A great company doesn’t necessarily make a great stock pick, and a troubled company doesn’t necessarily make a bad stock pick.
That’s because in addition to analyzing the quality of the business and the expected earnings and cash flows it may produce, investors need to consider the price they’ll pay for it.
Regardless of how popular a growth stock is, it doesn’t make sense as a long-term investment if its price gets too high relative to its fundamentals.
This articles has three example growth stocks that I think are overvalued, and two growth stocks I’m buying for 2024 and beyond.
A Lesson From Howard Marks
One of my favorite investors of all time is Howard Marks, the billionaire co-founder of Oaktree Capital and world-renowned distressed bond investor. His performance is one of the best in the business and he is famous for his wise chairman essays.
I find that his investment advice applies well to all asset classes, including equities, and is worth listening to.
When he was first starting out in the investing world as a young man, Marks initially started in equities. Bonds were out of favor at the time.
Marks often points out in his interviews and speeches that there was a set of stocks in the 1960s known as the “Nifty Fifty”, which referred to the highest quality stocks in the market. These stocks, it was thought, were worth buying at any price. Coca Cola and other well-known stocks were among them. Many stocks in this group traded for well over 50x earnings.
As you may guess, most of these stocks went on to perform terribly over the next couple decades. They were significantly overvalued despite the fact that most of them were great companies and popular growth stocks. In the end, it’s earnings and cash flows that determine business value, and they exist in the real world rather than the dream world of high expectations.
Marks, fortunately, mostly skipped that area and ended up in the dark world of junk bonds. Junk bonds back then were unseemly, considered unsuitable for respectable portfolios, and so nobody wanted them. That kept demand low and thus made them incredibly profitable for prudent investors who bought at a discount.
Marks often tells the story of the 1978 edition of the Moody’s manual. The definition of a B-rated (junk) bond in that manual according to Marks was, “fails to possess the characteristics of a desirable investment.” In other words, junk bonds were by definition bad investments.
Marks thought, “yes, but at what price?”
Marks ironically went on to flourish and make great returns by investing in the debt of lower-quality businesses thanks to undervaluation, while the equity returns from high-quality businesses in that era suffered thanks to overvaluation. He managed his risk with a conservative and diversified approach while investing in an asset class that has a lot of inefficiencies.
Nothing is really good or bad by itself. It’s all relative to price. Low valuations can make the stock of a mediocre business safer than it should be. High valuations can make the stock of a great business far riskier than buyers realize.
I prefer to err on the side of a high quality businesses, but only if the price is reasonable. If I must be incredibly optimistic in my discounted cash flow analysis to justify the current stock price, I pass.
Currently I’m finding more bargains in value stocks than growth stocks, although there are some exceptions.
An Example of an Expensive Growth Stock
Right now, emerging markets are at one of the biggest valuation discounts to U.S. stocks in history, but investors aren’t too interested in them. Global growth rates are slowing, the dollar is strong, and U.S. markets have outperformed everything else, so that’s where money wants to be going forward as well.
Sometimes when I mention how cheap emerging markets are on an absolute and historical relative basis, people say, “yes but I avoid them because there is high corruption” or “they have a lot of export sensitivity to the U.S.” or “but when U.S. stock fall EM stocks fall even harder.”
It reminds me of Marks and junk bonds. Yes, emerging markets deserve a valuation discount. They should give higher returns in exchange for higher volatility. So, the question should be, “yes, but at what price?” Emerging markets were never this cheap relative to U.S. stocks when they had their biggest historical sell-offs.
In contrast, there are many stocks in the United States that investors want to buy almost regardless of price. They’re on a great trend, they’re of great quality, so we want to own them. But there’s the pesky problem of price.
In theory, any stock can surprise to the upside if its fundamentals dramatically outperform the consensus. Usually, however, stocks that get into a situation where their prices far surpass their fundamentals tend to either fall back to their fundamentals, or trade sideways with lackluster returns until their fundamentals catch up.
Investing is often about managing probability distributions. It’s not just about what one stock might do; it’s about what a basket of stocks with certain characteristics is most likely to do.
Cadence Design Systems (CDNS)
Cadence offers a suite of electrical and computer design software for engineers. I’ve used some of their tools myself, back in my engineering days.
They transitioned from a software sales model to a cloud-based subscription recurring revenue model, which gave them a strong uptick in growth. However, the valuation relative to forward growth expectations is now very high, so the stock doesn’t offer a lot of interest to me at the moment:
Analysts expect about 15% annualized earnings growth going forward, and the stock trades at a price/earnings rate of over 50x. That’s a price/earnings/growth ratio or “PEG ratio” of over 3x, which is not particularly attractive.
I’d need to see a 40% reduction in CDNS’s stock price to get interested in this stock, even though the company itself is doing great and will probably continue to do so. Alternatively, if the stock price goes into a choppy sideways pattern for a while and earnings catch up over a few years, that could make the stock more attractive as well.
2 Fairly-Valued Growth Stocks for 2024
It pays to be picky when the market has priced growth stocks to very high valuations, especially compared to value stocks.
Growth stocks have outpaced value stocks for 15 years now. This has been a market where throwing money at the fastest-growing names has easily paid off, much like the 1990s.
Going forward over the next several years, however, this trend might not continue so smoothly.
I’m investing with a bit of a value tilt now, where there are many companies trading at or below my estimated fair value. Additionally, ex-USA equities appear reasonably-priced, especially in the emerging markets. For this article, however, I’m focusing on reasonably-priced growth stocks.
HDFC Bank (HDB)
An example of a growth stock I find value in is HDFC Bank of India. It’s not necessarily a screaming buy based on the numbers, but it’s a reasonable investment relative to the high quality and strong growth of the business:
HDFC Bank is growing earnings at 15-20% per year recently, and trades for a little over 20x earnings. This gives it a “PEG ratio” of under 1.5x, which is pretty attractive as India’s largest bank.
Booking Holdings (BKNG)
Booking Holdings (BKNG) owns many travel websites, as well as restaurant websites like Open Table.
They had a rough patch during the COVID-19 pandemic, but otherwise has enjoyed a strong and persistent uptrend in fundamentals. Analysts expect 15-20% annualized EPS growth going forward, and the price/earnings ratio is under 25x. This generally results in a “PEG ratio” of around 1.5x or so depending on where exactly EPS growth ends up shaking out.
Additionally, Booking Holdings has about as much cash as they have debt, which gives them zero “net debt” and thus a fortress balance sheet. Overall, I consider to be a reasonable buy-and-hold growth stock in 2024 when looking out 3-5 years or more.
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