The last year has seen a huge recovery in value stocks, inflation beneficiaries in particular. At the same time growth stocks have had a torrid time. Nasdaq is down 26% from its peak in November at the time of writing, and commentators are beginning to draw comparisons to the bursting of the tech bubble back in 2000. This week we have a look at the potential for further falls and what it might take for a meaningful rally.

The obvious near-term cause of the tech collapse has been the rise in inflation and consequent rises in short and long-term interest rates. Just as falling rates drove the growth stock bull market of the last ten years, rising rates have led to its demise.

In our funds, we mix macro views with long term themes. At present, we are positioned for economic uncertainty, combined with a long-term belief that inflation will be higher and rates will rise over coming years. We would like to balance this with some of our themes, but these tend to have a growth bias and hence we have reduced exposure currently. For this reason, the question of when growth might, at least, cease to underperform is important to us.

One way of thinking about near term peaks and rallying points is to consider valuations. In bull markets, bubble valuations tend to get to levels that are self evidently extreme, the same being true in bear markets. Anecdotes abound as to the absurd valuations of some of the smaller tech stocks at the peak. At the top, Zoom, with around $2bn of revenues, had a market value in excess of BP, with $180bn. Obviously, hindsight helps but both those prices were clearly wrong.

Where we are now on that journey is harder to assess, but a look a current valuations might help. Tech stock valuations in many cases are not as transparent as you might think. In a lot of cases, earnings and cash flow are reported as rising strongly. However, this cash flow is in many cases largely or entirely used in buying back shares. Some investors regard share buybacks as equivalent to dividends. We think they couldn’t be more wrong. Shareholders do not benefit from buy backs if the share count at these companies doesn’t fall. In practice shares are being reissued in the form of options to management. In essence, the vast bulk of value is being syphoned off to the management. This isn’t solely a tech/growth stock issue, but it is certainly highly prevalent in that sector.

Take Meta (owner of Facebook), as an example. Over the past 5 years it has spent $88bn buying back shares equivalent to nearly 20% of its market value at the start, yet its share count is barely changed. That $87bn is the vast bulk of reported profits and cash flow over the period. Shareholders have benefitted from a slightly higher share price, but any real value creation has largely gone to the beneficiaries of share issuance and buybacks. In simple terms, around $90bn has been transferred from shareholders to staff and management. To what degree would staff work at these companies if they didn’t continuously receive compensation in the form of generous share grants against rising stock prices.

Conversely, shareholders in Exxon Mobil have received $71bn in dividends over the same period and their share count remains the same. The vast bulk of its value generation has gone to shareholders rather than management, yet its market value remains only 60% that of Meta.

This suggests that the tech stock rout has further to run. Shareholders receive little value from holding these shares other than a rising stock price, and these are no longer rising. While superficially price to earnings ratios may be significantly lower than before, these ratios are not comparable to other stocks.

In conclusion, we think you need to be more selective than in the past when looking at growth themes. The easy times are over, we are in a rising rate and inflation environment. That is not to say that some growth stocks won’t be amongst the best performers in coming years, genuine growth stocks can always perform well.  However, many of the past winners may turn out to have been illusions created by cheap money. Over time, we would expect the growth themes in our portfolio to increase, but for now we remain very selective.