The investing world is beset by bouts of tunnel vision that are sparked off by a seemingly plausible narrative that spirals to the point where it is easy for our attention to be diverted by scenarios that appear entirely obvious.
As we have discussed before, part of this process is driven by an informational cascade whereby a drop of truth gets reflexively whipped up into a torrent of information that supports a specific narrative. Today’s informational cascade centres on the premise that equity markets are reaching levels of euphoria last seen in 1999—especially in the technology sector.
We have had extensive discussions with our talented team of technology analysts and like every cascade there is undoubtedly a drip of truth. We have struggled with the valuations of a number of companies that have come to market recently. Our core tool for appraising value is a discounted cash flow (DCF) analysis using a 10 year forecast period. We are happy to flex this time horizon to explore different distributions of returns—an exercise that is imprudent not to do for companies that have multiple moats and significant underpenetrated markets.
Our recent work on the business-to-business opportunity for our payment network investments Visa and MasterCard is a case in point. However, we really struggle with some of the analysis that is being touted by the investment banks to justify some of the recent IPOs. One recent sell-side DCF we saw this week used a 21 year competitive advantage period, where the company generates excess returns, to justify a price for a software business that has only been in existence for 8 years.
Elsewhere our technology hardware guru John Bond sent us a pitch book for a battery manufacturer that is looking to list on the equity markets. Management does not expect this company to produce any revenue until 2024 and have used a 1x enterprise-to-projected sales multiple in 8 years’ time (2028!!) as a carrot to entice investors because it is significantly lower than cash burning Tesla’s 13x 2021 sales multiple—and Tesla actually sells products and generates revenue today.
We have numerous other examples of what we view as carefree euphoria and given this backdrop it is not hard to see how the drip drip drip of information has turned into a torrent of inevitability that we are experiencing 1999-esque levels of euphoria. We make no attempts to forecast equity markets, it is a fool’s errand, but we do think it is important to avoid generalisations.
The current cascade has resulted in some commentators, such as Howard Marks, to include companies in the catchy media acronym of ‘FAANMG’ as part of the euphoria. As we have discussed before we think it’s incredibly important to avoid generalisations and look at any investment on a case-by-case basis. Our main exposure to the FAANMG group is via our investments in Microsoft and Google’s parent company, Alphabet. Both companies enjoy monopoly positions in their businesses that are surrounded by multiple economic moats. In addition they have significant balance sheet optionality and most importantly we believe that both companies, with proven business models, will both trade on 9% (or 11x) free cash flow, not revenue, to enterprise value yields in 2025. Although Microsoft and Alphabet may be tarred with the euphoric brush of 1999-esque mania we think that the risk, both business and valuation, to which we are exposing our clients is a world away from the aforementioned battery maker and recently listed software company.
Who knows when this informational cascade will subside, but we remain poised to capitalise on any investor myopia for the long-term benefit of our investors.
This is an excerpt from the Global Leaders Investment Letter which is written quarterly by portfolio managers Mick Dillon, CFA and Bertie Thomson, CFA.
The Global Leaders Strategy invests in a concentrated portfolio of market-leading companies from across the globe. We believe that companies that combine exceptional outcomes for their customers with strong leadership can generate high and sustainable returns on invested capital (ROIC) which can lead to outstanding shareholder returns.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.