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Absurdly expensive stocks — like those today — rarely become global leaders, history shows

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It feels as if you’re always just the click of a link away from a comparison between the dot-com bubble and today’s technology-stock valuations.

It’s not only in tech that valuation look toppy. If we use enterprise value (market capitalization plus net debt) to sales (EV/S) as our primary indicator, the number of extraordinarily high-priced companies in the Russell 1000 is approaching record levels (first chart, below), while it’s at an all-time high in MSCI World (second chart, below).

As stocks are so expensive, it’s a good time to ask how they’ve performed historically. The answer, in short: Not well — but not as badly as one might expect. And that is partially driven by long-term positive skewness in returns, where a few successes can offset many losers.

For stocks in the Russell 1000 (MSCI World) whose EV/S exceeds 10 for the first time, the median underperformance is 65% (33%) cumulatively over the next five years. The mean outcome is a bit better — reflecting that positive skewness — with underperformance of 28% and 7%, respectively, for the Russell 1000 and MSCI World.

However, if we look at even more extremely valued companies, using 20 times as our threshold (and such companies do exist today!), the prospects look dimmer. In the Russell 1000 (MSCI World), cumulative relative underperformance averages 42% (22%). The median cumulative underperformance is 73% (50%)! While it may not be totally fair to say these companies are un-investable, historically the odds have been stacked against them.

Historical record

Is it different this time?

To those happy holders of stocks trading at egregiously high multiples, there are two material differences between the markets of 2020 and those of history: First, the risk-free rate is currently close to zero in developed markets, and, in theory, a company with accelerating growth at a zero discount rate has no upper bound on its valuation. Second, it is clear that return on capital for the best cohort of companies — the FAANGMs, for instance — has entered a new paradigm in terms of the potential for persistence at a higher plateau. (FAANGM is an acronym for Facebook
FB,
+0.35%
,
Apple
AAPL,
+0.51%
,
Amazon
AMZN,
+0.37%
,
Netflix
NFLX,
+0.59%
,
Google holding company Alphabet
GOOG,
+0.98%

 
GOOGL,
+1.03%

 and Microsoft
MSFT,
+0.63%
.
)

As far as return on equity (ROE) goes, the median company in the top decile of the Russell 1000 (excluding financials and real estate) makes 44%. Assuming growth of 5% in perpetuity (not an ungenerous assumption), and a cost of equity of 6% (long bonds plus a 5%-ish equity risk premium, again in perpetuity) the Gordon Growth Model suggests a warranted price-to-book multiple of 39 times.

At first blush, very high ROEs and low discount rates do seem to justify eye-watering valuations. But this conclusion rests on the assumption that the current cohort of the most expensive stocks are also the most profitable. And this is manifestly not the case, as the chart below shows. The median ROE for the cohort of Russell 1000 stocks with an EV/Sales greater than 10 has been no better than zero on average since 1999. And for EV/sales greater than 20, ROE has been materially more negative over time.

The picture for MSCI World is broadly comparable, as the chart below shows.

More unfortunately still, the median ROE for the five years after crossing the 10 and 20 times sales thresholds doesn’t improve at all for either Russell 1000 or MSCI World, meaning that nothing in history supports the idea that today’s absurdly expensive stocks become tomorrow’s global leaders, at least as far as returns on capital goes.

New paradigm

When an investor is paying 10, 20 or more in terms of sales, there is the expectation of significant future growth. With ultra-low interest rates and persistently high returns on capital for a significant number of companies, and particularly given the high-profile success stories of the FAANGM stocks, it can appear at first glance that we have indeed entered a new paradigm.

Looking back over history presents a very different story. Indeed, the exception of the FAANGM stocks appears to mask a more powerful and persistent truth: Stocks valued at excessively high levels rarely deliver earnings to justify these inflated prices.

It feels unfashionable in the age of the unicorn to suggest that the valuation techniques we learned in school still hold water. But a close analysis of historical precedent presents us with precisely these lessons, and we urge long-term investors to think hard before launching into the frantic scramble to uncover the next FAANGM miracle stock.

Daniel Taylor is chief investment officer of Man Numeric.



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My fiancée’s mother asked us to raise her 2 kids, as we live in a good school district and she has a gambling addiction — then she claimed their stimulus checks

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Dear Quentin,

Last year, in February, my fiancée’s stepfather passed away. After his passing, my fiancée’s mother asked both her and me to raise her younger sons, as we had recently purchased a new home, have degrees and will be able to provide a great area for their education, such as help with homework and the ability to communicate with their schools or doctors. My fiancée’s mother cannot read, write or speak English, and she has an addiction to gambling at casinos.

COVID-19 hit soon afterward. We both were let go from our jobs, and are making it by with unemployment and savings.

With that said, in March of this year, we filed taxes and my fiancée claimed both of her brothers since they had lived with us for almost nine months of last year. We received both of their stimulus payments a few days later. About three weeks later, we found out that my fiancée’s mother had also received the stimulus payments, even though she is adamant that she did not claim her children this year.

Upon seeing the money, I advised her to leave the money as the Internal Revenue Service may eventually ask for it back. Her new boyfriend then quickly told her to withdraw it anyway. They’ll deal with it later if the IRS asks for it, he said.

My question is: Will this situation hurt my fiancée and me in any way? I fear that the IRS may find out sooner or later about the error and seek the money from us, as her mother may have already gambled away that stimulus money, and make us pay for it even though we are using it as it was intended: for bills and necessities.

