Category: Special Events

Constellation Software is a company with an incredible long-term track record. Its founder and CEO, Mark Leonard, writes in his shareholder letters that a company should not hoard capital unnecessarily.

I completely agree. Money that a company cannot effectively invest should be returned to shareholders as soon as possible. 

Capital hoarding dilutes returns

Here is an illustration of why capital hoarding dilutes returns.

Let’s say there are two companies: Company A and Company B. They will each generate $1 in free cash flow per share per year for 10 years before they cease operating. The difference is that Company A returns all its annual free cash flow to shareholders each year while Company B hoards its cash. Company B also earns negligible interest, and only returns all of the cash to shareholders in one go at the end of 10 years.

With the above as a backdrop, Company A’s shareholders will receive $1 each year as dividends. On the other hand, Company B’s shareholders will receive $10 as a dividend once, in the 10th year. While the total amount that is eventually returned to both sets of shareholders is $10, shareholders of Company A will be much wealthier after 10 years.

This is because shareholders of Company A can invest the dividends earned each year. A shareholder of Company A who is able to invest the dividends at 10% per year, will end up with $15.90 per share after 10 years if all the dividends are invested.

How this impacts the valuation

In the scenario above, investors should be willing to pay more for Company A’s shares. 

We can calculate the values of the shares of Company A and Company B using a discounted cash flow model to get the present value of the stream of cash flows that will be returned to shareholders.

Using a 10% discount rate, Company A’s shares have a present value of $6.76 per share. Company B’s shares on the other hand, have a value of just $4.24. This makes sense as Company A’s shareholders will end year 10 with $15.90 per share, while Company B shareholders will end year 10 with just $10 per share.

As you can see, two identical companies that generate the exact same cash flow can have significant differences in their value simply due to whether the company is maximising shareholder returns by returning cash to shareholders appropriately.

Real-life impact

Unfortunately, in the real world, I notice many companies that hoard cash unnecessarily. This is especially rampant in the Singapore stock market, where many companies are controlled by wealthy families who may not have minority shareholder interests at heart. These companies hoard cash and pay only a minimal amount of dividends each year, which ends up not maximising shareholder value.

But that’s not the most destructive thing. Spending the cash on investments that destroy shareholder value is even more damaging to shareholders. Some examples of poor capital spending include buying back overpriced shares, making poor acquisitions, buying lousy assets, or diversifying into poor businesses.

Bottom line

Proper capital management can have a massive impact on the value of a company’s shares. When building valuation frameworks, investors often assume that the cash generated each year will be returned to shareholders in that same year. But that’s not usually the case. Some companies may keep the capital and invest it well, thereby creating more value for shareholders. But some may hoard the cash or make poor investments. 

We have to keep this in mind when thinking about how much we should pay for a company’s shares.

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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.

This morning, I gave a presentation for iFAST Global Markets’ Virtual Symposium – Strategies to Build Wealth During the Bear Market event. I would like to thank the iFAST Global Markets team, in particular Ko Yang Zhi, for their invitation. The title of my presentation is the same as the title of this article you’re reading. You can check out the slide deck for my presentation by hitting this orange button:

You can also find my speech, along with the accompanying slides, below!

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Presentation

[Slide 2] Hi everyone, I’m Ser Jing. I launched Compounder Fund, a global equities investment fund, July 2020 together with my friend Jeremy Chia. The both of us also run an investment blog called The Good Investors, with the URL (www.thegoodinvestors.sg). Prior to Compounder Fund and the blog, I was with The Motley Fool Singapore from Jan 2013 – Oct 2019. For those of you who may not know, The Motley Fool Singapore was an investment website and we specialised in selling investment research online.

[Slide 2] During this presentation, I’ll be sharing myths regarding the stock market that I commonly read or hear about. These myths are dangerous if they’re not debunked because they can harm your long-term investing returns by influencing your investing behaviour in negative ways. During the presentation, I’ll need your participation. There will be a few questions I’ll be asking, and I need your help to answer them. I’ll be covering nine myths in all, and there will be some time for a Q&A at the end. With each myth that I debunk – with factual data – I’ll also discuss a key lesson that we can learn from each of them. 

