Quality vs. Momentum; Facing this Market Downturn Head On

Paul FennerPortfolio Management

In the 1960’s and 1970’s there were a group of companies favored by institutional investors characterized by consistent earnings growth and high P/E ratios named the Nifty 50.  Within the past two decades, the markets rode in on another grouping of big companies dubbed the “Four Horseman of Technology” which consisted of Amazon, Google (now Alphabet), Apple, and Facebook.  Today we usher in the latest collection of momentum stocks termed “FANG” stocks, which represents Facebook, Amazon, Netflix, and Google.

According to research by Palo Capital, the “FANG” stocks were collectively up over 60% in 2015 while the remaining 496 stocks in the S&P in aggregate were down 4.8% for 2015.  Here was the current Price to Earnings (P/E) ratios for the group of “FANG” stocks as of January 8th;

  • Facebook – 98.3
  • Amazon – 875.9
  • Netflix – 297.6
  • Google – 33.7

For comparison purposes, the overall S&P500 index supported a P/E of 19 for the same date.

So now for a couple of disclosures;

  1. We own shares in Facebook with the caveat that we bought at a much lower P/E
  2. We did own shares in Google but sold in mid-2015
  3. P/E ratios are only one relative valuation metric for which to calculate a company’s worth, these ratios do not tell the whole story of a company

So what is the one area that these four companies have in common?  They are all growing their revenue at high speeds and that is what the U.S. equity market seemed to be paying attention to during 2015.  Amazon for example had grown their revenues by 948% from 2005 to 2014 which averages out to be 28% per year.  However, at times they barely recorded much income and although they threw off a large amount of cash from operations each year, their economic margin has been in decline since 2009.

This is not to say that Amazon isn’t a great company because it is.  My family uses Amazon practically on a weekly basis.  But at times even great companies such as Amazon can get ahead of themselves from a valuation standpoint.  This same point could be made for the other three “FANG” stocks as well.  Chances are when the revenue growth begins to slow, the stock prices are likely to decline and potentially decline at a faster rate.

As we have previously communicated, I believe that the decline in revenue and earnings amongst most companies along with the decline of revenue and earnings estimates are the drivers behind the decline in stocks that we have seen to begin 2016.

We have noted time and time again that there will always be headline risk within the financial markets.  At this point in time there are concerns regarding;

  • The economic slowdown in China,
  • Federal Reserve raising interest rates,
  • Continued disturbances within the Middle East, &
  • North Korea testing a potential hydrogen bomb

While none of these areas of concern can be brushed aside and our decline in revenue is certainly not helping China, the decline is revenue and growth estimates is more concerning to us when it comes to company valuations.

We have now experienced an entire year with unusually low gasoline prices but where has the increase in consumer spending gone that the financial experts predicted?  Spending on items such as healthcare, education, and experiences are the three main areas that have seen increased revenue growth.  Have you been in an airport lately or paid a college tuition bill?  Both of those industries have been able to push through price increases that most people cannot avoid.

At TAMMA, I am continuing to focus on our processes that emphasize quality over momentum.  I am focused on finding companies that;

  1. Have low levels or zero debt; allows companies to ride out economic downturns and make strategic business decisions when other panic and assets go on sale
  2. Generate strong cash flows; while some companies can financially re-engineer their earnings per share, cash is one of the strongest indicators of a healthy company who can again withstand economic headwinds
  3. Can reasonably grow revenue; companies must have adequate catalysts that will keep customers coming back which could be a great product, customer service, or some other factor that makes them a must-have

Although the data that I review doesn’t show signs of a meltdown that we had in 2008, when the financial markets turn down as we saw the first two weeks of 2016, most financial assets begin to move towards a correlation of 1.  This means that there are very few places to protect your assets from a drop in prices other than to go to cash.  And while we currently recommend having a healthy amount of cash on hand, we never recommend being all in or all out of the equity markets.  Trying to time the markets have been proven to lead to lower returns in both the short and long run.