By Mike Barrett
High-quality businesses that lose half their market cap in a matter of months are always worth a closer look.
Let’s take a closer look at chipmaker Nvidia (NVDA). The tech darling’s shares have fallen about 50% from their October highs.
As demand for its high-performance chips surged into 2018, so did investor expectations. The company consistently beat those expectations, and the stock consequently rose more than 1,100% from October 2015 to October 2018…
Then, the growth story began to crack, financial results started underperforming expectations, and the share price tumbled.
In the table below, you can see how revenue growth expectations are now back to where they were four years ago, in the mid-single digits…
That’s good news for value-oriented investors. You want to buy when expectations are low, provided you think the outlook for future growth is stronger.
The biggest problem is that expectations for Nvidia’s operating and free cash flow margins remain very high. This is a significant risk.
When management recently pre-announced fourth-quarter results, it noted the adjusted gross margin would be below its previous guidance by about 6.5 percentage points. This means operating and free cash flow margins are also likely to decline significantly.
But investors are still inclined to give Nvidia the benefit of the doubt. They’ve dialed back growth expectations, but they don’t expect the slowdown to materially hurt profitability. For value investors seeking a measurable margin of safety, Nvidia doesn’t appear to fit the bill, even though shares have pulled back lately.
In his latest book, Mastering the Market Cycle, investing legend Howard Marks reminds readers that the odds of success change as we move across the investment cycle.
Take another look at the chart above. Anyone who bought at the beginning of this particular cycle would still be sitting on a five-bagger today, even after the recent decline. Expectations were low, and the margin of safety and odds of success were high.
But buying the stock later in the cycle, like back in October, when expectations were high and the odds of success were much lower, would have been disastrous.
Situations where the odds of success are clearly stacked in your favor remain few and far between today. And as stocks have bounced higher from their late-2018 lows, expectations have, too. That doesn’t mean stock prices can’t continue to move even higher… But to do so, they’ll have to beat already-high and rising expectations.