The market frenzies surrounding GameStop, WallStreetBets versus Robinhood, inflationary concerns/taper tantrum, the significant price runs of special purpose acquisition companies (SPACs), and recent technology initial public offering (IPO) stocks have altered capital markets in meaningful ways. These changes have many market participants questioning the relevance of fundamental analysis and the extent of disruption to traditional valuation methods. Are these incidents just noise, or have market valuations truly decoupled from traditional discounted cash flow metrics?

On April 8, 2021, CFA Society Toronto’s Corporate Finance Committee invited a panel of experts to examine why market valuations are out of sync with fundamental analysis. The session was moderated by Stephen Forrester, CFA, professor of finance at Ivey Business School, and attended by guest panelists Bruce Campbell, CFA, Founder and Portfolio Manager at StoneCastle Investment Management; Jennifer Radman, CFA, Head of Investments and Senior Portfolio Manager at Caldwell Investment Management; and Graeme Moffat, Chief Scientist, StartupFounder and Senior Fellow at the Munk School of Global Affairs and Public Policy.

Is fundamental analysis dead?

“Fundamental analysis is not dead, it is just in hibernation,” said Jennifer Radman, whose firm is a bottom-up investor interested in “positive rerating stories” in Canada. She explained that ultimately, a company’s ability to create shareholder value is determined by its ability to generate positive cash flows. Bruce Campbell agreed and noted that while fundamental valuations may be out of sync with the economic reality today, there are areas where valuation will always be important. The valuation pendulum will swing back to the origin in the future, and fundamental analysis will be relevant again. The timing of this, however, is uncertain.

In contrast, Graeme Moffat said that “fundamental analysis is dead.” He noted that it has failed to adapt to many of the changes in the way assets are valued and held. For instance, traditional finance theories ignore behavioural biases and assume that investors are rational. However, the meme stock saga of 2021, in which day traders operated on frictionless trading platforms in a gamified manner to disrupt normal market activity, has proven yet again that the stock market can remain irrational a lot longer than one can remain solvent.

The role of technology

Technology may be the most enabling factor in the recent disruption in capital markets. Commission-free trading, fractional-share investing, and the lightning speed with which information is disseminated on the internet have all given rise to a new breed of investors who, with no regard for fundamental analysis, have turned the traditional investing hierarchy upside down.

“What we are seeing is a combination of mania, luck, and gambling,” says Moffat.

This is driven by a combination of fiscal and monetary stimulus. Fiscal policy put money directly into consumers’ pockets, while the government kept the economy humming along with a combination of low interest rates and continued bond purchases. An online survey from Deutsche Bank published in February 2021 revealed that respondents, all users of online broker platforms, planned to use approximately 40 percent of their stimulus cheques for equity investments, potentially amounting to an inflow of US$170 billion to U.S. capital markets.

The rise of the intangibles

In Capitalism Without Capital: The Rise of the Intangible Economy, authors Jonathan Haskel and Stian Westlake discuss the growing importance of intangible assets and their critical role in ensuring both a company’s and the economy’s long-term success. Yet traditional valuation methodologies fail to capture this important asset class.

Intangible industries such as software, cloud, data, and artificial intelligence, among others, have strong network effects. Network effect refers to the phenomenon where the value of a product or service increases as more people use it. Alphabet, for instance, leads the online search market with a global share of over 80 percent. It owns the world’s most widely used search engine, and such a large and growing user base has created a network that is difficult to replicate. The company has also benefited from a wide a range of complementary products and services, including Android, Maps, Gmail, and YouTube. For companies that trade in intangibles, it is hard to predict what the competitive advantages will be, making it difficult for fundamental analysis to capture this asset class.

How then do we evaluate such companies and industries? Moffat prefers a venture capital valuation model as opposed to a fundamental analysis valuation model, with a focus on upcoming technology changes and long-term shifts in traditional industries. Technology risk, which assesses a company’s competitive advantage to disrupt or displace incumbent technology, is a key factor in valuing the technology startup space. While quantitative analysis can be used to evaluate execution risk (defined as the ability of the business to perform and deliver), it is not a useful measure for technology risk.  

The SPAC bubble

Special purpose acquisition companies (SPACs) have been around for decades, but they only recently enjoyed a rapid surge in popularity. Also known as publicly traded shell companies, or “blank-cheque companies,” SPACs are investment vehicles that raise capital from investors through a SPAC IPO to be later used to acquire one or more target companies. SPACs generally have two years to find a target; if they do not, the money raised is returned to investors. In the past year, high-profile sponsors, large deals, and strong returns have propelled the SPAC market into the mainstream.

The problem lies in the evaluation of a SPAC as a potential investment before a merger agreement is announced. Are SPACs a legitimate path to the public markets that provide early-stage private companies with access to growth capital and liquidity? Or are they a backdoor path to the public markets that allow sponsors to sidestep regulations to make quick profits? 

According to Moffat, SPACs are a fantastic way for retail investors to tap into growth and technology companies promoting innovation that otherwise may have decided to stay private due to the challenges in raising money through a traditional IPO. He cautions investors, though, that not all SPACs will be successful, and there is significant risk involved in investing in SPACs. Ultimately, investors must do their due diligence before making investment decisions, including assessing their risk tolerance and time horizon, which is all the more important when considering investing in opportunities such as SPACs and cryptocurrencies (which Moffat calls the ultimate intangible), as these could be an “all or nothing bet.”  

 Source: SPAC Analytics

*SPAC data is as of June 27, 2021

The way forward

What will come next as investors throw caution to the wind to avoid missing out on the ride? Many investors are quick to brand themselves as value investors based on doing a cursory screening of low multiple stocks. There is, however, more to stock research and analysis than just looking at valuation metrics. “It is important that investors uncover the catalysts for businesses that change an out-of-favour value trade into a growth trade before making investment decisions,” Campbell noted. This means that, going forward, professional researchers and investment advisors will play an even more important role in channelling and distilling the current deluge of information in a logical and deliberative manner.

Is regulation a solution to the valuation conundrum? Campbell doesn’t think so, not in the grand scheme of things. He believes the markets are already highly regulated, and there is no guarantee that additional layers of regulations would protect naive investors. Markets continue to evolve, and market participants will find yet more opportunities to explore. Moffat adds,

“There is a limit to the extent to which you can protect people from themselves while still maintaining market dynamism.” To a great extent, markets are driven by emotions, including greed.

In an economy pumped with cash chasing fewer assets, these emotions can serve as a catalyst for investors to take greater risks, regardless of their ability. 

Radman cautions, however, that directing government funds to drive market speculation is problematic. She worries that the current stretched market valuations will become unsustainable at some point, and while the how and when of this is unknown, recessions can result from misallocation of capital.

In conclusion, while fundamental analysis may appear to be dead, it is not so. Will it be the sole or most important means for valuing a company? No. As markets and market participants evolve, so will valuation methodologies. In the long run, however, fundamentals will continue to matter. To quote Jason Zweig, a columnist for The Wall Street Journal, “One of these days, perhaps sooner rather than later, stocks will stop going up and the importance of understanding what you own will reassert itself. For the time being, though, investors who used to think of themselves as wise may continue to look foolish.”