Given the sharp decline in share prices of certain sectors to start the year, particularly among shares of smaller, more speculative technology firms, it is a natural question to ask how an investor should react in such markets. This blog will explore some of my thoughts about behaving in these markets.

1) It’s impossible to know whether a stock is undervalued without having studied it

Some investors have an instinct to assume that whatever falls a lot in price is undervalued. The problem with this is that it assumes the shares were previously at some point fairly valued: suppose there was a stock that has a hypothetical fair value of $10, and investors in their enthusiasm pushed the share price up to $50, and then back down to $20. Assuming the situation has not changed (which is not usually a good assumption), shares are still 50% overvalued!

There are many possible scenarios when a company’s share price falls significantly that do not make the shares attractive to buy: perhaps the shares went from very overvalued to modestly overvalued or maybe something negative happened and the shares simply should be worth less. The only way to adequately determine that the shares are in fact undervalued is through a balanced analysis of risks and opportunities facing the company without being swayed by the prevailing narrative in the markets.

As a side note, this is why we spend time studying high-quality businesses that appear to be trading at expensive prices. Share prices can swing wildly without much reason in the short term and we want to be prepared if the opportunity presents itself. As an example, one company that we recently purchased for clients is CoStar Group. We have followed CoStar for several years and while we admired the business and the management team, believed shares were too expensive. After CoStar shares sold off by over 20% following a weak earnings report in late 2021, we were prepared to take advantage and acquired a position.

2) Share prices have real world impacts

The caveat to analyzing stocks using a rational, balanced view is that the share price itself can be an important input into the value of the company. Some investors often like to think of “intrinsic value” of a company’s shares as an independent figure that has minimal relation to the wild fluctuations of the stock market and the share price. In reality, a company’s share price has real-world impacts on the value of a company: a high and rising share price attracts employees and provides cheap capital and credibility for the management to pursue its growth opportunities. On the flip side, companies with weak and stagnating share prices lack the confidence in the markets to pursue strategic initiatives such as M&A and have to overpay to attract quality talent. These factors are especially important among younger, unprofitable companies that rely on their equity as currency.

As share prices fall, investors get more nervous leading to less capital overall in the sector. This happened in 2001 when the tech crash led to a flight in venture capital and less funding for the growth opportunities of these unprofitable young companies. Many firms ended up going bankrupt, while others had to make large layoffs to be profitable given the lack of external funding. I expect a similar pattern to repeat in the near future for many of the unprofitable technology companies that have sold off, even though we remain very far away from a dearth of capital availability.

3) The attractiveness of share prices is all relative

Baskin’s portfolio has held up fairly well since December when high-growth stocks started to come down. As much as we want to pat ourselves on the back for our prescience, the relative attractiveness of our portfolio is now lower.

To understand why, the attractiveness of a given purchase is always determined relative to the alternatives. If you’re looking to buy a car, you look at all the various makes and models and decide which car is the best value for its price: $25,000 for a Hyundai, $50,000 for a BMW, or $300,000 for a Ferrari. However, if you can buy the Ferrari for $100,000, the BMW and Hyundai clearly become relatively worse deals at $50,000 and $25,000!

The same principle is true in stocks. I’m not saying that any of the companies whose share prices are down 50%-60% are Ferraris, nor am I saying that they’re attractively valued (see point 1 above), but high growth companies on average should be worth more than low growth companies and therefore lower-growth, more mature sectors such as consumer staples are now relatively less attractive than high-growth technology companies whose shares have fallen significantly.

4) It is impossible to time the bottom

Often times, investors get worried about buying a falling stock despite having done the research because of the fear that the stock and the market could keep falling. This is not a valid reason to not buy the stock, because you can only know whether a stock has bottomed after the fact. Once again, the best an investor can do again is to trust their own analysis to have conviction in the value that they are buying.

Where does this leave us today

Having studied a handful of these so-called “high-growth” companies, my general view is that valuations have gone from highly overvalued from late 2020 to mid 2021 to relatively fairly valued today. Shares of many leading, profitable software and technology companies are now trading at values similar to pre-COVID levels despite their structural acceleration of growth. Despite the tough comparable going forward, many of these companies further took advantage of their lofty share prices to issue shares and strengthen their financial position, and thus are fairly well capitalized to continue investing despite the recent share price drop.

For our part, our strategy is to stick with our existing portfolio which is made up of high-quality businesses that we admire and have followed for a long time. Swapping for a new company leads to increased risk due to a lower conviction level as well as realized capital gains taxes. On the other hand, we are certainly looking to opportunistically buy shares of high quality companies at more attractive prices.