Value and Growth

It is often stated that things are never as bad as they seem or as good as they seem. I was reminded of that maxim when reading about the fortunes of two firms recently.

Firstly, Qantas, which as recently as the first half of 2014 looked in dire trouble. Qantas made a massive loss in the year to July 2014. High oil prices, a high cost base and the battle for market share with Virgin Australia had sent the Qantas share price to $1.09.

At that time Qantas was a deep value stock. Recall that value stocks have low ratios of market value to book value (low market to book). Qantas had a (MV/BV) ratio of 0.5 in July 2014 when the average stock market listed firm has a market to book ratio of about 2.3.

In the long run value stocks out perform growth stocks. That is a statistical regularity observed all around the world (even if it is not easily explained).

The behavioural finance explanation for why value stocks outperform growth stocks is that investors get too pessimistic and unexcited about some firms (mostly old economy firms such as Qantas) and too optimistic and over-excited about some firms (mostly new economy high tech firms like Uber). The turnaround of Qantas shares, which are now at $2.40, is consistent with the behavioural finance explanation.

Secondly, a growth firm caught my eye recently. The Lending Club listed on the New York Stock Exchange (NYSE) on 10 December. Its shares began trading at $15 and then jumped 56% on the first day to the give The Lending Club a market cap of $9 billion.

This is a crazy valuation. You know that I am not one to pretend to know more than the market about valuations of stocks. Large stock markets are informationally efficient and if you think you know more than the market then think again. Nonetheless, we know that stock market bubbles of different magnitudes can occur. We have already seen one massive tech bubble in the years 1998-2000.

Consider the facts here. The Lending Club is a platform that allows borrowers and lenders to find each other. It disintermediates banks in consumer lending. The stock market is excited about firms that can ‘disrupt’ a market. Amazon disrupted book selling, Google disrupted search, Uber is promising to disrupt the taxi industry and now The Lending Club and many others are promising to disrupt banking.

If the shares of Lending Club are worth $9 billion, then they must have profits of a few hundred million, right? Wrong. Well, they must have brokered loans worth tens of billions right? Wrong. The whole of the peer to peer sector has lent less than $15 billion globally (versus $85 trillion in the rest of the banking sectors and credit markets). Then the The Lending Club must surely have some barrier to entry of competitors - a patent perhaps or maybe a unique licence from the US Government or even a first mover advantage to create a natural monopoly (like eBay and Facebook did). Wrong again, there simply is no barrier to the entry of competitors.

The market is just so, so, so excited about disruption that it is prepared to pay $9 billion for a firm that promises something that it will not be able to deliver. The notion with The Lending Club is that banks are just monopolies that don’t provide any value or solve any real problems. Once there is a platform for connecting borrowers and lenders then the avaricious banks will be out of the picture. This is incredibly naive. Large banks are powerful incumbents that do create real value and will not be easily pushed aside.

The Lending Club is a great example of the market getting too excited about something new. Peer-to-peer lenders will have IPOs in Australia too at some stage. It might make sense to participate in those IPOs to get the first day pop in the share price, but investors who hold these stocks long term will regret it.