May 15, 2022

You Are What You Earn

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Bottom Line:


The declines in cryptocurrencies and profitless tech stocks continued to mount this week, pulling the broader indices down with them. While investors may consider bargain hunting among the rubble, the profitless will need to raise large amounts of capital to keep funding their operations. Given the sympathetic declines of the profitable companies, we suggest bargain shopping in more sustainable corners of the market. Thanks to continued economic and earnings growth, valuations across major indices have declined markedly. Large cap stocks now trade at less than 17x their forward earnings, mid cap stocks trade for 12x and small cap stocks for 11.5x. We still expect this market to struggle for lift until a downtrend in inflation manifests. But as it does, valuations should create a floor and, at these levels, actually have room for expansion.  


The Full Story:


In another anxious week for investors, a series of Crypto collapses spilled over into sympathetic tech stocks and into the broader market as forced sellers searched for liquidity. For the market newbies with “diamond hands” who have never experienced a downturn, this has been a painful experience. Consider the declines in the following fan-favorites:


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These names all have similar characteristics: great growth, high valuations, and in most cases, no earnings. Goldman Sachs actually created an index of companies known as the Non-Profitable Tech Index to isolate their performance. See (and look-out) below:


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I have been asked several times over the past week whether this technology washout made a compelling buying opportunity. Perhaps, for traders looking for a violent short covering rally, but for longer-term investors this requires more thought.


Companies that do not power their expansion with profits must power it through continuous capital raises. Amazon did not earn a dime for a decade, neither did Tesla, but each managed to fundraise their way through, using brute force and sheer will, with multiple near-death experiences along the way. With investors becoming more discerning and profit-minded, this current class of profitless tech firms may find themselves gasping for cash. Those that supply it will certainly take advantage of desperation by diluting the value for existing shareholders.


Those of us old enough to remember the early 2000s recall the challenges the newly minted NASDAQ dotcoms faced at the time. It took 15 years for that index to recapture new highs with very few of the dotcom darlings in tow. As a modern analog, the ARK Innovation Fund (ETF ticker: ARKK) holds 35 “disruptive” and mostly unprofitable technology stocks. The recent performance path eerily resembles the Nasdaq’s path at the turn of the century. For those non-profitable tech investors hoping to quickly reclaim even, beware the following chart:


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Where the Earnings Are


Fortunately, while there are many publicly listed companies that don’t make money, there are many more that do. And while the world has been preoccupied with other considerations, Q1 2022 earnings season has come and gone.


For the quarter, 79% of S&P 500 companies beat their earnings expectations while 75% beat their revenue expectations. At the beginning of the quarter, analysts expected earnings growth of 4.6%. Finalized earnings growth will likely double that amount to between 9-10%.


For the coming quarters, analysts expect earnings to grow 4.8% in Q2, 10.6% in Q3, and 10.1% in Q4. For the full year, analysts expect earnings growth overall of 10.1%. When earnings grow and prices decline, valuations can compress quickly. Here are the valuation trends across the S&P 500 large cap index, the S&P 400 midcap index, and the S&P 600 small cap index:


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As shown, large cap stock valuations have declined to their pre-pandemic averages, while mid cap valuations have fallen near their pandemic lows and small cap valuations have fallen to their Great Recession lows.


While there likely remains work to be done to bring the profitless back to reality, the profitable have certainly rationalized their valuations. This market may have a lot of problems, but at this point, valuation isn’t one of them.


Have a great Sunday!


David S. Waddell 
CEO, Chief Investment Strategist



Sources: Bloomberg, Yardeni, Yahoo Finance


David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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