Tag: ZM

High flying growth companies will badly damage new shareholders

The problem with having a huge amount of anticipated growth baked into your stock price is that the expectations become incredibly difficult to achieve.

High expectations result in high stock prices.

I’ll post the charts of two of these companies which are household names – Zoom (Nasdaq: ZM) and Docusign (Nasdaq: DOCU):

We will look at Zoom first.

At its peak of $450/share, Zoom was valued at around $134 billion. Keeping the math incredibly simple, in order to flat-line at a terminal P/E of 15 (this appears to be the median P/E ratio of the S&P 500 at the moment), Zoom needs to make $9 billion a year in net income, or about $30/share.

After Covid-mania, Zoom’s income trajectory did very well:

However, the last quarter made it pretty evident that their growth trajectory has flat-lined. Annualized, they are at $3.55/share, quite a distance away from the $30/share required!

Even at a market price of $180/share today, they are sitting at an anticipated expectation of $12/share at sometime in the future.

Despite the fact that Zoom offers a quality software product (any subscribers to “Late Night Finance” will have Zoom to thank for this), there are natural competitive limitations (such as the fact that Microsoft, Google and the others are going to slowly suck away any notion of margins out of their software product) which will prevent them from getting there.

The point here – even though the stock has gone down 60% from peak-to-trough, there’s still plenty to go, at least on my books. They are still expensive and bake in a lot of anticipated growth which they will be lucky to achieve – let alone eclipse.

The second example was Docusign. Their great feature was to enable digital signing of documents for real estate agents, lawyers, etc., and fared very well during Covid-19. It’s an excellent product and intuitive.

They peaked out at $315/share recently, or a US$62 billion valuation. Using the P/E 15 metric, the anticipated terminal earnings is about $21/share.

The issue here is two-fold.

One is that there is a natural ceiling to how much you can charge for this service. Competing software solutions (e.g. “Just sign this Adobe secure PDF and email it back”) and old fashioned solutions (come to my office to scribble some ink on a piece of paper) are natural barriers to significant price increases.

Two is that the existing company doesn’t make that much money:

Now that they are reporting some earnings, investors at this moment suddenly realized “Hey! It’s a long way to get to $21!” and are bailing out.

Now they are trading down to US$27 billion, but this is still very high.

There are all sorts of $10 billion+ market capitalization companies which have featured in this manner (e.g. Peleton, Zillow, Panantir, etc.) which the new investors (virtually anybody buying stock in 2021) are getting taken out and shot.

This is not to say the underlying companies are not any good – indeed, for example, Zoom offers a great product. There are many other instances of this, and I just look at other corporations that I give money to. Costco, for example – they trade at 2023 anticipated earnings of 40 times. Massively expensive, I would never buy their stock, but they have proven to be the most reliable retailer especially during these crazy Covid-19 times.

As the US Fed and the Bank of Canada try to pull back on what is obviously having huge negative economic consequences (QE has finally reached some sort of ceiling before really bad stuff happens), growth anticipation is going to get further scaled back.

As long as the monetary policy winds are turning into headwinds (instead of the huge tailwinds we have been receiving since March 2020), going forward, positive returns are going to be generated by the companies that can actually generate them, as opposed to those that give promises of them. The party times of speculative excess, while they will continue to exist in pockets here and there, are slowly coming to a close.

The super premium companies (e.g. Apple and Microsoft) will continue to give bond-like returns, simply because they are franchise companies that are entrenched and continue to remain dominant and no reason exists why they will not continue to be that way in the immediate future. Apple equity trades at a FY 2023 (09/2023) estimate of 3.8% earnings yield, and Microsoft is slightly richer at 3.2%. Just like how the capital value of long-term bonds trade wildly with changes of yield, if Apple and Microsoft investors suddenly decide that 4.8% and 4.2% are more appropriate risk premiums (an entirely plausible scenario for a whole variety of foreseeable reasons), your investment will be taking a 20% and 25% hit, respectively (rounding to the nearest 5% here).