[Slide 3] Before I dive into the presentation, nothing I say should be taken to be investment advice or a recommendation to act on any security or investment product. I may also have a vested interest in the stocks mentioned during this presentation

[Slide 4] Let’s start with the first myth. Imagine that you’re now back in 1992 and you found a country that had a GDP (gross domestic product) of US$427 billion. You also have a perfect crystal ball that’s telling you that this country’s GDP would go on to compound by 13.7% per year till 2021, ending the year with US$17.7 trillion in GDP. Take a second to think if you would want to invest in the stock market of this country in 1992? Note that these are all real figures.

[Slide 5] The country I’m talking about here is China and if you said yes to my question, a dollar that you had invested in the MSCI China Index – a collection of large and mid-sized companies in the country – in late-1992 would have become roughly… a dollar by October this year. You heard that correctly: Chinese stocks have been flat for 30 years despite a 13.7% annualised growth in GDP over the same period. The reason is because stocks ultimately go up if their underlying businesses do well.

[Slide 6] And in the case of China, you can see that the earnings per share of the MSCI China Index was basically flat from 1995 to 2021.

[Slide 7] So the first myth I want to debunk is that a country’s stock market will definitely do well if its economy is growing robustly. And the lesson here is that the gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. 

[Slide 8] Now for the second myth. Let’s go back in time again, this time to September 2005 – in case you’re wondering, we’ll be doing quite a bit of time travelling in today’s presentation. You’re in September 2005 now and you can see that gold is worth A$620 per ounce. The perfect crystal ball you had in Myth 1 is now telling you that the price of gold would climb by 10% per year to A$1,550 in September 2015. The golden question facing you now in September 2005 is this: Do you want to invest in Australian gold mining stocks for the next 10 years?

[Slide 9] If you said yes, you would be sitting on a loss of more than 30%. The S&P / ASX All Ordinaries Gold index, an index of gold-mining stocks in Australia’s stock market, fell by 4% annually from 3,372 points in September 2005 to 2,245 in September 2015.

[Slide 10] So the second myth is this: You should definitely invest in a commodity-producer’s stock if you’re sure that the price of the commodity will rise. The lesson here is the same as the first myth’s: The gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. In that mile are things like the quality of the business, the capability of the management team, the balance sheet strength of the company, and so on.

[Slide 11] Moving on to the third myth, I need your help to choose between two groups of real-life US-listed companies that you would prefer to invest in if you could go back in time to 2010.

[Slide 12] The first group comprises Company A, Company B, and Company C. This chart shows their stock prices from the start of 2010 to the end of 2021 – Company A is the purple line, Company B is orange, and Company C is blue. More specifically, the chart shows the percentage declines from a recent high that each company’s stock price had experienced in that timeframe. The chart looks brutally rough for all three companies. Their stock prices declined by 20% or more on multiple occasions from 2010 to 2021. In fact, Company B’s stock price had fallen by 40% from a recent high on four separate occasions, and Company C even suffered an 80% drop in 2011. Moreover, their stock prices were much more volatile than the S&P 500; the S&P 500 is a major stock market index in the USA and it experienced a decline of 20% or more from a recent high just once in early 2020. 

[Slide 13] The second group of companies are Company D, Company, E, and Company F. This table illustrates their stock prices and revenue growth from the start of 2010 to the end of 2021, along with the S&P 500’s gain. The second group has generated tremendous wealth for their investors, far in excess of the S&P 500’s return, because of years of rapid business growth.

[Slide 14] This chart is a pictorial representation of the stock price gains that Company D, Company E, Company F, and the S&P 500 have produced.So take a second to think about which group you would like to invest in. As a quick recap: The first group had experienced severe volatility in their stock prices in the 2010-to-2021 time frame, often falling by huge percentages.

[Slide 15] I’m guessing that most of you would prefer to invest in the second group. But here’s what’s interesting: Both groups refer to the same companies! Company A and Company D are Amazon; B and E are MercadoLibre, and C and F are Netflix. Amazon and Netflix are likely to be familiar to all of you watching this, but MercadoLibre is not – it is an e-commerce and digital payments giant that focuses on Latin America.

