Author: Jeremy Chia

Investors who have had a vested interest in high-growth stocks in the past year, myself included, have (to put it mildly) experienced steep drawdowns.

This begs the question, did we overpay for these companies? 

Many high-growth stocks in early 2021 were trading at high valuations and it was not uncommon to find such stocks trading at price-to-sales (P/S) multiples of more than 30. Their P/S multiples have since collapsed. Was that just too expensive or are multiples too cheap now?

Mapping the future

To answer this question, we need to make certain assumptions about the future. Let’s make the following conservative assumptions.

First, in 10 years’ time, a company’s valuation multiple will contract and will then trade between 25 to 40 times free cash flow. Second let’s assume the business in question can have a 20% free cash flow margin by then.

The table below shows a scenario of a company that initially had a P/S multiple of 50 and managed to grow revenue by 40% per year for the subsequent 10 years.

Without diving too much into the details, in the above scenario, I worked out that investors who paid 50 times revenue for the company would still enjoy a nice gain on the investment in 10 years of between 60% and 180%(depending on the free cash flow multiple it trades at in the future).

To be clear, I also included a 3% annual increase in share count to account for stock-based compensation which is commonplace for high-growth companies.

Looking at the table above, we can see that just because a company traded at a high multiple, does not mean it is doomed to provide poor returns. If the company can keep growing revenue at relatively high rates while eventually producing a healthy free cash flow margin, investors can still make a respectable return.

Bear in mind, many of the companies that were trading at 30 times revenue or higher in 2020 actually achieved faster growth rates than 40% in 2020 and 2021. This means their future revenue growth rates can fall below 40% for investors to still achieve fine returns.

It is also worth pointing out that many companies that were trading at high multiples also command high gross margins and have the potential for higher free cash flow margins than 20% (which was my assumption in the example above) at a mature phase. This means that even if the company grows revenue at a slower annual pace than 40%, investors could still make a handsome return.

Sieving the wheat from the chaff

Although the above calculations give me confidence that paying up for a company can provide good returns, not all companies have such durable growth potential.

During the bull run of 2020, there was likely too much optimism around mediocre companies. These companies don’t actually have the addressable market or the competitive advantage for them to keep growing to justify their high valuation multiples. These companies will likely never be able to return to their peaks.

When paying a high price for a company, we need to assess if the company has a high probability of growing into its valuation or if it is simply overpriced.  

Final thoughts

Just because stock prices are down now doesn’t mean those who paid a high price would not eventually yield good results. Zoom-out and look at the long-term picture. If a company can keep growing its business, then a high stock price may be warranted and still provide very respectable long term returns.

But at the same time, be mindful that not all companies will exhibit such durable growth. Make sure to assess if your companies are the real deal or just pretenders.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time

What if I told you that you could invest in a stock at a $90 price today and sell it for more than $3000 in 22 years time? You’d probably bite my hand off for such a deal.

That’s exactly what you could have achieved if you invested in Amazon.com 22 years ago in late-1999 and held the stock till today.

A $1000 investment back then would have turned into more than $33,000 today. The chart above shows the trajectory of Amazon’s stock price over that 22 year period. 

It looks like a pretty clean upwards trajectory but the stock price performance was actually anything but smooth. The chart below shows Amazon’s stock price from late-1999 to 2002 just after the dot com bubble burst.

Amazon’s stock price tumbled from more than US$90 to around US$12. Although this was the steepest drawdown, Amazon’s stock price experienced numerous other steep drawdowns over the past 22 years. The chart below shows how far Amazon’s stock was below its all-time high over the past 22 years.

Amazon took close to 10 years to regain its 1999 peak. And even after breaching that peak, Amazon still experienced numerous drawdowns from those peaks, with those drawdowns frequently reaching close to 30%.

This is the harsh reality of the stock market. Stock price rise and fall all the time and even the best companies can experience significant stock price declines along the way.

However, investors who bought Amazon at the highs of 1999, and maintained their long-term focus even after that massive subsequent drawdown in 2000-2002, would still have come out with excellent returns.

Today in 2022, with some stocks experiencing similarly steep drawdowns from their all-time highs, Amazon is a good reminder of how long-term investing pays off.

Instead of focusing on prices today, think about where the stock’s business can be in 10 or 20 years’ time. If you think the business will be stronger and the company will be worth much more, then ignore the prices today and focus on the future.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Amazon Inc. Holdings are subject to change at any time.

*Quotes may be lightly edited for reading purposes

ASML: Semiconductor Industry experiencing strong growth

Question: To close off, do you expect strong demand to continue beyond 2022? 

