Anchor your portfolio in quality
What is behind the weakness of the technology … the right way to navigate it … a “quality orientation” is crucial for all portfolios today
As I write on Monday morning, the tech pain continues.
Let’s do a quick MBA 101 to make sure we’re all on the same page with what drives it.
In theory, the value of a stock is equal to the net present value of a company’s future cash flows plus the value of its assets according to the company’s balance sheet.
To determine this “net present value of future cash flows”, we use a discount rate. This discount rate usually correlates with the prevailing bond yields.
The higher the returns, the higher the discount rate. Mathematically, a higher interest rate decreases the present value of future cash flows.
Technology growth stocks get the majority of their value from those future cash flows (rather than tons of hard assets like machines on their balance sheets).
So the higher the returns and the higher the discount rate, the lower the “net present value” of growth stocks.
And that translates into lower stock prices for technology companies.
If we follow these breadcrumbs it will lead us back to bond yields.
*** The recent spike in yields was triggered by the Fed’s minutes of its December monetary policy meeting released last week
Those minutes sounded more restrictive than some investors expected. Many believe there will be a rate hike as early as March.
This fear accelerated the rise in 10-year government bond yields that began in late summer. The rate of return has just topped 1.8%, which is a new high from the pandemic era.
As you can see below, the yield is up 42% since August. About 16% of that surge has occurred in 2022 so far.
Therefore, higher bond yields typically translate into lower prices for rate-sensitive growth stocks. And that’s exactly what happened to technology.
See below how the tech-heavy Nasdaq index started moving up and down from late November. The deflections in the circled area are about 6%.
Not too easy on the nerves.
*** But if similar sell-offs repeat themselves in the past, we may be nearing the bottom
The interest rate-driven sell-off of hyper-expensive tech stocks has nearly run its course if past shocks are any indication …
This is how Morgan Stanley estimated, who compared the slaughter in technology that began in December to the five previous cases in which rising government bond yields triggered similar defeats.
In that, a basket of highly rated tech companies fell an average of 18% from high to low – that’s now 15% in the latest episode.
Morgan Stanley’s analysis came before today’s 2.5% sell-off on Nasdaq (as I write). So it is likely that we are very close to this mean “tumble” level from the analysis.
Even as we near the bottom of selling pressures, it’s important to make sure you are holding only the best technology today. This means that you are staying away from “profitable” technology. You want high quality, profitable, high cash flow companies.
Our hypergrowth expert Luke Lango had this point in his last week Early stage investor Daily Notes:
Put particular emphasis on profitable companies.
This is the show me the money year. With monetary conditions tightening, investors are unwilling to take huge leaps of faith in companies that promise to make money tomorrow.
Rather, they are only buying stocks in companies that are making profits today. We believe that profitable stocks will outperform unprofitable stocks in the next few months.
In the meantime, join the “Escape to Quality”.
The recent trades can be described as a flight into low-risk, high-quality assets. We suspect that this flight to quality will continue.
Focus on companies with strong balance sheets, great cash flows, and high gross profit margins.
*** To see why this focus on earnings and fundamental strength is important, take a look at what happened to speculative technology stocks
Below we take a look at a chart from Morgan Stanley and Bloomberg that started last summer.
What you see is the percentage change in: 1) “expensive software” stocks, 2) “profitless technology” stocks, 3) “crowded stocks of hedge funds”, and 4) the S&P 500.
While the S&P has risen to nearly 10% during this period, “profitless technology” has been knocked down with a loss of 30%.
Back to Luke to learn how to manage the risk of further technical weaknesses when we enter an environment of rising interest rates:
Overall, we believe that protecting against short-term market volatility over the next few months requires an emphasis on high-margin, high-money, liquid technology companies with relatively low valuations.
*** Generally speaking, an “escape to quality” is a wise decision for all sectors, not just for technology
We all know that the broad market is trading at high valuations.
But I want to give you an additional, simplified perspective that could bring this home in a different way. Don’t be scared – it’s just a perspective on the market.
Below we look at the S&P 500 starting in 2009. This corresponds to the recovery from the global financial crisis.
I tried to fit a trend line on the chart. This trend line tries to track the median of all values in the diagram in such a way that half of the measured values are above the trend line and the other half are below.
I’ve circled what has happened since 2021. In short, market prices have climbed above the long-term trend line much higher than usual.
Well here’s the punch line …
If the S&P falls from its (as I write) level of 4,586 to its approximate trendline level of 3,800, that would be about a 17% loss.
And if you have a problem with where I drew the trend line I would suggest that engineering precision isn’t that important. As legendary investor Benjamin Graham once said, “You don’t have to know a man’s exact weight to know he’s fat.”
Whether we are talking about a 17%, 15% or 12% decrease, the point is the same …
The S&P is well above its long-term trend line than usual.
And remember, a mean reversion of 17% would only bring the value of the S&P back to its long-term trendline level.
Now look again at the table …
The last time we saw any significant spread between S&P price and its long-term trendline was 2013-2015. After this period of relative outperformance, the S&P returned to its trendline.
Over a period of roughly 7 months, beginning in the summer of 2015, the S&P lost nearly 15%.
Remember, this fall drove S&P down under its trend line. Our prospective 17% decline could happen if the S&P only finds support on its trendline – without falling below it, which would be perfectly reasonable.
The bottom line is that the S&P could fall 17% tomorrow and the multi-year history of growth in the market wouldn’t even take a bite … although many portfolios would.
*** Now, this doesn’t mean panicking and selling all of your stocks – starting with your technology stocks
The market can continue to rise. That is by no means unrealistic.
And if you’re selling now, how do you know when to get back in? There are tons of studies out there highlighting the almost impossible challenge of timing the market correctly.
And even if we are faced with a correction, it is important to see the big picture.
Back to high-quality technology companies as recommended by Luke, these companies are shaping the world of tomorrow. Yes, their stock prices could fall in the short term during troubled times, but this decade will see their dominance return.
These periods of weakness are normal and patience is essential.
Back to Luke:
You can hardly make a difference in America without coming into contact with Amazon, Apple or Microsoft. They are among the most successful companies in US history. Their rising market values have made many people very rich.
However, these incredible companies didn’t hit the world in a day, week, or even a year. It took them years and years to go from small to dominant.
Only their patient shareholders made that big money.
Even the largest companies need time to “gain” and let the compound returns do their thing.
As investors, we should keep this in mind … be patient with great companies … think long term … have reasonable expectations of our holdings … and Snowball on our way to prosperity.
I add that every stock Luke just mentioned has seen sharp double-digit declines over the past several decades. That’s just the name of the game.
In the short term, your best protection against volatility is a portfolio that includes companies with strong profits and reliable, growing cash flows. And especially today, it is companies that can raise their prices to offset inflation while maintaining their margins and profits.
But the bigger recommendation is to remember for the long term. If you have a long investment schedule and are invested in high quality stocks like the ones Luke recommends, patience, not panic, is your recipe today.
Have a nice evening,