[Slide 16] The third myth is that great long-term winners in the stock market will make you feel comfortable on their way up. But this myth couldn’t be further from the truth. Even the market’s best winners will make you feel like throwing up as they climb over time and there are two lessons here: (1) Volatility in the stock market is a feature and not an anomaly, and (2) The route to huge gains in the stock market will feel like a sickening roller-coaster.

[Slide 17] We’re now at the fourth myth, and it relates to something interesting about the stock price returns and business growth of Amazon, MercadoLibre, and Netflix. This table shows the revenue growth and stock price movement for all three companies in each year from 2010 to 2021. You will notice that the trio have each: (1) exhibited excellent revenue growth in each year for the period; (2) underperformed the S&P 500 in a few calendar years, sometimes significantly; and (3) seen their stock prices and business move in completely opposite directions in some years. But yet, all three of them have produced excellent business growth with matching stock price returns, as I discussed in Myth 3.

[Slide 18] The experience of Amazon, MercadoLibre, and Netflix are not isolated examples. In fact, Nobel-prize-winning economist Robert Shiller once published research in the 1980s that looked at how the US stock market performed from 1871 to 1979. Shiller compared the market’s performance to how it should have rationally performed if investors had perfect knowledge on the future changes in its dividends. The result is the chart you’re looking at now. The solid line is the stock market’s actual performance while the dashed line is the rational performance. Although there were violent fluctuations in US stock prices, the fundamentals of American businesses – using dividends as a proxy – was much less volatile. The legendary investor Ben Graham has a beautiful analogy for the stock market, that it is a voting machine in the short run but a weighing machine in the long run. Plenty of shorter-term voting had taken place in the US stock market over the course of history. But importantly, the weighing scale did function beautifully. From 1871 to 1979, historical data on US stocks maintained by Shiller show that the S&P 500’s dividend and price had increased by 2,073% and 2,328%, respectively. 

[Slide 19] So the fourth myth is this: If a stock’s underlying business does well every year, the stock’s price will also do well each year. In fact, and this is the lesson: A company’s stock price can exhibit stomach-churning short-term volatility even when its underlying business is performing well, but in the long run, business fundamentals and stock prices do match up nicely.

[Slide 20] We’re at the fifth myth now, and I need your help to quickly think about this question: We’re now at the start of the year 1990 – how do you think the US stock market will fare over the next five years and the next 30 years, if I tell you that all three of the following will happen during the year: In July, the USA will enter a recession and a month later, the country will fight in a war in the Middle East and the price of oil will spike?

[Slide 21] Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. 

[Slide 22] From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.

[Slide 23] What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table here illustrates. Yet, the S&P 500 had steadily marched higher in that period.

[Slide 24] The myth here is that stocks can only do well during peaceful times. But the truth – and the lesson – is that uncertainty is always around, and disasters are always happening, but that does not mean we should not invest as stocks can still do well even in the face of trouble.

[Slide 25] For Myth No. 6, let’s consider the importance that some of the best investors in the world place in trying to predict the short-term movement of stock prices. We can use Peter Lynch and Warren Buffett as examples. But first, I’ll quickly run through why the both of them are widely considered to be investing greats. Lynch was the manager of the US-focused Fidelity Magellan Fund from 1977 to 1990. During his 13-year tenure, he produced an annual return of 29%, nearly double that of the S&P 500. Meanwhile, Buffett has been in control of his investment conglomerate Berkshire Hathaway since 1965. From then to 2018, he grew the book value per share of Berkshire by 18.7% per year by using its capital to invest in stocks and acquire companies with outstanding businesses. Over the same period, the S&P 500 compounded at less than 10% annually. 

[Slide 26] So how do Lynch and Buffett incorporate short-term predictions on the stock market in their investing process? They don’t. In an old interview with PBS, Lynch said: “What the market’s going to do in one or two years, you don’t know. Time is on your side in the stock market. It’s on your side. And when stocks go down, if you’ve got the money, you don’t worry about it and you’re putting more in, you shouldn’t worry about it. You should worry what are stocks going to be 10 years from now, 20 years from now, 30 years from now.”