ASML CEO Peter Wennick: Absolutely. I said it before, we are looking at the secular growth trend and we talked about this extensively during our Capital Markets day at the end of last year. The growth profile of this industry is impressive. The semiconductor industry is planned to double in size to a trillion dollars by the end of this decade. And of course, this will also have an effect on our business. So what do we do? And I have to admit, we as an industry, us and our customers and their customers, we have underestimated the long-term growth profile of the company. So we need to catch up. How do we do that? We build capacity. And that is what we are very much focusing on. Building capacity at ASML, but also in the supply chain. To make sure that we can significantly increase our output both for DUV and for EUV and for our metrology and measurement systems – basically across our entire product line. So, bearing that in mind, I’m even more optimistic about the long-term growth profile of this company. 

WISE plc: Cross border transaction volume growing and prices decreasing

WISE Trading update: Revenue grew by 34% YoY and 13% QoQ to £149.8 million, broadly in line with the rate of growth in volume. Our continuing efforts to engineer and optimise away costs to support sustainably lower prices for customers resulted in a lower take rate as expected, reducing to 0.73%, down 2bps YoY and 1bp QoQ. This reflects the price drops which are partially offset by incremental revenue from other sources beyond cross-border transactions.

Looking ahead, we continue to expect the take rate to be slightly lower in the second half of FY2022 (WISE’s financial year-end is 30 June) compared to the first half as a result of price reductions. This is expected to be more than offset by higher volumes as we now anticipate revenue growth of c. 30% for FY2022 over FY2021. We continue to expect gross margin for FY2022 to be c.65-67%, subject to foreign exchange related costs continuing to remain broadly stable.

Intuitive Surgical: Number of robot-assisted surgery grows in 2021

Gary Guthhart (CEO): Putting 2021 in context, demand for our robotically assisted interventions has been resilient during COVID. While these interventions get delayed during COVID peaks, the return when COVID wanes, and that is encouraging. Pandemic stresses on healthcare systems emphasize the need for the kind of high-quality, minimally invasive interventions or products enable. MIS (minimally invasive surgical) procedures allow greater use of ambulatory surgery, free up resources and ORs relative to other approaches, and often enable faster patient return to home and overall recovery.

In 2021, da Vinci procedures grew 28% compared to full-year 2020, reflecting a partial recovery in surgery after the first wave of the pandemic. Over the two-year period, 2020 and 2021, the compound annual growth rate in procedures was 14%. 

Netflix: Low member add guidance for Q1 2022 due to combination of factors but business still structurally unchanged

Spencer Neumann (CFO): No structural change in the business that we see. We guided to 2.5 million paid net adds in Q1. And what’s reflected there is pretty much the same trends we saw in Q4: so healthy retention with churn down, healthy viewing and engagement with viewing up and acquisition growing but a bit slower than pre-COVID levels, just hasn’t fully recovered.

And we’re trying to pinpoint why that is. It’s tough to say exactly why our acquisition hasn’t recovered to pre-COVID levels. It’s probably a bit of just overall COVID overhang that’s still happening after two years of a global pandemic that we’re still unfortunately not fully out of, some macroeconomic strain in some parts of the world like Latin America in particular. While we can’t pinpoint or point a straight line using — when we look at the data on a competitive impact, there may be on the marginal side of our growth, some impact from competition but which, again, we just don’t see it specifically.

So overall, that’s what’s reflected in the guide. I’d say our big titles are also landing, at least our known big titles, a little bit later in the quarter with Season 2 of “Bridgerton” in March, “The Adam Project” also in March. As you know, we are also changing prices in some countries in Q1 of this year and it happens to be our largest country, as we announced last week, actually our largest region with Canada as well. So that’s probably a little bit more impact than a typical quarter.

Microsoft: Broad-based growth and optimism from management

Amy Hood (CFO): And finally, for FY22, given our strong performance in the first half of the fiscal year and our current H2 outlook, full-year operating margins should be slightly up year-over-year even with the impact of changes in accounting estimates noted earlier and the significant strategic investments we are making to capture the tremendous opportunities ahead of us.

In closing, digital technologies are increasingly essential to empowering every person and organization on the planet to achieve more and we are well-positioned with innovative, high-value products. Our diverse, yet connected portfolio of solutions span end markets, customer sizes, and business models uniquely enabling us to deliver long-term revenue and profit growth. 

Tesla: Steady growth and FSD software will become financially important

Elon Musk (CEO): In 2022, supply chain will continue to be the fundamental limiter of output across all factories. So the chip shortage, while better than last year, is still an issue. There are multiple supply chain challenges. And last year was difficult to predict, and hopefully, this year will be smooth sailing, but I’m not sure what you do for an encore to 2021, 2020.

