I’m always shocked to see how most investors buy into an overpriced stock. Investors are being led into risker asset classes such as equities because of the current investment environment. Today’s environment is defined by its negative real interest rates and unrelenting monetary stimuli. This flood of capital flows to the highest quality stocks that have previously outperformed and are therefore expected to outperform in the future.
This expectation of exceptional returns is what sets the stage for analysts and investors to justify high prices. A vicious cycle is created because as performance strengthens, expectations increase as well.
This cycle maintains bloated valuations and prices stray from fundamentals.
Investors have a tendency to justify this by citing exceptional prospects for growth as well as a profile with less risk because of the high quality of the stocks. However, the forgotten factor is that the price itself often proves to be a substantial risk.
Price is simply defined as the amount you pay for a stock. By itself, it carries no risk.
However, once an expectation for future growth is added to the definition, price becomes a risk factor. If you think about it, as your expectations increase, so do your risks. In the short term, one might be able to justify high expectations; however, it is difficult to justify maintaining those expectations for the long-term.
The truth is that most stocks are not capable of sustaining such high levels of reinvestment and growth indefinitely. Basic economics dictate that eventually, every business will peak, slow and may ultimately decline. The longer a price reflects an inflated expectation of earnings, the higher the capital risk for the shareholder.
If you follow the US markets, you are likely to have heard about the recent and remarkable downfall of Twitter (NYSE:TWTR), a leading social media platform.
Over the past two and a half years, Twitter stock has fallen more than 70%. When something like this occurs, it generally shows a very basic and serious error in forecasting. Brokers release downgraded recommendations against rebased expectations and valuations lose what were once justifiable premiums. Now, the question of “what went wrong?” arises.
Anther question that starts being asked is, how expectations were able to drift so far apart from reality?
A simple reason this occurred is because price movements were driven by valuation revisions which lowered the PE multiple. This is known as multiple compression and is a very common occurrence with expensive stocks.
When stock prices becomes way too disconnected with reality, the price itself then becomes a major risk factor.
Even with the recent big price drop, Twitter is still relatively expensive and likely to suffer from further multiple compression if high expectations are continually unmet.
What we need to take away from this is an understanding and recognition of past excesses. The longer a stock his traded with an inflated valuation, the greater the risk.
The current trading environment is one that is leading investors in search of high returns into more risk laden asset classes. As with anything, there is no guarantee that these stocks will necessarily perform poorly.
In fact, over the short term, they might be somewhat successful. However, it is important to remember, especially if there is an implication of unsustainable levels of growth, that price can be a risk factor for major capital loss, like that of Twitter.