[Slide 27] Then there’s Buffett, who wrote a famous op-ed for The New York Times in October 2008, at the height of the Great Financial Crisis. In it, Buffett shared: “Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

[Slide 28] Myth No.6 is something I hear often, and that is that great stock market investors know exactly what’s going to happen to stock prices in the next month or year ahead. But as I’ve discussed, even the best in the business have no clue what stocks would do in the short run, and yet that did not prevent them from clocking incredible long-term returns. So the lesson here is that we can still achieve great long-term investing results even if we have no idea what the market’s going to do over the short run. 

[Slide 29] The seventh myth involves stocks and recessions. What do you think will happen if you have perfect clairvoyance and are able to tell when the US economy will enter and exit a recession and thus sell stocks just before a recession hits and buy them back just before a recession ends?

[Slide 30] If you had this clairvoyance from 1980 to 2018, you would wish you did not have the special ability. According to research from Michael Batnick, a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. This is the black line in the chart. But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint. This is the red line.

[Slide 31] The seventh myth is that it is important for stock market investors to side-step recessions. But the data shows us an important lesson: Trying to side-step recessions can end up harming our returns, so it’s far better to stay invested and accept that recessions are par for the course when it comes to investing.

[Slide 32] Moving to Myth No. 8, when we’re in an economic downturn, I think it’s natural to assume that it’s safer to invest when the coast is clear. But the reality is that the stock market tends to recover before good news about the economy arrives. For example, if we go back to the most recent recession in the USA prior to COVID, that would be the recession that lasted from December 2007 to June 2009. In that episode, the S&P 500 reached a trough in March 2009 of around 680 points. Back then, the unemployment rate in the country was around 8%. But by the time the unemployment rate reached  a peak in late 2009 at 10%, the S&P 500 was already around 50% higher than where it was in March 2009 and it has never looked back.

[Slide 33] So the myth here is that we should only invest when the coast is clear. But as the data shows – and to borrow a Warren Buffett quote I mentioned earlier, “if you wait for the robins, spring will be over.”

[Slide 34] And last but not least, we’re at Myth No.9, where it’s about interest rates and stocks. There’s plenty of attention being paid to interest rates because of its theoretical link with stock prices. Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since bonds, being an alternative to stocks, are providing a good return. On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return. And falling valuations for stocks would then lead to falling stock prices. But the real relationship between interest rates and stocks is nowhere near as clean as what’s described in theory.

[Slide 35] Ben Carlson’s research has shown that the S&P 500 climbed by 21% annually from 1954 to 1964 even when the yield on 3-month Treasury bills (a good proxy for the Fed Funds rate, which is the key interest rate set by the USA’s central bank, the Federal Reserve) surged from around 1.2% to 4.4% in the same period. In the 1960s, the yield on the 3-month Treasury bill doubled from just over 4% to 8%, but US stocks still rose by 7.7% per year. And then in the 1970s, rates climbed from 8% to 12% and the S&P 500 still produced an annual return of nearly 6%.

[Slide 36] Meanwhile, data from Robert Shiller show that the US 10-year Treasury yield was 2.3% at the start of 1950. The yield reached a peak of 15.3% in September 1981. In that same period, the S&P 500’s price-to-earnings (P/E) ratio moved from 7 to…  8. That’s right, the P/E ratio for the S&P 500 increased slightly despite the huge jump in interest rates.

[Slide 37] It’s worth noting too that the S&P 500’s P/E ratio of 7 at the start of 1950 was not a result of earnings that were temporarily inflated, as can be seen by the trend for the index’s earnings per share in preceding and subsequent five-year periods.

[Slide 38] Then we have this chart, which illustrates the historical relationship that the S&P 500’s price-to-earnings (P/E) ratio has had with 10-year Treasury yields. It turns out that the S&P 500’s P/E ratio has historically and – noticeably – peaked when the 10-year bond yield was around 5%, and not when the 10-year bond yield was materially lower at say 3% or 2%.

