Many of today’s investors, particularly the young aggressive Robinhood types, want big returns, and that is something more than the stock market, or the average stock, can provide. Read the academic literature, or Aswath Damodaran’s blog, Musings on Markets, and you will learn that investors can expect a return of about 6% per year on the average stock. 6% per year? To an aggressive young investor whose experience with the stocks is a twelve-year bull market topped off by a more than 90% increase in the NASDAQ index since its low in March 2020, 6% is chicken feed, they want big returns. In some cases, they even eschew stocks for options because the effective leverage opens the door to even bigger returns and big returns are what some sexy stocks have delivered. For instance, since the lows in March, Tesla is up about 700%, Snap is up about 600%, and Carvana is also up 600%.
What types of stocks can offer such big returns? Research at Cornell Capital Group provides an answer. We find that they cannot be stocks of companies whose values are largely driven by current earnings. The problem is that growing earnings is hard. A company has to build a new plant, buy equipment, hire new employees, attempt to attract new customers, and so on. All that takes time, implying that growth in earnings tends to be slow. If you want to see a company’s stock price rise by a factor of five or more in nine months, you cannot count on growing near-term earnings to provide the thrust.
Expectations are different. They can shift dramatically in the short run. All you need is a change in sentiment regarding the future, no actual change in current performance is required. All three stocks mentioned above, Tesla, Snap, and Carvana, skyrocketed not on massive increases in current earnings, or even increases in short-term expected earnings, but on the basis of newly discovered enthusiasm for their long-term potential.
At Cornell Capital Group we use a simple model to divide the value of a company’s stock into two components. The first component, which we call the “current observables,” includes the book value plus the value of current earnings assuming they can be maintained into perpetuity. The second component, which we refer to as the “speculative” part, is the difference between the stock price and the currently observable component. The table below presents results for Tesla, Snap, and Carvana along with three companies whose value is more anchored in the present, Johnson and Johnson (JNJ), Intel, and Verizon. The results are dramatic. Nearly 100% of the value of Snap and Carvana comes from the speculative component. Even for Tesla, which is in a capital-intensive business, the number is 83%. On the other hand, the speculative component is negative for JNJ, Intel and Verizon.
Percent of Stock Value Due to the Speculative Component
Percent of Stock Value Due to Current Observables
The implication is that investors who want big returns have to be looking at companies with large speculative components. This is not, apparently, news to them. The prices of these companies, in many cases, have been bid up to extraordinary levels in the hunt for big returns. The problem is that there is a downside as well. Expectations can change rapidly in either direction. If sentiment turns negative, the price of a company like Carvana could drop by half with virtually no change in current operations. That is the downside of big returns, they carry with them the risk of big losses. Thus far, a raging bull market has protected investors from that downside, but at the current level of prices it remains a distinct possibility that the future will not be so pleasant.