Growth stocks are by nature more volatile than slower growing companies. Hyper growth stocks (stocks with >40% revenue growth) are even more so. High quality companies that dominate their industries/markets often seem way overvalued by conventional valuation methods. And if one owns a portfolio of exclusively hyper growth stocks or one that’s largely dominated by such companies, then there are bound to be lots of ups and downs. Some investors fear this kind of volatility. They hate it, and many can’t stomach the large down swings. Fear and greed can be your friend or your enemy. It’s common for investors to get scared and sell out during drops and to buy on the upswings. Letting the emotions of fear and greed control your buy/sell button can lead to poor investment decisions. We are currently in the midst of a major selloff in growth stocks. This current drop is the fourth major selloff since I started meticulously tracking my portfolio returns. Let’s take a look at this 3+ year history as it provides some comfort, perspective, learnings.
The Long Game
The above chart shows the cumulative GauchoRico Portfolio return since 12/31/2017 (blue line) compared to the S&P 500 Total Return with dividends included (red line). Since the scale on the y-axis is linear, the most recent drops appear to be worse than the previous drops even though the current drop is the smallest (30%) of the four major drops; the others were 37%, 37%, and 45% from their respective prior peaks. The table below details the four major drops as well as the smaller drops in 2020.
| PEAK — BOTTOM | % DROP | Days: Old Peak to New ATH |
|---|---|---|
| 4Sep2018 – 24Dec2018 | -37% | 176 |
| 26Jul2019 – 22Oct2019 | -37% | 207/291* |
| 18Feb2020 – 16Mar2020 | -45% | 84 |
| 9Jul2020 – 16Jul2020 | -14% | 25 |
| 5Aug2020 – 11Aug2020 | -25% | 27 |
| 13Oct2020 – 10Nov2020 | -27% | 65 |
| 22Dec2020 – 3Jan2021 | -14% | 45 |
| 12Feb2021 – ??? | -30% | ??? |
It’s possible to carefully research, select, and monitor quality high growth stocks and achieve outsized returns; however, such a portfolio will occasionally experience deep declines. For most investors, such drops will feel horrible while they are happening, and many investors will opt for lower long term growth to avoid the bad feelings of these drops. In retrospect and when viewed over a long time horizon (as in the first chart above), the drops aren’t so bad, especially after the previous portfolio peaks are surpassed. Next, let’s examine the prior three drops of greater than 35%.
Fall 2018: Fed Chair Powell Threatens Interest Rate Hikes
For SaaS stocks and the GauchoRico Portfolio, 2018 was a great year. The stocks performed on fundamental revenue with high revenue growth rates, but valuation multiples also expanded for the sector. The portfolio hit a high of +111.9% YTD on September 4th. In the Fall of 2018, Federal Reserve Chairman Powell indicated that the Fed would need to raise the Fed Funds Rate several more times.
The stock market did not take kindly to the prospect of tighter monetary policy and sold off sharply. In fact, the selloff in December 2018, at that time, was the fastest decline to bear market territory (a -20% drop) since the Great Depression in the late 1920s. The GauchoRico Portfolio fell even more with a drop of 37% culminating on 24Dec 2018. The Fear & Greed Index hit 2 on a scale of 0 to 100 on December 24. The recovery to a new all-time took 65 days, and peak-to-trough-to-peak took 176 days.
Summer 2019: SaaS Sector Rotation
For SaaS stocks and the GauchoRico Portfolio, 2019 was another banner year. The portfolio companies continued to perform fundamentally, and SaaS valuation multiples continued to expand until 26Jul 2019. The speed with which the portfolio roared up was astonishing; with only 58 trading days in June/July 2018, the portfolio hit 19 new highs! At the peak on 26Jul, the GauchoRico Portfolio was at +100.0% YTD.
Then the sector rotation began with SaaS stocks selling off. The stock market as a whole did not sell off. The high multiples of SaaS stocks contracted for about three months with the portfolio hitting the trough on 22Oct. I recall wondering whether the SaaS valuation multiples had permanently reset or whether they would re-inflate. This is the same question that I am asking myself today.
The 37% drop took 88 days and longer than the 2018 37% drop. The recovery back to the 26Jul high from the 22Oct trough took 119 days (on an intraday basis) and 203 days on a closing price basis. The entire cycle from peak-to-trough-to-peak took 207 days (intraday close) and 291 days on a closing price basis. However, the next major drop (March 2020) was inside the 291 day range.
