Fancy buying some beaten down former growth stock darlings? Be careful. An image of the proverbial falling knife going through a hand comes to mind.
These type of fallen stars such as Zoom and Peloton often cascade downward much further than many expect once all of their fans have long since departed.
Value hunters can quickly all into value traps.
Verdad Capital, founded by portfolio manager Dan Rasmussen, devised the Bubble 500 list in the middle of 2020. They admit they were early in calling a bubble but have nailed it since then.
Here’s an update on Verdad’s Bubble 500, and why these stocks are still too risky to buy.
With excerpts from Josh Brown, The Reformed Broker
Over at Verdad Capital, Dan Rasmussen revisits their “Bubble 500” list of overpriced growth stocks, originally created in the Summer of 2020.
It’s filled with money-losing companies working in exciting areas of technology such as electric vehicles and gene editing therapy and so on.
Needless to say, this list of bubble stocks has gotten absolutely destroyed year-to-date, after having run straight up in Verdad’s face through the middle of 2021.
Dan explains two very important things in his update this week: The first is that sell-offs for growth stocks differ from sell-offs for value stocks in one very important way:
This breakdown is significant, especially for growth stocks. Remember, growth stocks trend, and value stocks mean revert. The psychology is simple.
People hear about a hot stock that’s gone up 3x, they buy some, it goes up 2x, they buy more: the whole attraction of buying a hot growth stock is the historic return trajectory.
Value stocks are the opposite: you do well buying them when they’re down.
This idea is counterintuitive – that some stocks actually become worse buys as they are falling to lower prices, but the explanation is psychological, not financial.
Stocks trading at excessive valuations require a fan base to sustain their share prices. That fan base is often a bandwagon-jumping melange of traders and investors who are attracted to recent gains.
Yes, they’ll latch onto the fundamental story, but the fact that the stock has been and currently is going up is the main thing. When the stock breaks, so too does the fandom.
And when the fan base moves on to greener pastures or runs out of money, a new fan base will not form for this stock with its chart in decline.
Broken growth stocks become orphans. There is no natural place for them to find a home.
Dan’s other point is equally important:
There’s a lot of room between where a broken growth stock can fall from and where a more value-oriented buyer might be compelled to take a look.
In the case of the Bubble 500, you could drive a truck through current valuation and an attractive entry point for fundamental investors, even after the recent plunge!
And so, once the trend gets broken, once the magic of the rising stock prices disappears, it’s a long way down until valuation becomes the justification for buying.
There are growth investors who want to buy hot trendy winners and value investors who want to buy bargains.
And there’s a long way between a 12.2x revenue multiple and, say, the sub-7x EBITDA multiple that Verdad and other deep value investors love.
Spreads between growth and value, in fact, are near all-time highs, which bodes poorly for growth once the crash gets underway.
Figure 3 shows the ratio of the EV/EBITDA multiples of the most expensive three deciles of US stocks to the cheapest three deciles of US stocks since 2015.
And the Bubble 500 stocks still trade at wild valuations:
- FuelCell trades at 16.8x revenues.
- Blink Charging trades at 44.3x revenues.
- MicroVision trades at 161.3x revenues.
- The median company trades at 12.2x sales, offers a -2.5% earnings yield, -7.5% return on assets, and -14.0% net income margin.
- Analysts remain bullish, assigning the median Bubble 500 company two-year forward revenue growth estimate of 20.8%.
The last word goes to Rasmussen at Verdad:
We called this bubble too early. And we admit it. And perhaps we’re wrong again here. But growth has had such a good run the last decade, and the excesses are just starting to be purged.
It’s not hard to imagine a scenario where this rout becomes a replay of the early 2000s tech bubble bursting, all of which would suggest highly valued growth stocks could have a ways further to fall.
Related stories: Bubble Spotter Grantham on What to Do Now As the Wild Rumpus” Begins