How Investing Thematically Helps Navigate Rising Valuations
By James Cakmak and Ryan Guttridge
Broad market indices have gone virtually straight up since the depths of the pandemic. Sure we had some minor corrections here and there, but the S&P and NASDAQ still soared 96% and 114% higher from the March 2020 low. In fact, we’ve gone six months without a 5% correction, the 15th longest streak over the past century.
From a pure financial performance perspective, June 2021 earnings are coming strong as expected. Valuations, on the other hand, are arguably stretched. And in many cases, beyond stretched.
The S&P currently trades at 22.5x 2021 estimated earnings. Only 8% in history dating back to 1871 has the index traded above this level. Not to sound too many alarm bells, but the S&P’s forward price-to-sales ratio has also surpassed levels prior to the dot-com bubble.
Suffice to say, optimism is baked in.
So this begs the question, where do we go from here? History is an important guide at this juncture.
Fulfilling the Internet’s Promise
When the Internet was first sold to us two decades ago, it was effectively pitched as a General Purpose Technology. GPT’s can be characterized as sweeping technological advances that not only improve the lives of customers served, but society as a whole.
Initially, the Internet accomplished the task of increasing the speed of information flow, but our lives were largely constant otherwise. We all still had to go to the office. It wasn’t until the advent of the cloud, and the imminent proliferation of 5G, where the internet truly becomes a GPT.
Technology, generally speaking, structures society. Cultural norms develop around technology, so when a new GPT is introduced it immediately puts cultural norms under pressure.
What we experienced over the past two decades with Internet’s global proliferation is what Carlota Perez dubs as the “Installation Phase.” This is where the foundation for the future gets built. Subsequent to this period is the “Turning Point”, or the timeframe marked by transition uncertainty and social pressures. This is when society is shaken up and the dominant forces of the next chapter are solidified.
The crux of the bull-bear debate as the market reaches higher highs is the uncertainty we face both from an economic standpoint and as a society. Everything we’ve come to assume about the world has been uprooted because of Covid. Will things go back to the way they were? Some say yes and some say no. We are firmly in the latter camp.
Literally, our lives were basically organized the same way since the beginning of the industrial revolution. Covid showed us that much of that structure needn’t be so rigid. Flexibility is great for employees, freeing vast swaths of time and removing geographical constraints. For businesses, labor forces no longer need to be limited by geography. Nevermind the ability to operate virtually is now a “must have” versus a “nice to have”.
During the turn of the century when the railroads were established, the Dow components saw 70% turnover for two straight decades from the companies that built the railroads to the ones that utilized them. The Turning Point phase should be no different in our era and lead to sub-par market returns as large segments become less important.
Good news, however, following the Turning Point is the “Deployment Phase”, also called the “Golden Age”. As such, we are on the precipice of the most profound societal change in recent history. Typically, the Turning Point lasts several years. However, COVID drastically accelerated it.
Thematic Investing > Historical Valuation Metrics
It is absolutely critical to view technology and investments through this lens. This requires a thematic approach to investing and sometimes sidelining the traditional backward looking valuation metrics we have become accustomed to, whether it be P/E, P/S, or DCF. There’s a reason why Shopify trades at 40x sales and Amazon 62x earnings. They each play a huge role in reshaping how we shop or grow a business. If you focused strictly on historical valuation averages you would have missed the boat on both these stocks.
The reason why traditional valuation metrics were so important was because it was always a question if businesses could scale fast enough to justify the valuation. Geographical, physical, and labor constraints have gone out the window thanks to the cloud and 5G. This changes the investment calculus since companies are essentially unbounded by physical limits.
Consider Zoom last year. Never in history was it possible for a company to double its revenue base in a single quarter, while simultaneously boosting cash flow by 900%. This isn’t an outlier.
If there’s anything you take away from this article, it’s how critical it is to think about growth through its compounding effects versus just linearly.
We see three key areas to focus on:
1) Scale-Free Dynamics. Is the company unbounded by physical limitations?
2) Networks within Networks. Can the networks of the users themselves help compound growth?
3) Pareto. The Internet generally awards disproportionate value to a minority of players. Winner-take-all and winner-take-most dynamics apply.
If these principles hold, many of the nosebleed valuations today will be more than justified in five years.
It would have taken years to shift society from its rigid work-life structure to the increasingly flexible one we are experiencing today. If there’s one silver lining to Covid, it’s that the future is here, now.
Ride the wave.
Clockwise Capital is an asset management firm with a private equity approach to the public markets. We focus on the meaning of time and the role it plays in people’s lives. We believe the essence of a great investment resides in the ability of a company to either save their customers time, or improve its quality. We understand how technology evolves to drive these two factors, which we believe define human progress. As a result, we search for securities with cyclically depressed valuations whose companies save time, thus using secularly advantaged industries to build a concentrated portfolio. With each series of investments our goal is to optimize edge, maximize return, while also minimizing correlation. This allows our portfolio to maintain a liquid, low duration fixed income balance, ready to capitalize on market volatility, while still generating market beating performance.
