Warren Buffett once said, “You don’t find out who’s been swimming naked until the tide goes out.” Well, the tide has gone out for technology-focused hedge funds.
In the first four months of the year, tens of billions of investors’ capital has been vaporized in what could be the quickest collapse of dollar value in hedge fund history.
Tiger Global’s main hedge fund fell by more than 40% through the end of April, with Bloomberg estimating the losses for the firm at roughly $16 billion. Many other large brand-name technology funds own the same names as Tiger and are likely to be down as much or more.
The performance looks even worse upon reflection. Theoretically, hedge funds are supposed to preserve capital in difficult markets. They are rarely fully exposed on the long side, and use wagers against companies to damp volatility. But with several funds doubling the Nasdaq Composite’s loss through April, it means their stock-picking, or alpha, was incredibly poor.
So, what did the managers get wrong and how can other investors avoid such pitfalls?
The biggest lesson from 2022’s tech blowup is that no change is permanent. Complacency is an investor’s worst trait. Even after a decade of tech dominance, fundamentals can quickly shift. And that’s what has happened this year, with the reopening sparking trends with the same speed as the pandemic before it. Shareholders need to closely follow business developments at the companies they own—and reading analyst reports is rarely enough.
After years of writing about stocks, I’ve learned that two things matter most to a stock’s future direction: a company’s growth trajectory and the changes to earnings estimates from Wall Street. Taking my focus off those data points has caused me to make mistakes in my own stock analysis. (Just a reminder that as an employee of Dow Jones, publisher of Barron’s, I don’t buy or sell stocks I write about.)
In terms of growth, investors should take their cue from venture capitalist Bill Gurley, who has long said that nothing matters more to valuation multiples than growth rates. The market tends to extrapolate rising growth far into the future, sending multiples higher. The reverse is also true. A slowdown will drive multiple compression.
Zoom Video Communications
(ticker: ZM) is a good example of the market’s myopic focus on growth. The videoconferencing company’s price-to-sales multiple rocketed higher as quarterly sales growth hit 369% at the peak of the pandemic. A year later, the company was still posting impressive growth of 21%, but it wasn’t enough. The multiple and the stock cratered.
The second key factor is a bit more complicated but perhaps even more important: understanding how earnings are tracking relative to Wall Street’s estimates. In a podcast interview last month, Dan Benton, who once ran the world’s largest technology hedge fund, argued that the biggest driver for stock prices is positive or negative earnings surprises.
In the case of both
(NFLX), multiple quarters of misses have been responsible for the stocks’ long slides. The misses don’t have to be on actual results. Disappointing outlooks are even more damaging. Once you see one quarter of misses, it’s time to double down on your research.
“When a company is predicated on consistent earnings beats, revenue beats, margin expansion, and they disappoint, there’s an air pocket into that stock,” Benton said, referencing Netflix.
After tech stocks’ big drop, there may now be opportunities using the same framework laid out above. Which companies are best positioned to generate strong growth and upside earnings surprises over the next year?
I have two suggestions:
I’m biased toward companies exposed to console videogames. The overall videogame market is in the middle of a multiyear product cycle, which began when Sony and
(MSFT) launched their latest consoles in 2020.
While Sony has been plagued by chip shortages in making its PlayStation 5, those issues will eventually get sorted out. Once that happens, Sony should thrive thanks to strong hardware sales and rising software royalties for games sold on its platform.
Electronic Arts, meanwhile, should do well as a leading game maker with an array of popular sports titles and franchises like Apex Legends. Now that
(ATVI) has agreed to merge with Microsoft (MSFT), EA also has scarcity value as one of the few big independent publishers remaining. The company could ultimately attract takeover attention from a larger tech company.
This past week,
Advanced Micro Devices
(AMD), the leading chip supplier for the PlayStation and Microsoft Xbox, said it was seeing strong demand for its console chips and expected to see higher sales later this year and in 2023. AMD’s commentary matches the trends I see at retailers. Whenever PlayStation 5 consoles become available, they sell out in minutes.
Both Sony and EA are scheduled to report earnings this coming week. While I’m not sure about this quarters’ results given the supply issues, I’m confident in both companies’ ability to generate stellar results over the next two years.
Write to Tae Kim at email@example.com