Nonetheless, we do expect significant growth in 2022 over 2021, comfortably above 50% growth in 2022. Full self-driving. So, over time, we think full self-driving will become the most important source of profitability for Tesla. Actually, if you run the numbers on robotaxis, it’s kind of nutty — it’s nutty good from a financial standpoint.

And I think we are completely confident at this point that it will be achieved. And my personal guess is that we’ll achieve full self-driving this year with a data safety level significantly greater than the present. So it’s the cars in the fleet essentially becoming self-driving by a software update, I think, might end up being the biggest increase in asset value of any asset class in history. 

Mastercard: Cross border transactions growing, Omicron only expected to have temporary impact

Michael Miebach (CEO): Looking at Mastercard’s spending trends, switch volume growth continued to improve quarter over quarter. Both consumer credit and debit continued to grow well. 

Turning to cross-border. The recovery has continued with overall Quarter 4 cross-border levels now higher than those in 2019. Cross-border travel continued to show improvement relative to Quarter 3 levels, aided by border openings in the U.S., U.K. and Canada. 

While Omicron has had some recent impact on cross-border travel, we continue to believe that cross-border travel will return to 2019 levels by the end of this year. Cross-border card-not-present spending ex travel continued to hold up well in the quarter. So overall, the spending trends are moving in the right direction with some near-term travel-related headwinds as a result of the variant.

Visa: Long growth runway ahead

Vasant Prabhu (Vice-Chair and CFO): FY ’22 is off to an excellent start. We expect our growth this year will be well above the pre-COVID rate as cross-border recovers. This will likely continue into fiscal year ’23. 

Beyond that, we are confident the business can sustain a revenue growth rate above pre-COVID levels for three reasons: first, an acceleration away from cash and check for merchant payments, both domestic and cross-border, as digitization becomes pervasive across consumers and businesses globally; second, acceleration of cash, check and wire transfer displacement as our new flows initiatives penetrate a broad range of new use cases with very large total addressable markets; third, sustainable high-teens growth across our value-added services, both from existing services and new offerings. As new flows and value-added services become a larger part of our revenue mix, growing faster than consumer payments, the sustainable growth rate will continue to rise. We are and will continue to invest in the capabilities required to capture the extraordinary growth opportunity ahead of us.

Apple: Strong quarter with broad-based growth

Tim Cook (CEO): Today, we are proud to announce Apple’s biggest quarter ever. Through the busy holiday season, we set an all-time revenue record of nearly $124 billion, up 11% from last year and better than we had expected at the beginning of the quarter. And we are pleased to see that our active installed base of devices is now at a new record with more than 1.8 billion devices.

We set all-time records for both developed and emerging markets and saw revenue growth across all of our product categories, except for iPad, which we said would be supply-constrained.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Apple, Mastercard, Visa, ASML, Microsoft, Netflix, Wise, Intuitive Surgical, and Tesla. Holdings are subject to change at any time.

Interest rates are rising around the world. The Bank of England increased interest rates in December 2021 from 0.1% to 0.25% while countries such as Japan, New Zealand, and Brazil have all raised their respective interest rates too. 

The Federal Reserve, the central bank of the United States, also seems wary of inflation and is likely contemplating raising rates this year. 

How do these actions of central banks around the world impact stocks?

Interest rates can theoretically impact stock prices in a few ways. First, it can impact the profits of a business. Companies with debt will experience an increase in borrowing costs which leads to lower profits and cash flows, all else equal.

Higher interest rates can also theoretically affect stock valuations as fixed-income yields become more attractive. This means stocks require a higher rate of return – and thus a lower valuation – to compete with the now higher-yielding instruments.

Higher rates impact high growth companies disproportionately

Higher interest rates, in theory, also impact high growth companies more than low-growth companies.

This occurs because most of the current value of high growth companies is derived from cash flows generated much later in the future. Take Tesla for example.

Tesla is a high growth company whose cash flows it will generate many years in the future make up the bulk of the company’s value. 

Using the last full-year results (FY2020), I modelled* the company with the following parameters: Revenue growth of 50% for 10 years; achieve an 18% free cash flow margin in the 10th year; share dilution of 5% a year; and a terminal growth rate of 6%.

If I need a 12% required rate of return, the net present value (discounted value of all future cash flows) per share works out to US$1,362. But if I need a 15% rate of return, the net present value per share drops to just $739. Just a 3% increase in the required rate of return reduces the company’s net present value per share by 46%.

