A lot of debate has emerged recently over why growth shares have tended to outperform value shares with the low interest rate environment worldwide one obvious reason. As interest or risk free rates on cash or other risk free assets like US treasuries fall lower, then the growth on offer from equities or other asset classes such as property becomes more attractive.
So as investors demand less compensation for buying risky equities valuations become higher, as investors are prepared to pay more for the yield and free cashflow offered.
This effect has been particularly magnified in growth shares where the net present value of future cash flows grows even higher as analysts factor in even lower risk free returns into the future in their valuation models.
At the small-cap end of the market a lot of traders will also buy shares with no regard to valuation, sometimes because they don't understand it, and sometimes because they are only buying for short term profits.
One high profile fundie in Steve Johnson at Forager has labeled 10 fast-rising ASX shares as a "bubble" based on the fact they all have valuations over $500 million, less than $50 million of revenue each, and lost $227 million as a collective group over the last 12 months. The Forager report and commentary is available to read here.
Let's take a quick look at the stocks Johnson claims are a bubble. For reference, I must also admit to knowing little about some of these companies.
All stats according to Forager Funds research as at June 25, 2019.
Avita Medical Ltd (ASX: AVH) is a regenerative medicine company with just $3 million of revenue and an enterprise value (EV) of $755 million. On those stats it looks a speculative bubble.
iSignthis Ltd (ASX: ISX) is a KYC verification platform that has an EV of $658 million and just $6 million of revenue. I'm also sceptical about this company and its valuation.
Polynovo Limited (ASX: PNV) is a medical device biotech business that made a loss of $5 million on revenue of just $9 million over the last 12 months, but sports an EV of $951 million. It looks like Mr. Johnson might have a point here!
Clinuvel Pharmaceuticals Limited (ASX: CUV) is another biotech that has a SCENESSE drug to treat skin disease that is in the queue for approval from the U.S. FDA. On June 3 it told the market the FDA needed more time to come to a full decision. It posted net income of $16 million on revenue of $27 million over the last 12 months. The market cap is $1.7 billion, but at least this company is a step in the right direction in boasting a substantial profit.
Pro Medicus Ltd (ASX: PME) is a business I have a bias towards as a small shareholder, which reported net income of $19 million on revenue of $45 million over the last 12 months according to Forager. The value is $2.7 billion plus now, whether this turns out to be a bubble will come down to sales and operating performance over the next 3 to 5 years.
Megaport Ltd (ASX: MP1) is the on-demand internet connectivity business that has an EV of $809 million, despite posting a $28 million loss on revenue of $26 million over the last 12 months.
Mesoblast Ltd (ASX: MSB) is probably the biggest capital sinkhole on the local share market in posting a $127 million loss on revenue of $23 million over just the last 12 months. The EV today is $710 million, but, remarkably, has been far higher.
Audinate Group Ltd (ASX: AD8) is a software and digital sound processing business that recently completed a significant capital raising. This suggests its own management and investment banking advisers may be impressed by its valuation. It posted net income of $1 million on just $25 million of revenue over the last 12 months.
Bubs Australia Ltd (ASX: BUB) is the goat-based baby formula business that's playing heavily on the 'Chinese demand' theme. It apparently made a huge $70 million loss on revenue of $33 million over the last 12 months.
Elixinol Global (ASX: EXL) sells hemp oil for use in medicinal cannabis products, which is a hot or potentially bubble-like sector right now. It has an EV of $466 million, yet made a $1 million loss on revenue of just $37 million over the last 12 months. Not my cup of tea.
Outlook
Using conventional valuations metrics and common sense it's hard to argue that all of these stocks' valuations don't have some bubble-like characteristics about them.
However, it's also worth remembering that in the share market everyone has an opinion, which will be right, wrong, irrelevant, uniformed, or up to all of the aforementioned – the only thing that really matters is returns.
So, remember that over the long term share prices will follow profits higher or lower. While it also pays to think of growth and value is indivisible metrics in my opinion. In other words an investment is a unworthy unless you have both.
Hardcore value investing or betting on turnaround stories then may be best left to the professionals, as it might be an even riskier approach than only buying high-quality companies (no debt, track record of earnings growth, etc) on reasonable valuations for the long term.
