When investing becomes speculation

Vito Maida has nothing against the so-called Magnificent Seven tech companies that have been driving gains in the S&P 500. But as a value investor, the president and portfolio manager at Patient Capital Management Inc. (Patient Capital), believes that that all of these stocks—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla—are excessively valued.

“These are all very good companies that provide excellent products and have had a profound impact on consumers and the way society operates,” Maida says. “But their current valuation and projections for growth prospects remain extreme.”

Maida notes that investor optimism continues to support the price of these stocks, driven by the perceived benefits of artificial intelligence to future growth, an unshakable faith in the eventuality of central bank rate cuts, and confidence that a decisive blow in the fight against inflation has already been dealt. The market, he adds, also tends to overvalue tech stocks because they are inherently future facing, fostering speculation that the new technologies they develop will drive additional growth.

The result is that valuations for these companies are sky-high. Patient Capital’s research shows that Meta (NASDAQ:META) traded at more than 33 times earnings in mid-April, Tesla (NASDAQ:TSLA) traded at 36 times, and Nvidia’s price-to-earnings ratio was north of 70.

“The underlying premise of these extraordinary valuations is that these companies are so exceptional, they will eventually dominate their entire industry,” Maida says.

However, in order for any of the Magnificent Seven stocks to be of interest to value investors like Maida, they need to justify their prices based on sustainable growth at current rates or higher. But the future is fickle. The rapid growth of tech companies can be sidelined by market trends, competitive technological advancements, new competition, geopolitical events and shifts in consumer preferences.

“The terminal multiple for even the best companies is no higher than 20,” Maida says. “In order to justify the current stock price for Nvidia, the terminal multiple would have to be 100. That means that the growth they’re experiencing now will basically continue forever. That’s not mathematically supportable.”

The research shows Microsoft’s sales in 2022 reached US$212 billion. With the company’s current price-to-earnings ratio of 33, Maida calculates that the stock valuation implies a perpetual growth rate of eight per cent. The gross domestic product (GDP) of the United States was $25.7 trillion that same year. Assuming a normalized GDP growth rate of three per cent, Microsoft’s sales would eclipse the entire U.S. economy in 102 years.

Maida thinks Tesla is also overvalued. His calculations show the sales amounted to 3.26 per cent of U.S. market share in 2023. However, its market valuation remains greater than the combined market valuations of its ten biggest global competitors.

“Eventually, when these companies fail to meet the optimistic growth projections the market expects, investor confidence shifts and can lead to downgrades in stock prices, even if they’re performing well,” Maida says.

Patient Capital’s portfolio is typically concentrated in no more than 20 high-quality businesses that were trading at a 40 to 50 per cent discount from their intrinsic value. These companies typically have long operating histories and act on predictable business models.

Maida notes, however, that a rising tide lifts all boats. Optimism over the Magnificent Seven has spread throughout the market, presenting a greater challenge for value investors to find discounted stocks.

“We’re still finding some long-term value in Canada, particularly in telecoms and banks,” he says. “We’re also looking at one or two pockets in the U.S. that we consider undervalued.”

Patient Capital’s discipline is absolute. It would rather exit the market and invest in T-Bills than buy overvalued stocks or continue to hold stocks that have reached their intrinsic value.

“In our view, if you buy stock in a company that’s extremely overvalued, that isn’t investing,” Maida says. “That’s simply speculation.”

Lysander Funds Limited offers Lysander-Patient Capital Equity Fund, Series A and Series F. Patient Capital is the portfolio manager of the fund.

For more information on Patient Capital Management, visit: https://patientcapital.com.

For more information on Lysander Funds, visit: www.lysanderfunds.com.

This story was created by Canadian Family Offices’ commercial content division on behalf of Lysander Funds Limited, which is a member and content provider of this publication.

The views and information expressed in this article are for informational purposes only. They are not intended as investment, financial, legal, accounting, tax or other advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently, and past performance may not be repeated.

Lysander Funds Limited pays a fee to Canadian Family Offices for content generation in public communications including media articles such as this article, which may be construed as promotion of Lysander Funds Limited, its affiliates or the Lysander Funds.

^®Lysander Funds is a registered trademark of Lysander Funds Limited.