Priced for perfection?

Source: Bloomberg, Standard Chartered

Thereafter, the stock price took a significant downturn, falling 83% in the next three years. The impact was not just short-term. From its peak on the 27 March 2000, it took until September 2021 for the stock to deliver positive returns, even assuming that the investor reinvested any dividends distributed. Today, the stock is trading almost exactly at its 2000 peak.

Was the stock’s performance a reflection of the company’s fortunes? To some degree yes. Earnings continued to grow into Q1 2001, but then fell into negative territory for the next year. However, by the end of 2002, trailing 12 months earnings hit a new record high and never really looked back. Since then, earnings have grown more than fivefold at a compound annual growth rate of 9-10%.

Source: Bloomberg, Standard Chartered

The challenge was not the company’s long-term outlook or doubts about the future of the internet, but the fervour with which investors extrapolated that outlook. In Q1 2000, the stock’s price-to-earnings ratio was over 250 times.

Fast forward to today and there is a risk we are about to see history repeat itself in another technology company. Before the latest earnings release, Nvidia’s price-to-earnings ratio, based on trailing earnings was over 220 times. This is not quite the nosebleed levels that we saw from Cisco (265x), but it is not too far away. Of course, Nvidia earnings blasted above market expectations for the latest quarter and the consensus expects them to grow strongly into the future. Indeed, assuming forecasts for earnings to triple in 2024 prove correct, the price-earnings ratio would be a ‘mere’ 45x.

Of course, what this does mean is a lot of the forecast growth is in the price already. It is, of course, possible the stock continues on a tear as the company outperforms market expectations. Valuations are rarely a useful predictive indicator for short term market performance. However, it does suggest that investors should be aware of the risks of a semi-permanent loss in value if they invest at current prices. If the company only doubles its earnings next year, let alone they decline, then the sell-off could be dramatic. Remember, Cisco as a company has performed very well over the past two decades, but 20 years is a long time for an investor to wait to get their money back.

So how should an investor operate in this environment? It is always critical to right-size any investment, but the narrower the investment, the more important this becomes.

We view investing through two lenses: foundation and opportunistic. I would place single stock holdings, especially stocks with the likelihood of significant volatility, in the opportunistic bucket. Investors should ask themselves, how they would feel if the stock went down, 20%, 50% or even 80% and then recovered only after decades. What would their brain tell them to do? If the answer is: ‘sell’ (which is more likely), then a limited exposure to the stock would make sense. It should not be viewed as part of a foundational portfolio, but more as something on the opportunistic fringes, with the allocation accounting for a small fraction of the investor’s overall diversified portfolio.

(Steve Brice is Group Chief Investment Officer at Standard Chartered Bank’s Wealth Management unit)