Don’t Stop Or I’ll Shoot
January was the worst month for U.S. stock markets since the start of the pandemic in early 2020. While the TSX was buoyed up by strong commodity prices, the S&P 500 fell by 5.3% and the NASDAQ fell by 9%. It is not unusual for markets to retrace gains made in strong periods, and there is no doubt that since the markets bottomed in April 2020, this has been a very strong period indeed. From trough to peak, the S&P 500 doubled, the NASDAQ rose 139% and the TSX rose 92%. Really, we have no business complaining about a bad month! However, it is certainly worth while looking at some of the factors behind the bruising start to the year.
Of course, we all recognize that the persistence of the COVID plague and the particular virulence of the Omicron variant are important. Coupled with this are the threat of a war in Eastern Europe, political division in the U.S. and tensions between the world’s two largest economies, the U.S. and China. But another reason is probably more important in explaining what happened in January. It is the realization that interest rates are going to rise, and the notion that rising rates will have an impact, maybe a serious one, on future economic growth.
Here is a good way to think about investing in growth companies. Imagine that there is a box with 10 pieces of paper in it. One is a $100 bill, three are $50 bills, and the rest are $10 dollar bills. How much would you pay to put your hand in the box and pick one piece of paper? The logical answer is that there is a total of $310 in the box, divided by 10 possible outcomes. So, any one chance is worth $31. (Put another way, if you paid $31 ten times, you are guaranteed to get your money back). Logically, investors should view newer, more speculative companies this way, but of course, they don’t. Most think they can pick out the $100 bill more than one time out of ten. Maybe they think they can pick it out half the time and are prepared to pay $50 for the chance. Well, that’s okay. It’s their money, and their choice.
But now imagine that someone comes along and says “the rules of the game have changed, I’m taking the $100 bill out of the box and replacing it with a piece of worthless monopoly game money.” Now the total value of the paper in the box is only $210, and the logical price for a chance to pick is now only $21. That’s down $10 or 33% from what it was before the $100 bill was removed. Now, nobody, no matter how confident, would pay $50 for a chance to pick. The potential reward has been cut by a third.
This is exactly what happens when investors lose their belief that companies will grow rapidly. Suddenly, the reward for taking the gamble has dropped, often by a lot. Peloton, the maker of fancy stationary bikes, has seen its stock drop from $150 to $26, or about 83%. Not because there is anything wrong with the bikes, but because the company lowered its growth forecast. It changed itself from a possible $100 bill to at best a $50 bill and maybe only a $10 bill, and investors changed the amount they were prepared to pay to take a chance accordingly. The same has happened to many newer companies that were highly favoured by growth investors, including such well known names as Shopify, Door Dash, Beyond Meat and Lightspeed. The fear of high interest rates leading to slow growth made gambling riskier. As our clients know, Baskin Wealth Management does not invest in speculative companies like these.
In the past two weeks, even though they are very solid and well-established, three of our portfolio companies have suffered a similar fate. Netflix issued a forecast that its subscriber growth in the next quarter would be less than previously expected. The stock promptly dropped 30% (it has since recovered about half of that). PayPal similarly disappointed the market in its outlook for future revenue, prompting a one day 25% thrashing, and Facebook reported record profits, higher than expected, but forecast slowing growth in the next quarter. Its stock fell 25% on the opening bell the next day.
Some investors have very short time horizons and will ruthlessly sell positions based on expectations for the next three months. Others are more patient and recognize that every company goes through ups and downs, periods of higher and lower growth. Patient investors remember that Apple and Microsoft each fell by more than 80% in the dot-com bust of 2000-2001, and then went on to become among the most valuable companies in history.
We know that interest rates will be going up in the next few months and will probably be rising for as long as a couple of years. This should be no surprise to anyone, as the central bankers in the U.S., Canada and Europe have taken great pains to warn markets that this would be happening. Will higher rates crush growth and even lead to a recession? We doubt it. We continue to believe that much of the inflation being seen around the world will ease when COVID restrictions are removed, as is now happening quite rapidly. We believe that central banks will not go overboard in their efforts to rein in inflation and will not raise rates so high as to cause a recession.
All of our clients know that we are not short-term investors. Like everyone else, we hate to see the price of our portfolio companies go down, but we try and remain focused on the value of the companies, which does not go up or down 25% or 30% in a day. Right now the markets are hypersensitive to fears of falling growth, and sellers have itchy trigger fingers. They are essentially saying “Don’t stop growing fast, or we’ll kill your stock”.
As always, we will continue to own companies that have real value, and we will not sell based on what might happen in one or two quarters.
Barry Schwartz on BNN – January 4, 2022
Barry Schwartz on BNN – January 24, 2022
David Baskin on BNN – January 25, 2022