Treading Lightly

February 24, 2024

 

Dear Investors,

 

It has been a crazy start to the year. Already, the S&P 500 has broken the $5,000 level and is up almost 7% year-to-date, trailing the tech-heavy Nasdaq 100 just slightly. The rally has been driven largely by the AI giant Nvidia, which reported earnings earlier this week and saw a 16% jump the following day after once again crushing earnings and revenue estimates.

 

The so called “Magnificent Seven” stocks, which include Apple, Microsoft, Amazon, Nvidia, Meta, Tesla, and Google, have continued to be the center of attention with mainstream media. While these companies are clearly profitable, and growth expectations are certainly optimistic, we can’t forget that valuations matter and euphoria eventually subsides.

 

As of today, these are the multiples and percentile ranks of these tech giants:

 

 

Nvidia Corporation (Nasdaq: NVDA), the chip making monster run by the electrical engineering titan Jensen Huang, is up over 60% so far this year and has surpassed the Market Capitalization of both Alphabet (Google) and Amazon, now flirting with a valuation of $2 Trillion. Journalists, investors, and active traders have been claiming that Artificial Intelligence can be as big as the internet, if not even more massive. Of this, Sonic Capital Analysts have no doubt – artificial intelligence and large-scale computing needs may very well be the future, but let us not forget that even the internet giants that are thriving today were once participants in one of the largest speculative bubbles ever that popped during the start of the millennium.

 

Price-to-Earnings ratios surpassing 50x are often hard to justify but are occasionally warranted in cases of massive growth expectations, which certainly applies to a large number of companies within the tech industry. Still, judging from their current percentile ranks, many of these multiples are high even relative to their own history.

 

There is nothing more brutal than being a value investor sitting on the sidelines while most fund managers are making money hand over fist simply by being indexed. But value investing has been one of the few strategies that has truly been able to withstand the test of time, with many of the legends attributing their success to their commitment to this approach.

 

 

The Buffett Indicator, deservingly named after the Oracle himself, is an interesting measure of the stock market’s relative value based on total capitalization and Gross Domestic Product in the American Economy at any given time. The above analysis shows that this ratio is not at a historical high, but is approximately 1.7 standard deviations above its historical trendline, indicating that the market is moderately overvalued and has been for some time.

 

Although Warren Buffett has said that this model is the best single measure of where valuations stand at any given moment, there is no indicator that is completely definitive, and just because certain assets may be overvalued, there is nothing preventing them from becoming even more overvalued. Models like this must be used in conjunction with other forms of analysis to better gauge the market and where we stand in more macro-economic cycles.

 

 

While interest rates don’t directly say anything about relative equity market valuations, an inverted yield curve is arguably the most reliable predictor of an impending economic recession, which certainly affects the performance of financial assets. The market has been behaving as if investors have forgotten the yield curve is still massively inverted.

 

On top of this warning signal, the most recent CPI print came in substantially higher than expected, lowering hopes of the Fed decreasing interest rates any time soon. Jerome Powell himself indicated at one of the most recent meetings that we have not yet reached a soft landing, but the market seems to have shrugged off this concern, plowing higher based solely on earnings growth expectations. This type of reaction – a bullish move to what seems like bad news – is often indicative of further upside potential in the short term, but nonetheless makes us want to tread lightly in the event of a market correction over the longer or medium term.

 

Today’s economic environment we believe to be most similar to that of the 1970s. Inflation remains above the target rate and even some of the euphemisms used now sound eerily similar to those used 50 years ago – the “Magnificent Seven” stocks could be the next “Nifty Fifty” stocks, which perpetuated the stock market crash between 1973 and 1974. Most of those companies were extremely popular decades ago and were characterized by their strong and consistent growth in earnings and were favored by institutional investors for their seemingly invincible market positions, which eventually lead to unjustifiably high Price-to-Earnings ratio. Sound familiar? Although many of the companies are still around, they are certainly not the powerhouses they once were, and these once innovative companies now seem to be just a relic of their time. Anyone remember Kodak? Yeah, me neither.

 

 

Although we can make the macro comparison to the 1970s, it is interesting to see the relative performance of tech companies vs. the rest of the market over the last 20 years. The ratio of the S&P 500 to the tech sector specifically now appears to be at a level near the peak of the bubble in the early 2000’s.

