Warren Buffett once said, “You never know who’s been swimming naked until the tide goes out.” Well, the trend has been cut short for tech-focused hedge funds.
In the first four months of the year, tens of billions of investor capital evaporated in what could be the fastest dollar collapse in hedge fund history.
Tiger Global’s main hedge fund is down more than 40% through the end of April, with Bloomberg estimating the company’s losses at $16 billion. Several other big name brand tech funds have the same names as Tiger and are likely to go down a lot or more.
Performance seems worse upon reflection. In theory, hedge funds are supposed to conserve capital in challenging markets. They rarely get full exposure on the long side, and use bets against companies to smooth out volatility. But with many funds doubling the Nasdaq’s composite loss through April, that means stock picking, or alpha, has been incredibly poor.
So, what did managers get wrong and how can other investors avoid such pitfalls?
The biggest lesson from the technology explosion of 2022 is that there is no lasting change. Complacency is the worst trait of an investor. Even after a decade of tech dominance, the fundamentals can change quickly. And that is what happened this year, with openness to trends re-opening at the same pace as the previous pandemic. Shareholders need to keep a close eye on business developments in the companies they own – and reading analyst reports is seldom enough.
After years of writing about stocks, I’ve learned that there are two very important things about the stock’s future direction: the company’s growth trajectory and changes in earnings estimates from Wall Street. Taking my focus away from these data points resulted in mistakes in my stock analysis. (Just as a reminder that as an employee of Dow Jones, publisher Barons, I don’t buy or sell the stocks I write about.)
In terms of growth, investors should follow the lead of venture capitalist Bill Gurley, who has long said that nothing is more important to evaluating multiples than growth rates. The market tends to extrapolate incremental growth far into the future, resulting in higher multiples. And the opposite is also true. Deceleration will result in multiple compression.
Zoom video communication
(Stock ticker: ZM) is a good example of the market’s myopic focus on growth. Price-to-sales for the video conferencing company skyrocketed as quarterly sales growth reached 369% at the height of the pandemic. A year later, the company was still posting an impressive 21% growth, but it wasn’t enough. Multiple hole stock.
The second key factor is a bit more complex but perhaps more important: understanding how earnings track relative to Wall Street estimates. In an interview via a podcast last month, Dan Benton, who once ran the world’s largest technical hedge fund, argued that the biggest driver of stock prices is positive or negative earnings surprises.
In the case of both
(NFLX), several quarters of errors were responsible for the stock’s long slide. Errors do not have to be on the actual results. Disappointing expectations are more harmful. Once you see a quarter of the missing errors, it’s time to double your search.
“When a company relies on consistent earnings, revenue strikes, margin expansion, and disappointment, there is an air pocket in that stock,” Benton said, referring to Netflix.
After the big drop in tech stocks, there may be opportunities now using the same framework outlined above. Which companies are most likely to deliver solid growth and upside earnings surprises over the next year?
I have two suggestions:
I’m biased towards companies exposed to video games. The video game market is generally in the middle of a multi-year production cycle, which began when Sony and
(MSFT) launched its latest console in 2020.
While Sony is short on chips in its manufacture for the PlayStation 5, these issues will eventually be resolved. Once that happens, Sony should thrive thanks to strong hardware sales and growing software revenue for games sold on its platform.
Meanwhile, Electronic Arts should do well as a leading game maker with a host of popular sports titles and franchises such as Apex Legends. Now this
(ATVI) has agreed to merge with Microsoft (MSFT), and EA has scarcity value as one of the few remaining large independent publishers. The company can eventually catch the attention of a larger technology company.
Advanced Micro Devices
(AMD), the leading supplier of chips for PlayStation and Microsoft Xbox, said it is seeing strong demand for its console chips and is expected to see higher sales later this year and into 2023. AMD’s comment matches the trends I see in retailers. When PlayStation 5 consoles are available, they sell out within minutes.
Both Sony and EA are set to announce their earnings this coming week. Although I am not sure of this quarter’s results due to supply issues, I am confident that the two companies will be able to deliver excellent results over the next two years.
write to Tae Kim at [email protected]