Written by Damen Kloeckner, Associate Analyst
The current investment environment, characterised by negative real interest rates and unremitting monetary stimuli, is leading investors into riskier asset classes such as equities. This influx of capital is directed to the highest quality stocks – those that have demonstrably outperformed in the past, and are expected to outperform in the future. It is this expectation of superior returns that creates the setting for analysts and investors to justify ever-higher prices. The stronger the performance, the higher the expectations become, forming a vicious cycle that perpetuates bloated valuations and prices detached from fundamentals. Investors tend to justify this by citing not just superior growth prospects but also a lesser risk profile stemming from the high quality of the stocks. What is often neglected is that in these cases, the price itself often becomes a significant risk factor.
Price in itself is arbitrary – it is simply what you pay for a stock. It is expectation of future growth that the price implies that carries risk. Logic would dictate that the higher the expectation, the greater the risk of disappointment. The bigger they are, the harder the fall. Lofty expectations are often justifiable in the short run, creating a fallacy around the sustainability of outperformance. The truth is however, that the vast majority of stocks simply cannot sustain such high levels of reinvestment and growth forever. It is simple economics that every company will eventually reach a point of maturity, slow and possibly decline. The longer the price reflects an unrealistic expectation of earnings, the greater the risk of disappointment and hence the risk of capital risk for the shareholder.
For those that follow the US markets, you may have seen the recent and spectacular downfall of LinkedIn (NYSE:LNKD), a leading professional networking and social media platform. When a stock falls more than 40% in one day, as was the case here on 6 February 2016, it is usually a reflection of a fundamental and severe forecasting error. Brokers release downgraded recommendations against rebased expectations, valuations lose their hitherto justifiable premiums and the question ‘what went wrong?’ is weighed in on. Equally important, though rarely as publicised, is the question of how expectations so dramatically and fatally departed from reality. In the case of LinkedIn, the chart below may give us a hint.

Figure 1. LNKD price change contribution analysis
Source: Thomson Reuters Datastream
What do you notice about the share price’s steep decline since October 2015? EPS forecasts actually increased over the period and yet the share price continued to plummet. The price movements were driven by valuation revisions which lowered the PE multiple from the lofty 80 times it traded at in October to around 32 times in early February. This is known as multiple compression and is a disconcertingly common phenomenon amongst expensive stocks. The expectations implied by the share price became disconnected with reality and price inconspicuously became a major risk factor. It is also telling that LinkedIn is still relatively expensive and may face further multiple compression in the coming months.
Unfortunately, this is not an issue isolated in the US. For an example closer to home, we can look at ASX market darling, Domino’s (DMP.AX). This is a high quality fast food retailer that has masterfully employed technology to differentiate its offering and grow with dizzying speed and proficiency into a number of key markets around the world. The problem is that the current share price suggests Domino’s is not only capable of sustaining this growth, but significantly improving it. A five year comparison of share price, price to earnings ratio and forecast earnings per share is telling. The price has risen 8.9 times during that time but the expectation of earnings has grown just 2.6 times. It has gained incredible momentum with investors (exacerbated by index investing), to the point where betting against it is tantamount to sacrilege. However, if we apply the same attribution analysis to Domino’s, we see some startling similarities with LinkedIn.

Figure 1. DMP price change contribution analysis
Source: Thomson Reuters Datastream
Domino’s has fallen around 17% from its January 2016 peak despite flat EPS forecasts. Long the beneficiary of extreme multiple expansion, Domino’s is experiencing clear multiple compression. The results themselves have not disappointing, but with expectations so high, too much anticipation have already been priced in. Herein lies the danger. Currently trading at 52 times forecast EPS, Domino’s is more than three times more expensive than the ASX Industrials Index (PER: 17 times). This implies that it needs to grow EPS around three times faster than the index over the next five years to justify its valuation. At this juncture, it looks like Domino’s will do just that, at least in FY16. The real concern is that this growth is not sustainable. At some point, be it through disappointing guidance, a downgrade or some other revelation, expectations for growth will inevitably fall, and may take the stock price with it. To illustrate this point, below is a comparison of current consensus forecast versus the numbers required to justify the current share price within our model.

Figure 3. Key forecast inputs summary – consensus versus required
Source: Clime estimates, Thomson Reuters SmartEstimates
The difficult lesson in all of this is to recognise the excesses of the past. The longer a stock has traded on a bloated valuation, the higher the risk of disappointment. In an environment currently driving investors into ever riskier asset classes in pursuit of meaningful returns, this is particularly pertinent. Still, this is not to guarantee that these stocks will disappoint or perform poorly, especially as momentum acts in their favour over the short term. Rather, it is a reminder that price in itself can be a source of risk and capital loss, particularly if it implies an unsustainable level of earnings growth.