The S&P500 corrected in March due to COVID-19, but it quickly recovered to positive 4.2% YTD at the time of this writing, September 21^st. Media has extensively covered this story as one of partial recovery driven by FAAMG stocks outperforming the rest.

 

(Source: RBC Capital Markets as of September 21, 2020)

 

By contrast, NASDAQ is up ~14% year-to-date. Investors have bid up stocks which optically benefit from the pandemic such as technology and especially software companies. The table below shows how a select group of quality software companies have performed over this period.

(Source: RBC Capital Markets as of September 21, 2020)

 

A few points:

• The group is ~5.5x more expensive on an EV-to-Sales than the S&P500.
• The group has outperformed the S&P500 by 44% YTD. We should note that a big part of the return was derived from ZM. YTD performance drops to 28% if we were to exclude it.
• Most of the companies in the group are trading above 10x EV-to-Sales, the SaaS average multiple.
• Half of the companies above are currently unprofitable.

We use a sales-based ratio because it is easier to compare companies in similar sectors. The market is stating that the group on average has better growth and profitability prospects. Yet, is there a price too dear to pay for such a company? Scott McNeely was the CEO of Sun Microsystems, one of the darlings of the 2000s tech bubble. At its peak, the company hit a 10x sales valuation. The excerpt below is from a 2002 Bloomberg interview:

 

“At 10x revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

 

However, let’s entertain the idea and explore scenarios under which an investor can achieve a good rate of return while paying at least 10x revenue. After all, Sun Microsystems was primarily a hardware company whereas our group is software-only. For this exercise we are going to select Microsoft because it has a long trading history (including the 2000 tech bubble) and is still holding a dominant position.

(Source: SEC EDGAR, S&P Global)

 

We are taking a reverse approach, in other words, what price should you have paid for MSFT in order to achieve a satisfactory rate of return. At the peak of the tech bubble, MSFT reached $58/share and was trading for 16x P/S. If you bought then and held until September 21, 2020 you would generate a 6.15% annualized return and would have beaten the S&P500 by 2%. If you bought MSFT for $36/share (10x P/S), which was the case in January 4, 1999, you would have gotten 8.18% annualized vs 4.36% for the S&P500. In both cases, paying at least 10x revenues compensated the investor. What is the catch?

 

(Source: Yahoo Finance, graph depicting the MSFT's break-even line considering a $36/share cost base)

1. MSFT grew revenues and EPS by 9.89% and 6.9% CAGR since 1999. Predicting 3 years of earnings is difficult, let alone 2 decades in the ever-changing technology sector.
2. Years of underperformance following the tech bubble would have forced you to sell long before MSFT recovered. Assuming you acquired MSFT for $36 a share, it would have taken investors almost a decade to break even in 2008.
3. It also assumes you would have had to predict MSFT entering the cloud business (1/3 of profits) one decade ahead of it’s conception. Apple, which was another home run since 2000, radically changed it’s business.

But MSFT wasn’t the only stock to perform well. Here are the few companies that performed well during this period and are still trading:

(Source: SEC Edgar, Thomson Reuters Eikon)

 

If you bought a stock anywhere near 10x revenue, your investment would have worked out only in a handful cases out of hundreds, close to low single-digit hit rate. And in all cases you would have waited 5 – 10 years to just break-even.

 

“It is difficult to make predictions, particularly about the future” – Mark Twain

 

We don’t know if there will be a second tech bubble, we are not making a prediction. We also understand that a good business deserves a higher multiple. In order to do well in investing and neutralize the error rate, we make sure to pay a reasonable price for a business.