“When Does The Party End?”” – Goldman Finds Revenue Multiples Have Never Been Higher

“When Does The Party End?”” – Goldman Finds Revenue Multiples Have Never Been Higher

With stocks rising to record high after record high, and with even Goldman’s clients now asking “When does the party end?” as noted by Goldman’s David Kostin overnight, the answer is simple: nothing has changed. Specifically, between the Fed’s ongoing monetization of tens of billions monthly in bonds, the missing piece to the equation is also a known one – corporate buybacks. In fact as Goldman admits, “February was the busiest month in our buyback desk’s history.” (which surely is Chinese walled off from Goldman’s prop trading desk). Why? Because as Reuters reported previously, this was the second-busiest week ever recorded for high-grade bond issuance. And with the use of proceeds certainly not going to capex, companies continue to buyback their shares in record amounts to mask the decline in actual cash earnings by lowering the amount of shares outstanding and thus keeping EPS rising or flat.

But aren’t companies leery of buying back their shares at all time highs?

Well, not if in the process of purchasing they can get the momentum chasing algos and what little retail dumb money is left to piggyback along, and generate additional upside, which then allows companies to use their overvalued equity as M&A currency. Confirming precisely that corporations now see their stocks as the most highly valued ever, is that the share of M&A primarily paid for in stock is now at an all time high! It’s ok though – nothing quite like issuing record amounts of debt (as we said would happen back in 2012) to buy back one’s stock so that the same stock can hit record levels and then be used as currency to purchase other companies – as Homer Simpson would say, a “tidy little package.”

And confirming just how incredulous investors are in this latest “growth stock mania” phase is that as Goldman says, it has led many investors to ask: “When does the party end?” Growth companies such as Facebook, Yelp, and Alexion Pharmaceuticals have returned more than 30% YTD and trade at high valuations that imply market expectations for strong future growth.

Goldman’s punchline: the median company’s EV/sales ratio is now the highest in 35 years, surpassing even the dot com bubble.

Goldman then wonders, with the market at full valuation what amount of growth is necessary to sustain the lofty valuations and fulfill the expectations embedded in premium multiples. To answer the question, the vampire squid analyzed the historical performance of stocks across the Russell 3000, examining EV/sales ratios in order to include smaller growth companies. Its findings:

Of stocks with the highest embedded expectations, only those able to realize truly exceptional revenue growth reliably outperform. Exhibit 5 shows the median 1-, 3-, and 5-year forward returns for stocks with EV/sales ratios of 10x-15x. The median stock in this category underperforms its sector peers in most cases. For example, even stocks able to double or triple sales in a year have historically lagged by a median of 10 pp during those 12 months. Only stocks that grew revenues by more than 500% over a five year period (43% CAGR) typically outperformed, and then by less than 5 pp.

In other words, the party rarely continues for long. Shares priced to grow the fastest rarely succeed in growing into their valuations. Firms ranking in the top 10% of EV/sales ratios (typically 10x and higher), generally lag peers over 1-, 3-, and 5-year horizons, regardless of realized growth.

Many investors find the historical example surprising given its contrast with recent trends. The median Russell 3000 stock with a EV/sales ratio above 10x one year ago returned 34% during the past 12 months, outperforming the index’s median stock by 500 bp.

Not surprisingly, it is the cheap stocks that perform better in the long-run. Stocks on the other end of the distribution have historically tended to
outperform across time horizons, regardless of growth rate (Exhibit 6). The median firm with EV/sales below 0.5x typically outpaces sector peers. But who knows – after all never before has the entire stock market been a bubble of such unprecedented proportions blown willingly and knowingly by a Fed which has gone all in on its bet its record balance sheet will trickle down into the economy via the Russell 2000 “transmission mechanism”, and never before has the Fed – which now in retrospect admits the 2007 market was a bubble – cast so blind an eye on the current bubble which as even Goldman admits is bigger than it ever was before.

Which then, according to Goldman, leaves investors with a choice: (1) Target the stocks priced to grow the fastest and either ride the current wave of popularity or aim to beat the historical odds by identifying the outliers; or (2) invest in stocks with low multiples and outperform as a base case, with larger returns as a bonus for identifying the firms that actually deliver the fastest growth.

In our view there is a third choice – the same we have been advocating for the past 5 years: ignore the manipulated, broken, gamed stock market entirely, in which only criminal insiders and HFT algos can and do make money on a regular basis (because remember: no “advisor” will urge you to sell just before the all time highs… or 20% below it… or 50% below it – after all it is just a BTFD opportunity), and instead keep investing (as in not gambling) in hard assets, those which the Fed can not and will not print in order to generate the impression that things are better just because 99% of the population has no clue what the difference between real and nominal, and between paper and actual gains, is.

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