Fiancé

You can email The Moneyist with any financial and ethical questions related to coronavirus at qfottrell@marketwatch.com.

Dear Fiancé,

You are correct. The IRS will eventually ask for that money back, and it will likely do so by deducting the money from a future tax refund. You are also correct that your de facto mother-in-law should not spend the money. I take my hat off to you for raising these two children, and giving them a stable home and the head start in life that they deserve.

Many people in such a situation would write complaining about how they did X, Y and Z, and their in-laws were ungrateful. But you have taken the high road, knowing that these shenanigans are between you two and your fiancée’s mother, and do not involve your girlfriend’s two younger siblings. I am glad that you have not involved them in this somewhat messy situation.

You, of course, have done the right thing. The Moneyist column has dealt with dependents who claimed the stimulus, and parents who are not guardians of their children collecting it. The $1,400 economic stimulus payment, as you are aware, is not a loan. This third stimulus check is an advance tax credit on your 2021 taxes, and calculated based on your 2020 taxes.

If the IRS does not know who is telling the truth here, it will audit both parties. The truth will come to light eventually, and your fiancée’s mother and her boyfriend should be made aware that you are not in a position to help bail them out of this situation. They have knowingly walked into it, and there should be a clear boundary between helping her children and being a facilitator to this malfeasance.

The IRS has extensive guidance on what to do when someone fraudulently claims your dependent. “If you determine the other person was not eligible to claim your dependent, you’ll need to take steps to protect your right to claim the dependent and ensure an accurate filing,” it says. You have everything you need to know in order to take proactive steps here.

I leave that for you to decide.

The Moneyist: ‘I cut his hair because he won’t pay for a haircut’: My multimillionaire husband is 90. I’ve looked after him for 41 years, but he won’t help my son

Hello there, MarketWatchers. Check out the Moneyist private Facebook
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 group, where we look for answers to life’s thorniest money issues. Readers write in to me with all sorts of dilemmas. Post your questions, tell me what you want to know more about, or weigh in on the latest Moneyist columns.

By submitting your story to Dow Jones & Company, the publisher of MarketWatch, you understand and agree that we may use your story, or versions of it, in all media and platforms, including via third parties.



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I’m on track to retire at 58. My fiancée is in debt and drives my old car, and I support her family. How do I ensure my son inherits my wealth after I die?

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Dear Quentin,

I have dated my fiancée for just over three years. Within those three years, I have been severed from a job and spent two years unemployed looking for a new job. I have a new job, making roughly 75% of what I previously made, but it is a more than livable salary. My fiancée makes a modest salary in comparison to my own.

Financially, I had spent a lot of years going without in order to pay for my son’s college education and to stockpile savings in order to retire early. According to my financial planner, I am well ahead of my goal to retire at 58 (I’m 51 currently) with an IRA of around $2 million, plus savings and other liquid assets.

Currently, my fiancée is trying to get herself out of debt. She drives my old car and shares no utility bills or mortgage payments, but she does buy groceries, as the household is made up of her, her children and me. By supporting her family, I have very little I can do for my own son.

It has always been tradition in my family to leave an inheritance. I had planned on leaving my only son a rather large inheritance so that he may better himself and his family. My fiancée has children, and my concern is that if I am married (I live in Texas), the savings I have would go to her and subsequently her children, bypassing my son.

Since I am 10 years older than my fiancée, I suspect she may outlive me. How do I protect my assets so that they can be split as part of my wishes?

Nervous Fiancé and Father

You can email The Moneyist with any financial and ethical questions related to coronavirus at qfottrell@marketwatch.com.

Want to read more? Follow Quentin Fottrell on Twitterand read more of his columns here.

Dear F & F,

Texas is a community-property state, so what you bring into the marriage, you also take out of the marriage. Assets accrued during the marriage, with the exception of inheritance, are deemed marital or community property.

You have several options, including setting up a living trust to allow you to transfer your wealth to your son during your lifetime, and thereby avoiding going through probate, which can be an unpredictable, cumbersome and public process.

You have two choices of trust: revocable or irrevocable. The first can be changed. You could retitle financial accounts in your son’s name. The latter cannot be changed, and also serves to save on estate taxes. It’s typically used to leave assets to children and grandchildren.

Other routes: a prenuptial agreement, a will (obviously) and naming your son as your beneficiary on your life-insurance policy. With the help of an estate planner, you can devise ways to ensure your son is taken care of after you’re gone, and your future wife is not left out.

In the meantime, ensure you keep separate property separate. If you deposit an inheritance in a joint bank account, for instance, it becomes marital property. If your fiancée contributes to the renovation of a home in your name, it again becomes community property.

Speak to your fiancée about your concerns and goals. It’s important to be transparent and ensure that you and she are on the same page, and share the same financial expectations. You may also want to wait until your wife pays her debts before marrying.

Hello there, MarketWatchers. Check out the Moneyist private Facebook
US:FB
 group, where we look for answers to life’s thorniest money issues. Readers write in to me with all sorts of dilemmas. Post your questions, tell me what you want to know more about, or weigh in on the latest Moneyist columns.

By submitting your story to Dow Jones & Company, the publisher of MarketWatch, you understand and agree that we may use your story, or versions of it, in all media and platforms, including via third parties.





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