Bubbles and Anti-bubbles

The recent strength of the market rally has sparked concerns about a return of market bubbles. Bubbles are often easy to identify in hindsight because they exhibit exponential price movement compared to a benchmark or fundamental metrics.

For example, looking at the ratio of the Nasdaq to the S&P 500 reveals two major technology-related bubbles over the past three decades.

Source: FactSet, Vertium

The first was the Dot-com bubble (1998-2000) during the internet’s early development. The second was the COVID bubble (2020-2021), which saw a surge in disruptive technology stocks. Interestingly, the ARK Innovation ETF (ARKK), a listed fund heavily invested in disruptive technology stocks, mirrored the Dot-com boom and bust that occurred two decades earlier.

Source: FactSet

While bubbles are rare, they serve as a reminder that excessive investment flows chasing specific themes can drive stock prices wildly beyond their intrinsic value.  With the COVID bubble still fresh in our minds, its serves as a valuable benchmark to identify potential overvaluation and undervaluation.

The recent boom in Artificial Intelligence (AI) boom has captured investor attention, leading to exponential growth in some US stocks. In Australia, opportunities to capitalise on this trend are limited, with Next DC (NXT), a data centre company, being a notable example. Fuelled by AI-related investment flows, NXT’s share price has unsurprisingly skyrocketed. However, its valuation multiple has reached stratospheric heights, exceeding even its peak during the COVID bubble.

Source: FactSet

NXT's data centre peers, Equinix and Digital Realty, have also seen value increases. However, unlike NXT, their valuations haven't reached bubble territory. This is likely because the US offers more AI opportunities, which can more readily absorb the thematic investment flows. As a result, these companies trade below their peaks from the COVID bubble.

Source: FactSet

While some stocks seem to be in bubble territory, others are experiencing the opposite phenomenon – “Anti-bubble”. These stocks have depressed valuations despite strong fundamentals because investment flows in the opposite direction are holding back their share price. Xero (XRO) and Block (SQ) are prime examples of anti-bubble stocks as their valuations relative to their growth rates are significantly cheaper than their peers.

Source: FactSet

XRO’s earnings have grown considerably, yet its valuation multiple has significantly decreased. At its 2021 bubble peak, the stock traded at a sky-high multiple of 100x EV/EBITDA. Today, that multiple has shrunk by two-thirds!

Source: FactSet

SQ’s profile is even more dramatic. This company, formerly known as Square that bought Afterpay, traded at a staggering 150x EV/EBITDA during the COVID bubble. Today, its multiple is a mere fraction of that peak.

Source: FactSet

Both XRO and SQ share a common theme. They’ve adopted a “Rule of 40” business model, which seeks to balance growth and profits. This strategy targets a combined revenue growth rate and profit margin of at least 40%. This shift in business model of prioritizing profitable growth over rapid revenue expansion at any cost is impacting their share prices as investor preferences adjust. Some growth-focussed investors who may dislike slowing revenue growth are selling, while some value investors drawn to rising profits are buying. For example, SQ has attracted the attention of deep value investors like Michael Burry, who famously shorted the US housing market before the 2008 Financial Crisis.

Burry, along with many others, has taken notice of the disconnect between Block’s rising earnings and its lacklustre share price. Since mid-2023, SQ has consecutively exceeded analyst expectations and raised earnings guidance four times, with its forecast EBITDA nearly doubling over that time.

Source: FactSet

While the shift in investor focus explains some of SQ’s anti-bubble behaviour, there could be another factor at play – ARKK is one of SQ’s largest shareholders. During the COVID bubble, massive inflows into ARKK inflated the valuations of many of its holdings. Now, with the bubble burst, ARKK is experiencing significant outflows, forcing them to sell their holdings, putting downward pressure on SQ’s share price.

However, ARKK’s outflows might be a mere ripple compared to the potential tidal wave of buying that looms on the horizon if SQ is included in the S&P 500. Historically, SQ’s lack of profitability disqualified it from inclusion. However, its recent focus on profitability, SQ is a strong candidate for inclusion if it maintains positive GAAP earnings for four consecutive quarters.

Inclusion in the S&P500 would trigger significant buying from index funds, which would place it around the 200th rank in the index based on its current market capitalisation of US$45 billion. The index inclusion may also attract significant investment flows from active managers as there are very few companies in the index trading on a PE multiple of 21x with an expected growth rate of 29%. While SQ's current situation presents an anti-bubble opportunity, only time will tell if another "feeding frenzy" could inflate it into a new bubble.

In conclusion, the recent market surge has reignited concerns about potential stock market bubbles. Identifying these bubbles can be challenging, but historical comparisons and a focus on valuations relative to fundamentals can provide valuable insights. While some stocks like NXT exhibit characteristics of a bubble due to excessive investor enthusiasm, others like XRO and SQ2 present an intriguing "anti-bubble" scenario. Their strong fundamentals are overshadowed by a mix shift in investor preferences. Ultimately, understanding investment flows in both thematic trends and individual company fundamentals will help distinguish between bubbles fuelled by speculation and anti-bubbles harbouring hidden value.