On the other hand, let’s assume a company that starts off at a similar size as Tesla now but has much lower growth rates of just 10% and a terminal growth rate of 2%.

Using a 12% required rate of return, the net present value per share is $49. If I increase the required rate of return to 15%, the net present value per share drops 24% to $37. The key difference between Tesla and the slow growth company is that the slow growth company’s share price drops much less when the required rate of return rises.

High growth stocks have been hammered

As you can see, the higher required rate of return impacts high growth stocks disproportionately. This is possibly one of the reasons why we are seeing high growth companies whose values are largely derived from future cash flow fall more sharply than companies that have slower growth rates.

Personally, I have a large chunk of my wealth invested in high growth companies whose share prices have taken a drubbing. While it is not pleasant to see, there are two reasons why I am still optimistic.

First, based on my projected future cash flows for these companies and factoring in the fall in share prices, many of the companies I have a vested interest in look likely to provide very high rates of returns even if interest rates do keep on rising.

Second, interest rates tend to impact valuations only temporarily.

The Fed and the world’s other central banks make rate hikes and cuts based on the economic conditions at that time. Most of the time, interest rate hikes or cuts along with other monetary and fiscal measures are effective enough that the central banks will have to reverse the rate change after several years and on and on the cycle goes. As such, I believe that rate hikes and rate cuts are merely short term noise that should not impact the way we invest.

What to do now?

Personally, instead of fretting over rising rates, I focus my efforts on finding excellent companies that I believe have durable long-term growth potential.

Besides looking for growth, I also know that interest rates can impact the cost of borrowing for companies. As such, I tend to prefer to invest in companies that have relatively low debt or debt that they can easily service even if rates go up. 

By focusing on these characteristics of a business, I believe my portfolio will still be well-positioned in any interest rate environment.

*You can find the calculation in this Google Sheet

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Tesla. Holdings are subject to change at any time.

Are the best investors dead? 

That’s what a Fidelity internal performance review seems to suggest. Fidelity supposedly reviewed the performance of its customers from 2003 to 2013 and found that the best returns were from its customers who were either dead or inactive. These are customers who either died and had their assets frozen, or forgot about their assets.

Although I have not been able to find the original research paper by Fidelity, multiple sources have referred to it (see here, here, and here).

Whether the research was legitimate or not, the notion that inactive investors outperformed their peers does seem possible.

The market rewards inactivity

The stock market is volatile. The past two years has clearly demonstrated that. Volatility tempts investors to trade frequently in the hope of timing their buys and sells to coincide with peaks and troughs. However, in reality, buying at the lows and selling at near-term peaks is easier said than done.

Investors who trade frequently end up paying more trading fees and may miss out on the best days in the market. The latter is particularly harmful, as missing out on only a handful of the best days in the market has historically resulted in significantly lower returns.

Inactive investors, on the other hand, ride out the short-term volatility of the market whilst staying invested. With the stock market indexes historically going up over the long-term, investors who have simply sat tight and held on to their investments have done extremely well.

Choose wisely and diversify

But not all investments go up over time. A study by JP Morgan found that two-thirds of all stocks underperformed the Russell 3000 index from 1980 to 2014. Moreover, 40% of all stocks had a negative absolute return over the 30-year time frame. 

In fact, the bulk of the market’s returns was driven by just a small group of stocks.

What this means is that investors can’t simply buy and hold any stock. We must choose wisely or we’d risk underperforming or even losing money over the long term. 

To reduce our risk of losses and increase our chances of holding just one of these high performing investments, we should diversify our portfolio.

This reduces the risk of omission which can be much more costly than the risk of commission.

Learning from the dead

Once we have identified a diversified investment portfolio, we can start to copy the “dead”. By simply ignoring near term price volatility, doing nothing and letting our investments compound over time, investors are likely to outperform their more active peers. 

This strategy is, in fact, practised by one of the best-performing investment funds in the world, the Fundsmith Equity Fund. The fund, which is run by Terry Smith, has produced an annualised return of 18.4% since its inception in November 2010. This is far ahead of the MSCI World index which has returned 12.8% in the same time. 

Fundsmith follows a simple three-step investment strategy: “1. Buy good companies; 2. Don’t overpay; 3. Do nothing”

But don’t be fooled by the simplicity of Fundsmith’s approach. Buying good companies is one of the pillars of its success. But the third step – – do nothing – has been an important reason behind why Fundsmith’s investments have been allowed to compound.

If Fidelity’s research and Fundsmith’s track record are anything to go by, investors could increase their odds of outperforming more active market participants if they are able to replicate this patient approach.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.