One thing that has become clear to me over the past few years, and especially recently, is that we’re in a new paradigm. My use of those words alone should be concerning because new paradigms usually predate market crashes, just as they did in 1999 and 2006.
How many companies can you name that are being priced on a multiple of revenues instead of profits?
- Xero Limited (ASX: XRO)
- Nearmap Ltd (ASX: NEA)
- Afterpay Touch Group Ltd (ASX: APT)
- A2 Milk Company Ltd (ASX: A2M)
- Kogan.com Ltd (ASX: KGN)
Each of these companies is clearly being priced on revenue growth – and most of them are unprofitable.
Furthermore, each of those companies has dozens of imitators lower down the market that are clearly trying to play off a variety of themes like a Chinese food boom or a recurring revenue/Software-as-a-Service (SaaS) model.
Don’t get me wrong, these five are decent companies and I own shares in several of them. It is the pretenders lower down the market, and the blind bullishness of investors that I think are concerns.
There are a couple of new paradigms at work. First is the ‘recurring revenue’ model where sales growth and market share growth, not profits, is all that matters.
Second is the ‘cheap debt’ model. Does it seem strange to you that some of the fastest growing and most popular stocks in the market are lenders of some description?
Afterpay is one and Axsesstoday Ltd (ASX: AXL), an equipment financier for businesses, is another one.
Does it seem strange to you that a consumer credit business could be priced at 20x revenue? Does it seem strange to you than an equipment leasing business could be priced at 45x trailing earnings?
Sure, both Afterpay and Axsesstoday have a promising growth profile and expansion plans, but their valuations are definitely high. There are also several other risks that investors should be wary of.
First, risks in the market are increasing. Companies with vulnerable business models are already seeing problems come home to roost, even though business conditions are fairly normal. Blue Sky Alternative Investments Ltd (ASX: BLA), Big Un Limited (ASX: BIG) and Retail Food Group Limited (ASX: RFG) have each detonated spectacularly in the last few months.
If these blow ups are occurring even in mild conditions, what will happen if a housing downturn takes effect or interest rates start to rise?
Second, we’re already in the early stages of a possible housing downturn. Tighter lending conditions from APRA are simultaneously lowering the amount of easy credit and increasing the repayment requirements for existing loans.
This is a theme that will play out over the next couple of years as investors roll over from interest only to principle & interest loans. This will potentially reduce household feelings of wealth and exacerbate problems being caused by low wage growth.
Third, interest rates are already starting to rise in the USA and even in Australia. 1-year Australian government bond yields have been rising according to data from Bloomberg. If this continues, this is a sign that the debt market may be repricing even though the Reserve Bank holds rates steady. Thus the cost of borrowing may already be on the rise – and our big banks draw much of their funding from the USA.
Fourth, more concerning than interest rates themselves, is liquidity and the availability of debt. Currently there is ample availability of debt and many investors are willing to speculate on riskier and lower quality companies, in an attempt to earn higher returns.
As interest rates rise, liquidity may decrease, and should that happen, companies won’t just be paying higher interest rates, but they may not be able to refinance their debt at all – forcing them to raise capital instead.
I’m not predicting an imminent catastrophe, but I do think that the risks are rising and it is a really bad time for investors to be taking on extra risk and chasing higher returns in speculative companies.
Avoiding highly indebted or cyclical businesses seems a shrewd move, and if you wouldn’t buy more shares in one of your companies if it fell 70%, it might be time to think about whether you want to own that company at all.
When a veritable investing and entrepreneurial genius speaks, it pays to listen.
In fact, he's now preparing a $100B "war chest" to invest entirely in this "terrifying" new technology, which could spell huge profits for investors.
Motley Fool contributor Sean O'Neill owns shares of A2 Milk, Nearmap Ltd., and Xero. The Motley Fool Australia owns shares of and has recommended Nearmap Ltd. The Motley Fool Australia owns shares of A2 Milk, AFTERPAY T FPO, and Xero. The Motley Fool Australia has recommended Kogan.com ltd. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.