[Slide 39] The ninth myth is this: Rising interest rates are definitely bad for stock valuations and thus stock prices. But what the evidence shows is that stock valuations and prices have risen over time even when interest rates have soared. So there are two important lessons here: (1) While interest rates have a role to play in the movement of stocks, it is far from the only thing that matters; (2) one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.

[Slide 40] I’ve come to the end of my presentation today and I’m happy to take questions!

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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 currently have a vested interest in Amazon, MercadoLibre, and Netflix shares mentioned. Holdings are subject to change at any time.

Acquisitions often pose an analytical challenge for investors.

Should the fee be considered an operating expense, capital expense, or another sort of expense? What if part or all of the acquisition was financed using stock? How will the company’s financial standing be impacted? Is the acquisition fee too expensive? These are just some of the questions that shareholders need to answer.

The intricacies of each acquisition make analysing them a headache for investors. However, by breaking an acquisition assessment into parts, we can form a systematic approach to cover all angles.

Here is a short primer on the things to look out for in acquisitions.

Accounting for cash outlay

Free cash flow is often calculated as operating cash flow less capitalised expenses. On the cash flow statement, capitalised expenses are the purchase of property, plant, and equipment and other capitalised expenses such as capitalised software costs. 

Acquisitions do not fall into these categories and investors may sometimes exclude cash outlays from acquisitions from the calculation of annual free cash flow.

I believe the right way to account for the acquisition fee is by deducting it as a capital expenditure. This is because when acquiring another company, you are effectively buying over the company’s assets such as customers, technology, infrastructure, and talent.

If you were to build all of this from the ground up, you would have to spend money buying properties, acquiring talent, and on marketing to acquire customers etc. These costs would be counted as either current expenses or capitalised expenses. Acquiring a company should, therefore, be given a similar treatment.

Let’s take Adobe’s acquisition of Figma as an example.

Adobe announced last month that it would be buying Figma for US$20 billion at face value. US$10 billion of that is in cash, and the rest is in a fixed number of Adobe shares (at the time the deal was announced, the shares were worth US$10 billion). The $10 billion in cash is coming out of Adobe’s balance sheet and will have a very real impact on the cash on hand and the amount of cash that the company will be able to return to shareholders via buybacks or dividends.

As such, we need to account for it as capital expenses that reduce the company’s free cash flow. In the last twelve months, Adobe generated US$7 billion in free cash flow. If we deduct US$10 billion (the cash outlay for the acquisition of Figma), we see that Adobe has an adjusted free cash flow of negative US$3 billion.

But given that it is a one-off expense, does this mean anything? A resounding, yes.

When I assess free cash flow, I’m not scrutinising free cash flow over a single year. I’m examining the average free cash flow generated over multiple years. The acquisition cash outlay pulls down the long-term free cash flow average for Adobe, but it also paints a more complete picture of the cash flow that can be distributed to shareholders over time.

Consider dilution when looking at stock-based financing, instead of the current dollar amount

Many deals nowadays include some element of stock-based financing. Stock-based financing is a little bit more tricky to analyse than cash as stock prices can fluctuate.

Depending on the price of the stock, the dollar amount of stock that was used to finance the deal could be higher or lower. The Adobe-Figma deal is a good example. As mentioned earlier, the value of Adobe shares being offered to Figma shareholders was worth US$10 billion when the deal was revealed to the public. Today, with the steep fall in Adobe’s stock price, the value of those shares has declined by more than 20% to around US$7.7 billion.

Instead of worrying about the dollar value of the stock-based financing, I prefer to look at the number of shares that are being issued.

In the Adobe-Figma deal, Figma shareholders will receive about 27 million shares. In addition, employees and executives at Figma will receive an additional 6 million Adobe shares that will vest over the next four years. As of 23 September 2022, Adobe had 465 million shares outstanding. The Figma acquisition will increase the share count by 30 million, which represents dilution of around 6%.

In other words, all of Adobe’s future free cash flows will need to be shared with this new batch of shareholders, which will reduce Adobe’s cash flows per share by 6%. 

