Over the past couple of months, the air has been slowly hissing out of the market's top growth stocks like a deflating balloon. Companies that were highly sought after at the end of 2020 and at the beginning of 2021 are now being avoided by investors.
A poster child of this market sentiment is the Ark Innovation ETF (ARKK, Financial). The price of the ETF hit an all-time high of more than $156 at the beginning of February. It has since fallen in value by nearly 40%. Some of the ETF's holdings have racked up even worse performances. One of its top holdings, Teladoc Health Inc (TDOC, Financial), is off nearly 70% from its all-time high.
One has to ask why these stocks have performed so terribly over the past 10 months. As is the case with many market questions, there is no one clear answer. However, one factor stands out more than any other, and that is valuation.
Growth stocks fall to earth
Teladoc is a good example of a stock whose high-flying valuation couldn't last forever, even with reporting decent growth. The company's revenues have expanded over the past year. Revenues jumped 81% in the third quarter compared to the prior-year period. The firm reported a loss of $84 million, which was up compared to the year-ago period and the $400 million loss reported in the fourth quarter of 2020.
This is just one example of a company that has continued to grow, but whose equity has dropped sharply in value.
Many high-growth businesses were trading at inflated valuations at the beginning of the year. They could not maintain these multiples indefinitely, and that is what we're now seeing. The market is becoming more questioning of growth prospects. Investors are no longer as willing to pay high growth multiples and ignore other fundamental factors. This is creating a self-fulfilling cycle where growth and momentum investors are changing their views and selling, pushing down the value of the equity and driving more owners to sell.
This market environment is a great case study of the importance of valuation.
Importance of valuation
Valuations became distorted throughout 2020 and the beginning of 2021. Investors rushed to buy certain equities based on highly optimistic growth projections and a fear of missing out. Analysts argued that recent growth would last forever as these companies disrupted markets. Based on this outlook, they were worth paying a premium for, Wall Street argued.
As the environment has changed, this debate has changed. The problem investors face is that a high multiple is only justified when other investors are willing to pay more. When market sentiment changes, that multiple suddenly becomes irrelevant. No fundamental factors support the equity price, and investors' valuation calculations suddenly become worthless.
In times of turbulence and uncertainty, a company's valuation becomes the anchor investors can use to remain focused and calm. Without this anchor, one's decisions may be influenced by market movements, and this is not sensible investing. It is speculating.
As Warren Buffett (Trades, Portfolio) told his audience in 1999 at the Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting, speculators struggle to earn consistent profits. Investors who pick businesses at sensible prices can become very wealthy:
"We have no idea whether the market is going to go up today, or next week, or next month, or next year. We do know that we will only buy things that we think make sense, in terms of the value that we receive for Berkshire. And when we can't find things, the money piles up. And when we find — when we do find things, we pile in. But the stock market — I know of no one that has been successful at — and reallwell-picking of money predicting the actions of the market itself. I know a lot of people who have done well picking businesses and buying them at sensible prices. And that's what we're hoping to do."