That’s not a margin of error that I would want to take, but consider for a moment that there are hundreds of billions of dollars of passive capital that are tracking these very expensive equities. You are likely to receive better returns elsewhere.

Take a careful look at your portfolios – if you see anything trading at a very high anticipated price to cash flow expectation, you may wish to consider your overall risk and position accordingly. Companies warranting premium valuations not only need to justify it, but they need to be delivering on the growth trajectory baked into their valuations – just to retain the existing equity value.

Market observations

The S&P 500 is up another 100 points today, purportedly on a jobs report that the US hired people in the month of May (everybody was expecting layoffs). For example, the unemployment rate expected was 19.8%, while the actual rate was 13.3%. Suffice to say this was a shock.

So everything’s going crazy. Cruise liners are up about 20% (they’ll be able to raise another round of financing and sail through it). Energy stocks are going through the roof. There are all sorts of indications of a market recovery, and indeed, the “V” scenario happened:

Recall my daily rule of “only sell in up markets, buy in down markets”. There will be days things will go down, that’s the time to buy. On a day like today, the only real option is to lighten up and raise some cash. You’re too late if you do the opposite. Today, and especially for those in the past month, those that have cash on the sidelines are hurting. The only worse feeling in the stock market than losing money is to watch everybody else make money while you’ve got a pile of zero-yielding cash. The news headlines are going to gravitate away from Covid-19, protests and now gravitate towards recovery and give people a feeling of comfort. Again, this will be false, since it will be built up on a pile of debt taller than Olympus Mons, but this is a medium term consideration and not short-term, which will be euphoria.

You are also seeing the start of the capitulation of the gold market, which is down about $40 per ounce. Although the downside here is not going to be extreme (10-20% from the US$1,780 peak?), holders in gold will be wondering alongside those holding cash whether they should dip back into the markets at ever increasing prices. There will be a significant contingent of people holding on to hedge themselves against the excesses of monetary policy, but there are also a lot of “loose” holders that have held paper gold which will want to catch the equity train. In fact, for those contemplating dipping back into gold, consider that the Canadian dollar is likely to rise in the future due to the resurgence in commodities, so valued in Canadian dollars you will probably be able to pick up gold for relatively less.

In these sharp rallies, there are going to be two-three day periods where you will see volatility spikes and the main indexes will dip down, usually caused by some transient headline. These are really the only opportunities to deploy cash. The only factor is when they will happen – it is difficult to predict these sentiment spikes. These spikes down are designed to wash out very short-term holders (this tend to be retail investors very new to investing that are skittish to volatility and because they tend to act in swarms, it amplifies price changes), but the overall trend is going to continue to be up as long as Central Bank rocket fuel propels the market.

Speaking of which, by the end of this year, the Federal Reserve is going to step off throwing gasoline onto the fire, and depending on how ridiculous things get, may even signal an increase in interest rates next year (the buzz-word will be “re-normalization”, very ironic since nothing is normal now). Any rate increase will be nothing extreme – just a quarter point – but even they will start to recognize when the S&P 500 hits 3500 that they should be applying some brakes otherwise they are getting ready to engineer the market crash of the 21st century that will make the 2008-2009 economic crisis look like a correction. Central Bank interest rates cannot rise too much because there is just too much debt.

My last note is a very easy prediction. Zoom stock (Nasdaq: ZM) in three years will be lower than US$208/share. The borrow is extremely cheap right now, but once the Federal Reserve rocket ship stops, this is probably the easiest short candidate I have seen in ages. I wouldn’t short it now because all of the index-based buying can make it even more ridiculously expensive. But I did note that Zoom sent me a spam to my inbox offering me 30% off a yearly subscription (I was month-to-month) and this is more than their usual “buy 12 months for the price of 10” offer, which means that their management is smart enough to know their gravy train is ending, and ending soon (get the years’ worth of deferred revenues while you can!). Microsoft, Google, and even open source options are all competing for this market and Zoom has little in the way of competitive advantage other than incumbency protection.

Have a good weekend everybody.