It may be time to take some of the WAAAX off!

Chief Investment Officer and founder of Aitken Investment Management
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Sentiment and emotion play a huge role in the short-term pricing of equity markets. However, the way to compound returns in equities over the long run is to invest with a margin of safety, in companies that consistently grow their earnings and dividends

As the British-born American investor, economist, and professor (widely known as the “father of value investing”), Benjamin Graham said, in the short run, the equity market is a voting machine but in the long run, it’s a weighing machine. That remains accurate today.

The hardest aspect of investing is remaining patient and unemotional. It’s hard to retain discipline when you see others making money in stocks you don’t own and sectors you don’t understand.

My advice is to resist “FOMO” i.e. the fear of missing out.

This is not the time in the equity market cycle or economic cycle to give into FOMO. I believe losing discipline now could lead to years of losses in the wrong investments.

While the biggest capital gains have been made in profitless new technology stocks, I believe the equity market is starting to behave more like a weighing machine i.e. NOT good for profitless, expensive, new technology stocks. Equity investors are more discerning and are simply not paying the lofty “valuations” that private investors were happy to subscribe in the private equity market.

We saw evidence of this when WeWork cancelled their IPO process this week. WeWork was “valued” at $47 billion after the last round of investment from Japan’s Softbank Vision Fund. The IPO process appeared unable to even get a valuation of half the previous round “valuation”. No wonder the vendors pulled it, particularly the highly geared Softbank Vision Fund, which needs high exit prices to justify their entire investment strategy. This is a reminder of the potential dangers of pre-IPO unlisted investments that mark their “performance” to “valuations” based off the last round of equity invested. Illiquidity works both ways and there are attributes of a Ponzi scheme about many of these unlisted investment funds. Just remember, lobster pots are very easy to get into but almost impossible to get out of…

The WeWork IPO cancellation shouldn’t have been a big surprise. The post IPO performance of UBER (UBER.US) and Lyft (LYFT.US) is evidence that the equity markets have become more discerning than the private markets in valuing still unprofitable technology stocks. The chart below confirms UBER is -30% since IPO and Lyft -42%.

This de-rating trend is spreading further to profitless food delivery stocks such as Grubhub (GRUB.US) which is down -61%, online real estate portal Zillow (Z.US) -53%, EV and battery manufacturer Tesla (TSLA) -25% and music streaming business Spotify (SPOT.US) -38% over the last 12 months, to name a few examples.

These may well prove to be good businesses, but they were clearly trading without a margin of safety. Even after recent falls, it’s impossible to argue any offer clear “value” yet.

The US equity market appears to be pivoting away from unprofitable technology stocks towards highly profitable and cash generative established platform stocks, such as Microsoft (MSFT), Apple (APPL), Alphabet (GOOG) and Facebook (FB), to name a few. I think that’s sensible, as I see both valuation support and quarterly earnings growth confirmation pending (October) for those major US established tech names.

The point I am getting to today is that there are a number of high growth, marginally profitable/unprofitable businesses listed on the ASX that have defied the broader de-rating of new technology stocks. Because genuine “growth” is hard to find in Australian equities, anything with growth gets priced very aggressively. That’s fun while it lasts but dangerous for those who are late to the party.

It takes very little for a stock that’s priced for beyond perfection to disappoint and de-rate aggressively. When you buy with zero margin of safety, this is effectively the risk you are taking. A classic recent Australian example is profitable, yet expensive, A2 Milk Co (A2M). In July, there was a competition between the broker analysts to see who could have the highest earnings estimates leading into the August result. My fund stuck to its process and sold out of A2M into this hype ahead of the result. We sold our final stake the day the A2M CEO was on the front cover of the AFR. What came next was a “not perfect” result, lowered margin guidance, and a -27% share price fall on the back of -12% EPS cuts by analysts. Yes, the stock fell double the EPS cuts, but that also occurs as P/E is simultaneously reduced to reflect increased uncertainty.

The A2M example should have been a clear warning shot for other highly-valued next generation, low/no profitability names. It doesn’t seem to have been and I think it is prudent to be cautious on WAAAX names in Australia. They are all priced with no margin of safety and could all be subject to de-rating on delivery of even the slightest disappointment. Quite frankly, when a group of stocks has an acronym, the vast bulk of money has probably already been made.

The market capitalization of the WAAAX names are somewhat astonishing: Wisetech (WTC $11.3 billion), Afterpay ($9 billion), Appen (APX $2.6 billion), Altium ($4.5 billion), and Xero (XRO $9.3 billion). Afterpay added $1 billion in market cap yesterday alone! The combined market capitalisation of the WAAAX names is a staggering $36.7 billion. The current combined EBITDA of the WAAAX names is $324 million, according to Bloomberg consensus. For $26 billion you can buy Fortescue (FMG) and $6 billion of EBITDA! OK, just making the point.

If the market turned from a “voting machine” to a “weighing machine”, there would be a clear problem, as profitability simply doesn’t support valuations. I again refer you to the recent US de-ratings example above.

In technology, it’s time to get out of “concepts” and into “cashflow” is my opinion. Do you really need to take the capital risk in highly valued “concepts” when Microsoft (MSFT) has $133 billion of cash and cash equivalents, $56 billion of annual EBITDA, has just raised its quarterly dividend by +11% and announced a $40 billion buyback? I don’t think so and I believe it is time to be cautious on private tech valuations, unlisted tech/VC funds, and the WAAAX names in Australia.

Peak cycle valuations have passed. Investors are becoming more discerning. The difference between public market and private market valuations is widening. It’s time for conservatism and a margin of safety in technology investments. That margin of safety can still be found, but it’s right up the quality and duration curve in established technology companies.

My advice is to lose any FOMO you may have and consider the real capital risk you’re taking in paying unprecedented valuations for broadly unprofitable stocks, at what is potentially the peak of the “valuation” cycle. It may be time to take some of the WAAAX off.

Past performance is not a guide to future performance, as we all know too well.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.

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