March 2020: Pandemic Global Shutdown
Last year’s pandemic-induced market selloff was the fastest and worst since the Great Depression in the late 1920s. There was fear that the global financial system might collapse. The height of the panic occurred in mid-March with the Fear & Greed Index hitting 1 (on a scale of 0 to 100) during the intraday trading session on 12Mar. The GauchoRico Portfolio hit bottom on 16Mar. I wrote three portfolio updates in March 2020 (6Mar, 13Mar, and 31Mar) in which I analyzed what was happening and might happen in order to take the appropriate actions for my portfolio. It was one of the most scary times to be stock market investor, and several my friends even sold a substantial portion of their portfolios near the bottom.
I don’t think any stocks were spared the carnage that occurred in March 2020. The above chart zooms in on Q1 2020 so we can observe the speed with which the market plummeted. Once it became clear to investors that the world’s central banks and governments would do whatever it took to avert total collapse of the global financial system, the markets sharply rebounded. The chart below shows the entire year which makes the March 2020 drop look almost insignificant. The GauchoRico Portfolio experienced a once-in-a-lifetime surge. For those who are interested in reading about how I managed my portfolio during this crisis, it’s described in my portfolio updates with most of the interesting action between 6Mar and 30Apr.
The 45% drop from 18Feb to 16 March only took 27 days! During that time, the GauchoRico Portfolio had several huge single day drops:
- -10.0% on 6Mar
- -15.0% on 9Mar
- -8.8% on 11Mar
- -11.4% on12Mar
- -18.9% on 16Mar
The portfolio attained a new all-time high on 12May, just 57 days after the 16Mar trough. Peak-to-trough-to-peak was also fast taking just 84 days.
During the second half of 2020, there were several smaller drops in July, August, October, and December. I would not categorize these drops as major (although the October drop came close).
February 2021: Economy Reopening Soon?
We are now in the midst of another major drop after the GauchoRico Portfolio hit its last all-time high on 12Feb. In fact, the portfolio hit a series of six ATHs between 5Feb and 12Feb. So far this drop has lasted 21 days, and the portfolio is currently down exactly 30% from the 12Feb peak. During the morning trading on 5Mar, the portfolio was off about 34% from the 12Feb high.
The market in general has not dropped and the Fear & Greed Index is currently at 51 so this appears to be a rotation out of high growth stocks. The recent news that coronavirus vaccinations in the United States will be largely complete by the end of May rather than the end of the Summer may have shifted funds from companies like ZM, DOCU, and PTON. Or perhaps investors are just taking money from their winners and reallocating into stocks that they believe will benefit from the full reopening of the economy. We can speculate about the possible causes all we want, but I want to ask myself several questions.
Will My Portfolio Companies Continue to Grow?
I do not mean grow the stock price, but rather I’m referring to the business fundamentals, mainly revenue growth. Some people think companies like ZM, DOCU, and PTON will see slower growth. Perhaps, but my opinion is that a reopening economy will affect these companies less than others expect. Some of my other portfolio companies like CRWD, NET, and DDOG show no signs of slowing. I expect to see tailwinds from cloud adoption and digital transformation to last at least a couple more years. LSPD, in my opinion, should see a very large benefit from the reopening. Thus, I see nothing wrong with my companies, and I’m very pleased with my portfolio allocation.
What About Valuation Multiple Compression?
It’s a fact that since 2016 SaaS companies have seen a big expansion in their valuation multiples. Fast growing companies without earnings are typically valued on an enterprise value to sales (revenue) basis: EV/S. I’d estimate that these multiples have expanded by about 3x in the past four years. Below are the current (as of 5Mar) multiples of six of my stocks that comprise 95% of my portfolio’s total value. The 2021 growth estimates are my own.
| EV/S | EV/S Recent High | Stock % Below 52-wk High | TTM Growth | 2021 Growth (E) | |
|---|---|---|---|---|---|
| CRWD | 36.0 | 49.7 | 27% | 86% | 85% |
| NET | 32.0 | 46.2 | 30% | 50% | 50% |
| DDOG | 30.8 | 45.2 | 31% | 66% | 65% |
| ZM | 25.7 | 45.6 | 43% | 326% | 50% |
| DOCU | 22.4 | 31.9 | 30% | 45% | 55% |
| LSPD* | 22.2 | 32.6 | 29% | ~49% | 100% |
We’ve seen SaaS stock valuation multiples compress by more or less 1/3 from their recent highs. But the recent declines tell us very little about where they “should” be or where they might land. Just because valuations are now lower doesn’t mean they will rise again. They may rise, or they may reset at a lower level. We simply can’t know. However, we can look to the past to gain some perspective.