This is the real cost of stock-based financing.

Is the acquirer overstretching its finances?

Now that we know the true cost of the acquisition, the next thing we need to consider is whether the acquirer has sufficient cash to finance the deal.

Ideally, the acquirer needs to have either cash on hand or sufficient cash flow generation ability to ensure that any debt incurred can be easily repaid.

Let’s take a look at the Adobe-Figma deal again.

Adobe ended its latest fiscal quarter with US$5.8 billion in cash and US$4.1 billion in debt. To fund the US$10 billion cash outlay for the Figma deal, Adobe would have to use some of its cash on hand and borrow at least US$5 billion. Whatever the ratio of debt to cash on hand used, the $10 billion cash outlay will leave Adobe with net debt of US$8.3 billion. 

Although this is a historically high debt load for Adobe, I don’t see it as much of an issue. As mentioned earlier, Adobe generated US$7 billion in free cash flow in the last 12 months. If it can generate similar amounts of cash after the deal, it will be able to easily repay some or even most of the debt within a year, should management decide to.

Analysing the target company

Another important aspect of the deal is the quality of the company being acquired. Assessing the quality of a target company can be done in two parts. First, does the target possess a quality business?

As with assessing any company, we need to study aspects such as the quality of management, historical growth, ability to innovate etc. 

Again, I will use the Adobe-Figma acquisition as an example. Figma strikes me as a solid and innovative business. Its annual recurring revenue is growing sharply and its product seems well-loved by customers. Other elements of Figma look good too, such as its product-release cadence, and management capability and innovativeness. For example: Figma was launched in 2012 as the world’s first design tool purpose-built for the web, and it has a net-dollar retention rate of more than 150%.

Second, will the combined entity work well together?

In the Adobe-Figma deal, it does seem that many possible integrations could happen when the two companies combine. Scott Belsky, Adobe’s Chief Product Officer, recently spoke at-length about the synergies he sees between the two companies’ products. Acquiring Figma will also be a good way for Adobe to tap into a different type of user base.

Another element of the deal that is often overlooked is the effect of removing a competitor. In the Adobe-Figma deal, Adobe is effectively removing a growing competitor.

Does the price match the value?

Now that we have identified both the cost and the benefits of the deal, we can then assess if the price matches the value gained from the acquisition. This requires an estimation of the net cash flow generated from the acquisition.

In the Adobe-Figma deal, we need to estimate the net future cash flow benefit from the deal. We then compare these cash flows with the cash flows that were given up, which includes the US$10 billion cash outlay and the 6% dilution. You can find an example of a financial model here.

Final Thoughts

Given the many intricacies of a deal, acquisitions can be tricky for investors to assess. Presentation slides offered by a company’s management will inevitably present a compelling case for an acquisition. But some acquisitions may not turn out to be positive for shareholders of the acquirers. As such, shareholders need to do their due diligence when assessing an acquisition.

With stock prices of many companies falling sharply in recent months, and some companies still generating healthy amounts of free cash flow even in this downturn, we could potentially see more deals being struck in the near future.

If you are a shareholder of a company making an acquisition, try to look at the deal from the perspective of how it will impact the cash flows paid to you by your company over the long term. This is the bedrock of all analysis and should be the foundation to build your assessment.

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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 Adobe. Holdings are subject to change at any time.

2021 will be remembered as a year of a bull market.

The widely-followed S&P 500 index, which comprises 505 of the largest US companies in the stock market, returned 28.7%, well ahead of its long-term annualised return of around 9%.

But that’s only half the story. While the major index witnessed a big upward, many smaller cap tech stocks did not do so well. In particular, “high-growth tech stocks” collectively had a terrible year.

The ARK Innovation ETF, an investment fund managed by Catherine Wood that invests in companies that deploy “disruptive technology,” fell by 24.1% in 2021. Although most of the high-growth companies in ARK’s portfolio continue to produce excellent revenue growth, valuation-compressions have driven their stock prices lower.

