Is a bubble forming in growth stocks?

When the conversation shifts away from underlying value, trouble could be round the corner.

'Why waste your time investing in a stock that at best can double, when there are stocks out there that can ten bag?'. It's a question I've heard asked a lot lately, invariably in connection with stocks like Afterpay, Pro Medicus or Nearmap.

It's not without good reason. The name of the game is to build a portfolio of long-term compounders. If you find a stock with a durable competitive advantage, a long growth runway and a reasonable price, it's time to load up.

But people seem to be forgetting that a double in five years is still a 15 per cent return. That seems pretty good - particularly if you did it with relatively low risk - until you compare yourself to the smarter guy who bought Appen a year ago. It appears to be creating an environment in which all of the money is chasing a small number of high-growth opportunities - a sign that things are getting bubbly.

Investment cases are becoming less valuation-centric. It's not 'X has good fundamentals and trades at a relatively low price' - it's 'X has the best technology', 'Y is growing exponentially in the US' or 'Z is disrupting'.

It may be true, but the acronym is GARP (growth at a reasonable price), not GAAP (growth at any price). Granted, it's unlikely that a company's value can be pinned down to an exact number - and the range of possible valuations for high-growth companies is so wide that often, almost anything is possible. But when valuations are tethered only by investor imagination, and when cash flows cease to matter, there's no limit to the price people might pay. Again, it's a sign that a bubble is forming.

Multiples expanding

The other thing I've noticed is that investors have already forgotten last year's correction - which was a good reminder of how suddenly you can be punished for taking valuation risk. But price-to-sales ratios are once again extreme for stocks like Altium (19x), Wisetech (21x), Xero (17x) and Nanosonics (17x), never mind price to earnings, because in many cases there are few profits while the companies roll out their fabulous technology.

While there's no doubt these companies all have bright prospects, for now that's exactly what they are: prospects. How many have been proven over a long period of time, over different cycles and through periods of technological change? There are fantastic investment cases to be made for each, but I wonder what proportion of stocks with a price-to-sales multiple above 15 have gone on to beat the market. My guess would be few.

For a time, though, it creates a positive feedback loop. Investors are attracted by the high returns, which drives prices higher, which attracts more investors. Pretty soon, investors begin to fear missing out more than they do losing money, which is perhaps the biggest sign of all that we're getting into bubble territory.

As a budding value investor, there are a few things you read pretty early on. Peter Lynch says that a good company is not synonymous with a good investment. Howard Marks professes that it is hard to distinguish between excessive risk-taking and stock-picking ability. Warren Buffett maintains that we should invest in what we understand. He also tells us that it's easy to mistake short-term competitive advantages for truly enduring economic moats.

How many of these golden nuggets of investment wisdom are going unheeded right now? I think many. And I don't know if that means we are in a bubble right now, but it sure feels like we're heading for one.

Disclaimer
Intelligent Investor provides general financial advice as an authorised representative under the AFSL held by InvestSMART Publishing Pty Limited (Licensee). InvestSMART Funds Management Limited (RE) is the responsible entity of various managed investment schemes and funds and is a related party of the Licensee. The RE may own, buy or sell the shares suggested in this article simultaneous with, or following the release of this article. Any such transaction could affect the price of the share.

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