Valuations And Stock Returns: Looking Back on The Dot Com Period by Steven De Klerck
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Some studies perform an quantitative (valuation) analysis of a specific situation. One of these studies was published in 2000 by the managers of LSV Asset Management: "New Paradigm Or Same Old Hype In Investing" and it is absolutely a must-read. At a time when investors were completely under the spell of dot com, telecom and IT, Chan et al. (2000) analyzed the fundamentals underlying the hyperbolic increase in the valuations of stocks from the aforementioned sectors.
The researchers departed from the finding that in the years prior to the turn of the century, growth stocks realized a significant higher stock return compared with value stocks, which is in contrast with the historical outperformance of value stocks. The fact that the S&P500 is dominated by large cap growth stocks resulted in the underperformance of value-oriented asset managers and investors. Consequently, in this period value investors were subjected to great pressure to include growth stocks into their portfolio. In 1998, for example, large cap growth stocks realized a return of 41 percent; small cap value stocks lagged with a return of -1 percent.
Being an investor, how do you cope with an underperformance of 42 percent on an annual basis? The answer can be read in this study: a rational analysis of valuations in relation to underlying realized fundamentals.
In particular, Chan et al. (2000) examine how the valuation of growth stocks can be accounted for by changes in underlying fundamentals such as revenues and profits.
In the beginning of 1999, the researchers documented a price-to-sales ratio and a price-to-operating income ratio of 4.20 and 17.60 respectively for large cap growth stocks, significantly above the historical mean of 1.38 and 7.42 respectively over the 1970-1998 period. More than one quarter out of the hundred companies with the largest market capitalizations had a price-to-sales ratio above 7. Such valuations can only be justified in case companies for a number of decades should manage to realize extremely high grow rates in revenues and earnings – which is practically impossible given the lack of any persistence in historical growth rates. At the same time, Chan et al. (2000) documented a growth rate in revenues for large cap growth stocks of only 6.0 percent over the 1996-1998 period, lower than the historical mean of 10.3 percent. For operating income as performance criterion, these numbers were 9.6 percent and 10.6 percent respectively.
The conclusion was clear: the high stock returns and increasing valuations for large cap growth stocks were not supported by significant improvements in underlying fundamentals, on the contrary. At the same time, Chan et al. (2000) found no significant deterioration in revenue growth and/or earnings growth for small cap value stocks during the 1996-1998 period.
In light of these analyses, Chan et al. (2000) concluded that a new paradigm was out of the question and that the explanation for the very high valuations of growth stocks was mainly to be found in the psychological sphere; investors who, driven by overoptimism and excessively positive sentiment, force the valuations of growth stocks far above their intrinsic value. Hence, they concluded that growth stocks would realize disappointing returns in the upcoming years. At the same time, the researchers concluded that value stocks were on the threshold of a more than significant revival.
The abovementioned retrospective of the study published in 2000 demonstrates at least two issues for investors. First, very few companies deserve very high stock market valuations since only very few companies succeed in realizing high growth rates in revenues and earnings in a persistent manner. At the same time, this study holds a caution regarding the dangers that go with the practice of benchmarking. In the period around the turn of the century, this practice instigated asset managers to irrational investment decisions by means of taking in growth stocks in the portfolio – decisions which were not founded by improvements in revenues and earnings for growth stocks in relation to galloping valuations. However, both the study by Chan et al. (2000) and history demonstrate that the lack of excessively valued growth stocks in the period 1998-2000 did not happen to be a shortcoming, instead it was a sensible investment decision and consequently so was the implicit choice of underperformance. Long term investors preferably learn to deal in an intelligent way with these and similar periods. More information on this matter can be found in the "Mental approach" section.
At the peak of the tech bubble in early 2000, after a stellar period for growth stocks, Valuation Dispersion had widened more than at any time in U.S. capital markets history. This laid the foundation for seven consecutive years of success for value investors.
Arnott et al., 2009