 

To be clear, there is absolutely nothing inherently wrong with tech stocks, and clearly investors overweight in this area have done exceptionally well. However, no stock can go straight up forever and even these mega caps have a lot to live up to in the long term to warrant their current valuation. This being the case, we are treading lightly in this area – not directly shorting, but focusing our attention on other long opportunities in areas that seem to have been beaten up to an unfair extent. Let’s detail some of those farther.

 

Albemarle Corporation (NYSE: ALB) is Sonic Capital’s single largest position. This company is far more industrial and focuses on chemical production, specializing specifically in Lithium. The stock closed at $120.65 today and produced $13.42 in earnings per share over the last year, giving them a P/E multiple of just 9x. The entire lithium market has been in an extended decline for the last 1-2 years, and ALB in particular is sitting in a peak-to-trough drawdown of approximately 63%. There have only been three declines of this magnitude in the company’s history, and each has been followed by a massive recovery. As Baron Rothschild said, “The best time to buy is when there’s blood in the streets.”

 

 

In addition to being in a steep drawdown that historically acted as an incredible buying opportunity, ALB is also sitting at a Price-to-Book ratio that has acted as support in the prior selloffs.

 

 

The majority of the recent selloff in lithium and the associated stocks has been attributed to a decrease in electric vehicle demand and the existing supply being far in excess of what is needed for current production. However, Sonic Capital is of the opinion that these factors are already priced into the market and even though there is a current imbalance, if EV Manufacturers live up to their revenue expectations, these companies should benefit massively.

 

These factors are also already accounted for in the EPS estimates of Albemarle itself. As shown below, the last two years have shown unprecedented growth in earnings but are expected to be just a fraction of that for the next three years and finally pick up again in 2027.

 

 

Assuming that actual earnings come in at or near these estimates, we can extrapolate a predicted price for ALB in the future based on its historical Price-to-Earnings ratio. For the last 20 years, Albemarle’s P/E ratio has drifted between a low of 4.1x and 296x at its extreme. Within this timeframe, we can also calculate the stock’s median and average P/E ratio, which come to be 18.2x and 30.1x respectively. However, these statistics are calculated using the large outlying ratios that occurred in 2018 and 2021-2022. Even if we remove these outliers, the median and average P/E ratios still come to 17.9x and 21.7x. We can use these numbers in conjunction with the expected EPS in 2027 to arrive at an estimated stock price. In this case, the estimated range would come to $318 on the low end and $386 on the high end. To be conservative, we can use the lower number as a base-case price target. Even though the $318 estimate is several years away, this would still represent a compounded annual growth rate of over 38% if it came to fruition.

 

Outside of our main allocation in ALB, Sonic’s Separately Managed Accounts have long exposure to several other large cap stocks that seem to have been brutally beaten up over the last several years as a majority of investor capital has fled to tech. Some of these companies may sound familiar – Disney, PayPal, and Crocs to name a few. Although far less exciting than the high-flying chip makers, these profitable companies seem most ripe for a comeback after tumbling from their “post-covid boost”.

 

Although most accounts within Sonic’s management are actively traded, we do take advantage of many unique forms of analysis to assist in our decision making and add to our long-term alpha. It is unfortunate that many of the value-based positions in the main portfolio have been subject to undue selling pressure in the recent months, but these can provide what hopefully turns out to be a great entrance for a long-term investment.

 

As always, we will be keeping an eye out for the biggest opportunities and will constantly be adjusting position sizes accordingly, while adapting to the ever-changing macro environment.

 

Sincerely,

Maxwell Fischer

Investment and Trading Analyst

 

 

 

 

 

Disclaimer: The research presented and the conclusions drawn herein represent the opinions of the analysts and are based on current market conditions and data available at the time of writing. This document is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any securities. Investments in the securities mentioned may not be suitable for all investors and involve risks, including the potential loss of principal. Investors should consider their financial situation, investment objectives, and risk tolerance before making any investment. Past performance is not indicative of future results. We do not guarantee the accuracy or completeness of the information provided and are not responsible for any errors or omissions or for results obtained from the use of such information. Please consult with a qualified financial advisor to ensure that any investment decisions meet your individual circumstances.