Is Marc Faber’s Gloomy Market Outlook Correct?

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As the stock market declined sharply on Thursday, Marc Faber — aka “Dr. Doom” – told CNBC that he believes that the decline in stocks is just beginning. In particular, he pointed out that investors should be wary of owning high-growth stocks that are trading at nosebleed valuations. Is he right?

With the rise in stocks over the past couple of years, investors have become extremely optimistic. In particular, they have bid up the prices of high-growth stocks to outrageous prices in many cases. These valuations are unsustainable in the long run, but so long as there are investors who believe in these valuations, we can see them for an extended period of time.

Faber believes that this optimism is slowly turning into pessimism. Stocks that trade based more on their sales growth than their profits, such as LinkedIn (NASDAQ:LNKD) and Amazon (NASDAQ:AMZN), are extremely vulnerable to the downside. This is the case because once the momentum stops, an entire class of investors — high-growth momentum traders — will lose interest. These stocks can fall until another class of investors — value investors — start to become interested. But with many of these companies, generating very little profits compared with their current valuations, it is possible that we could see valuations collapse even if these companies’ sales can easily translate into profits in the near future.

Amazon is an excellent example of this sort of company. Management has generated less than $5 per share in profits over the past four years, and yet the stock trades at $318 per share! Investors have aggressively bid up the stock, assuming that the company’s sales growth could one day generate substantial earnings once the company begins to spend less money on its infrastructure build out.

I happen to agree with this to some extent, and I think that Amazon can be a great long-term investment. But without earnings, how do we go about valuing the company? Price to sales, price to gross profits, or price to operating cash flow are all possibilities, but they fail to give investors insight into the company’s ability to generate shareholder value.

Furthermore, one concern that has kept me out of the stock — at least at the current price — is the following: While Amazon may be able to generate profits once it slows down its infrastructure buildup, what will happen to its competitive advantage once it does this? If Amazon’s economic moat requires that all of its profits be spent on defending it, then what is the point in maintaining it? After all, one of the advantages of buying stock in a company that has an economic moat is that such companies are able to use this moat to generate profits.

Amazon isn’t the only company in this situation. Other companies are valued based upon what they might earn rather than what they do earn. While there are situations in which these companies are worth owning, Faber believes that we are entering one in which investors will demand tangible profits and real capital returns to shareholders in the form of dividends.

As a result, Faber wouldn’t be surprised to see these stocks crash. Nor would I.

What, then, is an appropriate investment approach? After all, we all want to own stocks of companies that are and will continue to grow their earnings, even in a weak economic environment.

The key is to focus on growth companies that actually have earnings. Consider Visa (NYSE:V), which has a price that is declining alongside LinkedIn’s. Visa trades at 23 times 2014 earnings estimates. This is expensive, but if market weakness continues as Faber predicts, then we could see Visa hit a reasonable valuation with a decline of 10 percent, and a great valuation with a decline of 20 percent.

LinkedIn, on the other hand, trades at 104 times this year’s earnings estimates. Even if a value investor were willing to pay 25 times earnings for this rapidly growing company, the stock has more than 75 percent downside before s/he will step in.

With these points in mind, be very selective of companies that are not generating any earnings in this stock market environment. That isn’t to say they are all bad investments, but they are all vulnerable to the downside in a weak market. More conservative investors should simply lay off these kinds of stocks and focus only on those companies that are generating profits for shareholders, as well as those companies that have secular tailwinds driving these earnings.

Disclosure: Ben Kramer-Miller is long shares of Visa.

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