In fact, I was pondering this very question in October 2019. Back then I turned to Salesforce.com (CRM) and its long history as a public company to gain some perspective as I was invested in mostly smaller SaaS companies without a long history as public companies. That analysis is still worth reading today. Prior to the run-up in the valuations of cloud companies (circa 2015-2016), CRM was growing revenue at about 25% and traded at an EV/S multiple of 6-9. At that time, CRM was already a very strong FCF generator so one could argue that we should also look at EV/TTM FCF as a valuation yardstick: CRM’s EV/TTM FCF was in the 30-55 range. Since this was prior to the valuation run-up, I would have high confidence in calling that a floor. In my opinion, EV/S multiples aren’t meant to be directly compared across companies although they can give some rough guidance. Also, revenue growth rate makes a huge difference in what EV/S multiple might be justifiable especially if growth rates can be maintained over several years into the future; the effect of compounding revenue growth will quickly drop the EV/S with all else being equal. Furthermore, when looking forward several years, the relationship between EV/S and revenue growth is not at all linear (i.e. a 50% grower deserves more than twice the EV/S compared to a 25% grower). I will not get into the weeds on how I compare companies against each other. I will reserve that for a future post. However, I will say that I weigh many factors. Revenue growth, in my opinion, is the single most important factor and our best friend when owning a high valuation, hyper growth stock; the reason is that time (with every passing quarter’s growth) will lower the valuation.
We can look at the current EV/S, predict the revenue growth rate into the future, and calculate what the new EV/S will be one, two, or three years out assuming our revenue growth rate targets are met. This concept and calculation provides me with great comfort when owning hyper growth stocks during a big selloff. Interestingly, a second great comfort comes from the falling stock prices because the more the prices fall, the higher the chance that they will rise in the future. And once they’ve fallen so much that they become screaming buys, I can choose to prudently start leveraging (such as converting shares into LEAPS as I described in this post). I think that perhaps it takes some experience and a high conviction in the companies that are in the portfolio to begin to relish in the big drops.
I’m always prepared for a 50% drop in my portfolio, and, while I do use leverage, I make sure that a 50% (or even a 60% drop) will not force me to deleverage at the bottom. I’ve experienced this once before, and it’s the second worst thing that can happen to an investor. Now that the portfolio has dropped 30%, and as much as 34% intraday on 5Mar, are we at the bottom? I have no idea and neither does anybody else. However, I can say with a high degree of confidence that my portfolio will be higher in two years. Probably much higher. I can also say that I believe many of my portfolio stocks are now in bargain territory. As a result, I have begun to leverage by selling shares to purchase 2023 LEAPS. However, I still have reserved more ammunition should the drop continue.
Final Thoughts
Big portfolio drops can be emotional, uncomfortable, or even terrifying. They have happened before, and they will happen again. That is a guarantee. The list of things that increase both comfort and confidence during such drops are the following:
- Examining past drops: Seeing the past drops and their recoveries provides much needed perspective.
- Owning high growth and high quality businesses: There’s no shortcut to analyzing businesses before buying the stock. Having done a thorough job on the analysis is a prerequisite to having confidence in the business. And having confidence in the business and its future prospects provides comfort in owning the stock during even the most severe drop.
- Past valuation ranges: Examining the past valuation range is helpful in gauging where the stock is currently trading. The past doesn’t necessarily predict the future, but it does provides additional perspective.
After a full year of lockdown and economic suppression, we may be on the cusp of the greatest economic expansion ever. There is no recession in sight. Fiscal and monetary support is still full throttle supportive. Economic growth is good for stocks. Inflation is still low…in fact it’s been below the ideal target of central banks for many years. They have tried to increase inflation, and they have failed for years. Everyone is signaling that easy money will continue even if inflation rises above the 2.5% target. Stocks can do well with higher inflation and with higher interest rates. Rotation away from high growth stocks will not last forever, and investors will flock back to growth soon enough. Valuations of SaaS companies may reset at lower levels, but growth will overcome this with time.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.