What Happens after Stocks Run Up in Price?
On the back of rapidly rising interest rates from central banks all over the world, in 2022, the talk was all about the impending recession. The script was quickly flipped in 2023 when the economic slowdown never materialized. The current talk of the town is on all things technology and AI.
This has driven prices of technology stocks to new heights, with Nvidia up over 220% and Meta up over 130% year-to-date.
Price-to-sales is one valuation metric where we can measure how much investors are willing to pay for every dollar of sales. A price-to-sales ratio of 5 simply means investors are paying $5 for every dollar of sales that the company has. The aggregate price-to-sales ratio for the broader S&P 500 index is around 2.46. At the moment, Nvidia holds the record with a price-to-sales ratio of over 45.
Interestingly, we can see that on average, these highly priced stocks slightly outperform the market over the next one year, driven by the momentum effect. Over the longer term, these stocks go on to underperform the market over the next 3 and 5 years and longer.
The problem with high valuations such as the price-to-sales ratio is that it comes with high expectations. The higher it goes, the more financial gravity works to pull it down. Michael Mauboussin’s work on Base Rates provides instructive evidence on how professional analyst expectations for company’s sales growth are too optimistic and too narrow when compared to actual results. This is dangerous because the day that the company fails to delivers expectations, its share price can take a large beating.
Warren Buffet gives caution about companies that predict rapid growth. An excerpt of his warning from his letter to shareholders in 2000.
“Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic - but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.”
Evidence suggests that while these stocks can continue to go higher in the short-term, your best bet in growing your long-term wealth is to have an efficient portfolio that is diversified across securities, sectors and geographies - and not only on companies which have very high growth expectations.
In the same way that you would rely on a doctor to treat you or a professional mechanic to service your automobile, investors can benefit greatly by working with an adviser — giving you the peace of mind knowing that your plan is in the hands of a professional.
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