think that is sensible as I see both valuation support and quarterly earnings growth confirmation pending (October) for those major US established tech names.

The point I am getting to today, is that there are a number of high growth, marginally profitable/unprofitable businesses listed on the ASX that have defied the broader de-rating of new technology stocks. Because genuine “growth” is hard to find in Australian equities, anything with growth gets priced very aggressively. That is fun while it lasts, but dangerous for those who are late to the party.

It takes very little for a stock that is priced for beyond perfection to disappoint and de-rate aggressively. 

When you buy with zero margin of safety this is effectively the risk you are taking. A classic recent Australian example is profitable, yet expensive, A2 Milk Co (A2M). In July, there was a competition between the broker analysts to see who could have the highest earnings estimates leading into the August result. My fund stuck to its process and sold out of A2M into this hype ahead of the result on valuation grounds. It turns out the day we sold our final stake was the day the A2M CEO was on the front cover of the AFR. What came next was a “not perfect” result, lowered margin guidance, and a -27% share price fall on the back of -12% EPS cuts by analysts. Yes, the stock fell double the EPS cuts, but that also occurs as P/E is simultaneously reduced to reflect increased uncertainty.

The A2M example should have been a clear warning shot for other highly valued next generation, low/no profitability names. I think it is prudent to be cautious on WAAAX names in Australia. They are all priced with no margin of safety and could all be subject to de-rating on delivery of even the slightest disappointment.

The market capitalisations of the WAAAX names are somewhat astonishing: Wisetech (WTC $11.3billion), Afterpay ($9billion), Appen (APX $2.6billion), Altium ($4.5billion), and Xero (XRO $9.3billion). Afterpay added $1b in market cap this week alone! The combined market capitalisation of the WAAAX names is a staggering $36.7billion. The current combined EBITDA of the WAAAX names is $324m according to Bloomberg consensus. For $26billion you can buy Fortescue (FMG) and $6billion of EBITDA!.. Ok, just making the point..

If the market turned from a “voting machine” to a “weighing machine” there would be a clear problem as profitability simply doesn’t support valuations. I again refer you to the recent US de-ratings example above.

In technology it’s time to get out of “concepts” and into “cashflow” is my opinion. Do you really need to take the capital risk in highly valued “concepts” when Microsoft (MSFT) has just raised its quarterly dividend by +11% and announced a $40billion buyback? I believe it is time to be cautious on private tech valuations, unlisted tech/VC funds, and the WAAAX names in Australia.

Peak cycle valuations have passed. Investors are becoming more discerning. The difference between public market and private market valuations is widening. It’s time for conservatism and a margin of safety in technology investments. That margin of safety can still be found, but it's right up the quality and duration curve in established technology companies.

My advice is to lose any FOMO you may have and consider the real capital risk you’re taking in paying unprecedented valuations for broadly unprofitable stocks at what is potentially the peak of the “valuation” cycle. It may be time to take some of the WAAAX off…

Invest with conviction, not momentum 

Aitken Investment Management looks to invest in companies with Financial Discipline & Balance Sheet Strength. Click the 'contact' button below to find out more.