SINGAPORE (Feb 19): As volatility in global equity markets extends into the second week, there is plenty of anxiety to spread around. According to Bloomberg, some US$23.8 billion ($31.5 billion) was pulled from equity funds, the bulk from exchange-traded funds (ETFs), from Feb 1 to 7 alone. That was one of the largest weekly outflows on record.
Valuations are back in focus, something that investors have largely turned a blind eye to as long as markets were rallying. Yes, the economy is humming along, consumer and business confidence is high and corporate earnings are beating expectations. But share prices have run ahead of underlying fundamentals, lifting benchmark indices to record after record highs — levels that are, even now, still above their long-term averages.
One of the most vulnerable sectors in this current selloff has been technology, the darling for so many investors for so long and among the most expensively priced stocks, at least in price-to-earnings (PE) terms.
Having led the rally over the past year, these stocks are now leading the way down. Some even draw parallels to the dotcom bubble in the late 1990s.
Six of the largest tech companies in the world — Apple, Amazon.com, Facebook, Microsoft Corp, Alibaba Group Holding and Alphabet —
have collectively lost US$288 billion in market cap since the Dow Jones Industrial
Average and Standard & Poor’s 500 index closed at record highs on Jan 26.
There is no doubt that these tech stocks have performed remarkably well. The real question is “Are they trading at bubble valuations?”
True, most are trading at PE multiples that are well above market average. But as I have said before, the absolute level of PE in abstract is next to meaningless. They have to be read in context, that is, relative to the company’s prospective growth and future incomes.
Here is my favourite EV/Ebitda and five-year Ebitda growth chart (see Chart 1). The six tech stocks (mentioned above) are trading at rich EV/Ebitda multiples — averaging 21.2 times — but it is also important to note that their average five-year Ebitda compound annual growth rate is a high 35.2%.
Let’s compare these with valuations and growth for the current DJIA component stocks (see Chart 2). Twelve of the 30 stocks actually recorded negative Ebitda growth over the past five years, whereas those with positive growth saw rates mostly below 10%. Yet, they are trading at EV/Ebitda of 13 times on average. And how does this compare historically?
In 2005, the DJIA component stocks were trading at a lower 10.6 times EV/Ebitda on the back of higher operating profit growth of 4.1%, on average (see Chart 3).
Of the 20 stocks that have remained a fixture on the DJIA over this period, 15 were trading at lower valuations back in 2005. Their EV/Ebitda averaged just over 10 times, while five-year Ebitda CAGR was 6.1%.
Clearly, the numbers are telling us that, if anything, it is the non-tech stocks that are currently overvalued! And that this was not the case in 2005.
Why is this so? The most obvious answer is passive funds, whose popularity skyrocketed over the past decade. The amount of money invested into ETFs more than doubled since 2009, after the global financial crisis.
As I mentioned previously, passive funds such as ETFs chase stocks in the underlying indices without regard to valuations, earnings, business risks or outlook. That is the definition of a bubble in the making.
As long as markets are rising, investors will keep throwing more money at these funds, attracted by their cheap costs. Gains beget more gains.
As with most bubbles, we will not be able to predict when the bubble will burst or what will be the trigger. It could be the relatively obscure (and little understood) volatility-linked ETF products that collapsed so spectacularly two weeks ago. Or it could be some other events in the future.
The point is that the risk is real. Once the trigger event happens, investors will all rush to the exit at the same time. Because of the concentration of risks in those ETF-held stocks, prices will drop sharply when liquidity (driven by passive funds themselves) disappears. There will be a snowball effect; the falling indices will lead to more redemptions and further selling.
As is the case when prices are rising, the selling will be indiscriminate and made without regard to underlying fundamentals.
Table 2 shows the collective shareholdings of the 10 biggest ETFs in the longstanding 20 DJIA stocks, which have risen manifold in a little over a decade. And these figures are actually an understatement, since we added holdings for only 10 funds. The actual shareholding of ETFs will be larger, as there are plenty of smaller-sized funds in the market.
My Global Portfolio fell 1.8%, for the second straight week, mirroring the continued selldown in markets. This pared total portfolio returns to 2.5% since inception. Nevertheless, we are still outperforming the benchmark MSCI World index, which is now down by 1.2% over the same period.
I took advantage of the recent selloff to buy more shares in Shanghai Haohai Biological Technology Co. This raised our total amount invested to levels similar to the rest of the stocks in the portfolio. We took a smaller bite earlier, as we are investing in a smaller, lesser-known company and are therefore more cautious on its potential.
But Shanghai Haohai has been doing well, expanding into the ophthalmology high-value materials industry to drive top-line growth and maintaining relatively high gross margins. Thus, we decided to up our stake in the company.
Finally, I would like to wish all readers a Happy and Prosperous Chinese New Year.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
