The Persistence of High-Priced Stocks Sitting on High Hopes

Tesla PS Ratio: A Stock Price & Market Capitalization Problem Owned by the Many

I’m staring at a list of stocks in the S&P 500 Index.  The results are sorted by their weighting in the index from largest to smallest.  At a 6.97% weight, Apple is at the top.[1]

To the right of each stock are 100s of columns of data showing the various metrics we calculate to measure valuation and firm health.  The spreadsheet is our most basic.  The fuel for our model portfolios designed to exploit investors’ documented behavioral errors.  These errors manifest themselves in inefficient markets.

Despite the recent correction, the opportunities for active managers are still vast.  Predictably, the fanaticism of indexing has created a toxic brew for its adherents.  We believe cheap beta is an incredibly important tool.  But a disciplined active manager has only had it easier at the peak of the dot.com bubble.  Let us explain:

The top 10 stocks in the S&P 500 represent 29.7% of the index.  Nearly a third of every dollar you invest in that index is going into just ten stocks.  The value-weighted average price to sales ratio is 7.3x.[i]  Madness.

Tesla stock price to sales ratio is the number one contributor to that offensive valuation metric.  The vaunted maker of electric vehicles sported a 14.5x multiple with a 2.44% weight in the index.  What follows is not an indictment of Tesla.  We offer another simple question to the index-funds-only crowd: why the dogma?

This newsletter has generated massive empirical evidence around the idiocy of paying 10x sales for a stock. Scott McNealy’s quote on Sun Microsystem’s stock is the “anchor” concept.[2]  Very simply: 10x is too much!

The chart below shows the weighting in the S&P 500 Index of stocks valued at over 10x P/S.  For any advisor or FA who has bought into the dogma of “only indexes” we ask you: do you think having dot.com levels of painfully inappropriate valuations in your clients’ portfolios is a good idea?  If so, why?

Another Problem Faced by Index Funds is the Highest Weight of Indefensible Valuations Since 2000

The Price to Sales Problem Looms Large

As most investors have noticed, markets have begun to fall.  After what some have suggested are 40 years of ever-larger policy mistakes, the bill is coming due.   With CPI soaring, the Fed halted their “QE” and suggested they would be selling $95bn of assets per month in a tapering function to shrink their bloated balance sheet.

$95bn sounds like a lot of money until you remember their balance sheet is $9 trillion.  Just hitting the “pause” button on the buying with a miniscule rate hike has sent stocks and bonds into a spiral.  We are glad we are not the Fed.  Recession, inflation or some ugly combination seems increasingly likely.

Cramer hosts folks calling a market bottom while others suggest the losses will continue.  This newsletter and the investment products run by the Fund Managers who author this work, do not time markets.  Plenty of other ways for us to look foolish.  We do, however, believe in algebra and the lessons of financial history.

Valuation is a horrible timing tool but, as we have shown, it has been a remarkably effective forecaster of realized 10 year forward returns. By November of 2021, Buffett’s market cap to GDP metric had hit an incredible 234%.  A level that swept past the previous peak of reckless speculation in 2000.

As the chart below shows, the sell-off to date has cut valuations to 184% of GDP.  That is still a level well above the peak of the dot.com mania.   The Fed may need to buckle to the recessionary pulses we see around us, but as George Noble explained at minute 8 in this video, the choices in fixed income are as difficult as in equities.

Recent Declines Cut Valuations from All Time Records… But they Are Still Above the Dot com Peak

With valuations still above dot.com levels and over 20% of the S&P 500 Index weight in stocks priced at a level with little if any precedent for generating durable returns, we believe this matters.  A lot.

For the purposes of the table above we did use the latter method. Specifically, we took all the stocks with a sales to price ratio of 0.10 or less, calculated a value-weighted average and then using the reciprocal to get the 13x you see above.  Were we to use a method of value weighting P/S multiples, the value would have been 14x.

YOU ARE NOW READING BASIC MEMBER LEVEL CONTENT

The Dot.com Precedent & The Fate of 10x Price to Sales vs The Rest

The chart below is simple.

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  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
[1] The data sheet I was looking at happened to be monthly, numbers are as of April 29, 2022

[2] Enter this into google search: “Kailash Concepts” “10x price to sales” if you want to see our archives on this

[i] This observation was made using a value weighting of the top 10 stocks’ calculated Price to Sales ratios.  We readily acknowledge that starting with “PS” and multiplying by weights will generate different values than using sales to price ratios, value weighting the collective sales to price ratios and then flipping them to a “P/S ratio.”  Using this method, the top 10 stocks had a PS ratio of 4.1x.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

May 27, 2022 |

Categories: Quick Takes

May 27, 2022

Categories: Quick Takes

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