A So-Far Rational Sell-Off. Post-Crash Crowding Effect Into Less-Exposed Sectors Likely to be BRUTAL.

I wrote this in response to a piece a friend sent and figured I’d just share verbatim.  Arguing that “cheap” PE ratios aren’t valid because the earnings estimates in them are stale. pre-virus numbers.

Tempted by the cheap valuations the equity rout has produced? Think again: stocks may still be much more expensive than they seem.  The ratio of price to estimated earnings for the S&P 500 Index has fallen to 15.5 times, much lower than the dotcom era’s 25.7 and almost the same as at the start of the bull market. Emerging-market stocks are similar: the benchmark gauge has fallen below its life-time average valuation and is also 30% cheaper than its all-time high.  But stock prices discount known risks more quickly than analysts’ estimates for earnings, which follow with a time lag. Indexes already reflect the latest reality, but profit forecasts don’t yet. That means the current price-to-earnings ratios are logical fallacies.

The author is right that SOME earnings estimates are way too high.  But SOME estimates are probably going to be roughly the same.  With a huge sector-by-sector variance.  So the post-crash crowding effect into stocks that aren’t going to take a hit is going to be BRUTAL.  Portfolio Managers will have to wake up next week and try to find ways to out-perform the holes they have found themselves in.  Unfortunately, the stocks that will do the best (especially SAAS) were already the “crowded longs” before this crisis.

Lets stick with the (hopefully) consensus “Coronavirus!” scenario not the “We are becoming Japan – deflation!” scenario.  Meaning things have sorted out by 3Q-4Q.  By that measure, the market has actually been (so far) pretty rational in this sell-off.

  • A lot of bankruptcies or emergency re-financings.  General carnage in the consumer oil, services space etc. etc.
  • A lot of companies will never make those lost revenues back.  Meals not sold, trips not taken, etc etc.
  • But a lot of companies will see very little change to revenues.  Especially “subscription” businesses.  Telcos, cable, Netflix, AWS, SAAS, etc….
  • But a lot of “Industrial goods” companies (I’m thinking my comm equipment guys but could be anyone) will be sitting on a wave of pent up demand.  The lost sales from 1Q and 2Q will mostly come into 3Q-4Q.  OK, not if the end customers are bankrupt.  But that will be a sector-by-sector effect.
    • I own Infinera, which was a mistake (a $200m convert they did last week crashed the stock).  But it is burned down to the ground (plenty of cash cushion after that convert) and any “lost” sales will come back.  They are also ramping up a new product cycle that should last for @3 years and the stock is now trading at 0.57 EV/TTM sales.  Any earnings hit will be a blip and they have the cash to ride this out.
  • A (tiny) sub-set of companies will sail right through this or even benefit.  I happen to own two of them more by luck than any “Coronavirus-proofing” moves on my part.  They are useful examples though.  Estimates for both either don’t change (Atlassian) or maybe go up (Cloudflare).
    • Atlassian:  Has a “no sales force” growth model (based on viral customer adoption) that runs at a pretty stable 30% revenue growth rate.  Its software is cheap and mission critical to its customers.  Over-indexed to tech so it might lose some big start-up customers, but their customer concentration is so low (100,000+ customers) even that only knocks off a few points of revenue growth.
    • Cloudflare – relies mostly on inside sales mining a large existing base of “free” customers.  Those customers are running websites which they can do from home, so business activity will keep up.  Cloudflare also just happened to launch a cheap ($3-$5 a month), easy-to-set-up-and-use “work from home” remote access service this quarter.  Corporate VPN’s are set up for occasional travel, not 100% work from home so demand for that service will be extremely high.

The market is reflecting that differential outlook.  Cloudflare has outperformed the S&P by 42%, Atlassian by 28%.  If you look at their charts alone, you’d never know we were in a panic (which is one big reason I’ve been feeling behind the curve the last week or so).

I’m using my stocks as examples because I know them and have been doing a lot of thinking about them.  I am taking ZERO credit for positioning myself for Coronavirus.  Like I said above, I was way too complacent.  Looking at the non-crisis in my stocks and not the obvious crisis in the markets.

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