With high-growth stocks starting 2021 at relatively high multiples, decelerating growth from the highs of 2020 understandably caused some investors to ditch high growth stocks for value stocks whose valuation multiples have expanded.

Some of the biggest pandemic winners of 2020, such as Zoom Video Communications (-49%), Peloton (-75%), and Teladoc (-54%) sank the most in 2021.

Long-term secular trends

So is this the end of an era for high-growth tech companies?

Personally, I doubt so. Companies that are serving large and growing industries and are disrupting older technologies are likely going to experience durable revenue growth for many years. It is also not uncommon for high-growth stocks to experience valuation swings. One group of high-growth stocks that has seen frequent valuation contractions and expansions is the software-as-a-service (SaaS) stocks. 

My friend Eugene Ng, who is a seasoned investor shared this interesting table on Twitter recently:

Software valuation corrections are frequent (every 1-3 years), and not uncommon (over last 21 years, since 2001). pic.twitter.com/hohnhi3Ofm

— Eugene Ng (@EugeneNg_VCap) January 3, 2022

What it shows is that SaaS stocks have experienced numerous valuation-contractions in the past 20 years and yet eventually return to higher multiples. Although current SaaS valuation ratios are still higher than at most times in history, these high ratios could persist as long as superior revenue growth can continue.

In the past, investors had chronically underappreciated the durability of revenue growth of SaaS companies. Today investors have wisened up to this and are giving SaaS stocks deservedly higher valuation ratios compared to the past. So it is very possible for their valuation ratios to expand again.

Moreover, even with slowing revenue growth which I mentioned earlier, many high-growth stocks are still expected to grow their revenues in the mid-twenties percentage range for years. We could witness higher stock prices for high-growth SaaS stocks in the future even from strong revenue growth alone.

Don’t fret

If you’re one of the many high-growth tech investors who have underperformed the market in 2021, what should you do?

First off, don’t fret. Even though it’s not pleasant knowing that your investments have underperformed an “unmanaged” basket of stocks (the S&P 500), know that underperforming for a short time period is not uncommon, even for the best investors.

In the 1950s and 1960s, Warren Buffett was a running an investment fund. When he shut his fund in 1969, he recommended his investors to invest with Bill Ruane, a friend of his. Unfortunately, Ruane underperformed the S&P 500 for five years straight from 1970 to 1974. But he eventually had the last laugh. From 1970 to 1984, Ruane’s fund produced an excellent annual return of 17.2% for its investors, far in excess of the S&P 500’s 10.0% annual gain.

The beauty of investing is that it is not a short-term game. What matters is how you fare over your entire investing time frame. Most of us, investors, are playing a multi-year or even multi-decade game. Despite its relatively weak performance in 2021, the ARK Innovation ETF is still well ahead of the S&P 500 since its inception in 2015. 

As investors with a long time horizon, it is important to look at the bigger picture.

2022 and beyond…

With the start of the new year, I’ve read numerous articles about how investors should position their portfolios for 2022. Although the authors of these articles mean well, it is extremely difficult to make single-year predictions. As such, I believe the real question should be how do you position a portfolio for a multi-year time frame.

So instead of thinking about how a portfolio could do in just the next 12 months, I prefer to consider what a portfolio could do over a five-year time horizon at least. By thinking in multi-year time frames, I give time for long-term secular trends to play out. I also don’t have to worry about short-term mispricings in the stock market, knowing that eventually, stock prices trend towards their true value (all its future cash flow discounted to the present).

By looking at the multi-year growth potential of a company, I can focus on what really matters over the long term rather than just near-term estimates. This helps me crystalise my investing strategy to optimise for my entire investment life.

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 Zoom and Teladoc. Holdings are subject to change at any time.

I was invited by Autodesk’s Singapore office to give a presentation on investing on 30 June 2021. I would like to thank the Autodesk team for inviting me and for the event’s superb organisation. During my presentation, I talked about what stocks are; active versus passive investing; what asset allocation is; and useful resources for individuals to learn about investing. You can check out the slide deck for my presentation below!

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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 currently do not have a vested interest in any shares mentioned. Holdings are subject to change at any time.