Alarm Clock Goes Off on Dream Stocks

by Joseph G. Paul

Investors have recently woken up to the reality of overpriced US momentum stocks in technology and biotech. But a knee-jerk shift toward defensive sectors isn’t the answer. In early April, money has flowed away from companies such as Netflix and Twitter, which we call “dream stocks” because investors believed they could grow without any help from the economy. A more thoughtful reaction to this collapse would be to reach for cheap stocks—rather than safe ones—because they have value on their side and will diversify interest-rate risk. And we believe that there are good reasons to anticipate more appreciation ahead—if you focus on the right parts of the market. Defensive Sectors Look Risky In the flight from momentum, investors appear to be flocking toward companies in utilities, real estate investment trusts or REITS and consumer staples. Yet these stocks are not risk-free. They are priced high relative to their own history because people are still paying a high price for safety. After all, the argument goes, if the economy doesn’t grow, companies in defensive sectors won’t suffer their usual valuation penalty that traces to high dividends, which leave very little capital for growth. But what if growth accelerates? In our view, companies that are unable to invest in future growth could underperform significantly if the economic recovery accelerates. By concentrating their portfolios in defensive companies, investors may miss an opportunity in those companies that are more likely to thrive in a faster-growth environment. Understanding Valuations Stock valuations help point the way. Spreads between the cheapest and most expensive quintiles of stocks based on price/book value are extremely wide. This has been driven largely by the inflated valuation of dream stocks in the most expensive group, as we explained in a recent blog, but also by continued underappreciation of companies with uncertain profit trajectories. Indeed, price/earnings multiples vary enormously. Even amid the recent declines of momentum stocks, the most expensive stocks trade at valuations that are still 4.8 times the market median (Display)—quite high relative to history, higher than during the financial crisis and approaching the record levels seen during the tech bubble. The pain investors have already experienced in this group could just be the beginning. Economic Growth to Unlock Value There are plenty of attractively valued stocks to be found at the other end of the spectrum. Many boast high profit margins that we believe are sustainable. In some cases, sales growth is well below the long-term trend and can be expected to improve. In others, improved cost structures and more benign competitive environments support future profits. These underpriced companies are generally more sensitive to economic growth, so their value could be unlocked when the economic waters become clearer. But these stocks have another important characteristic. Since the Fed has made clear that interest rates will rise when the US economy’s growth prospects improve, we’re likely to see economically sensitive stocks appreciate just as bond values are falling, providing much needed diversification to balanced portfolios. Those rushing into defensive stocks as shelter from the carnage in the dream stocks may find themselves trading one risk for another as the defensives are likely to underperform when interest rates rise. Momentum Rout Exposes Passive Flaws There’s another important lesson from the recent rout in momentum stocks. Investors who have bought into an index have also been buying into dream stocks, often unintentionally. As these stocks rose to excessive valuations, they automatically became a bigger part of the benchmark. In the aftermath of the correction, we think investors should reconsider the merits of buying the entire market without any scrutiny. Taking a stock-picking approach can also help avert a rush into expensive defensive stocks. In our view, staying active and focusing on attractively valued stocks that can perform well as an economic recovery unfolds is the best way to get a better night’s sleep in today’s restless markets.

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