Nvidia Historical Return & Expectations of Future Return
Nvidia has returned 189% over the trailing one year & is up 1,069% over the last 5 years. Is now the time to buy or sell?
There’s two angles to consider here:
What’s the expectation of the company's future cash flows?
How much surprise is not baked into prices today?
Angle one considers it’s expected return.
Angle two considers its unexpected return.
While both angles are considered in a company’s realized return (combination of both expected & unexpected), it’s the expected return that primarily drives a company's current price today.
The concern is not that the price is right:
The concern is based on current prices, what does that mean for future returns?
Said differently:
How much more unexpected return can you expect from Nvidia?
Their returns are unexpected because when you go back 5 years ago, few had confidence Nvidia would have return over 1,000% - much of their return has been driven by better-than-expected expectations of the company’s future cash flows (which caused this new information to be incorporated in prices with more buyers than sellers causing the price to increase).
When you look at the attribution of returns, it’s always been skewed to a few names that make up for the broader returns on the markets.
Consider this year, the market has been dominated by 7 names:
Tesla, Microsoft, Alphabet, Nvidia, Amazon, Meta, and Apple.
In 2023:
493 securities have returned 0%.
7 securities have returned 54.60%.
The S&P 500 has returned 11.68% - completely from these 7 names.
2017 research from Hendrik Bessembinder, Do Stocks Outperform Treasury Bills used the Center for Research and Securities Prices (CRSP) data encompassing U.S. stocks between 1926-2017 supports this claim through his finding:
58% of stocks failed to beat Treasury bill returns over their lives.
38% of stocks beat Treasury bills by just moderate amounts
4% of stocks are responsible for boosting the market’s overall returns higher than Treasury Bills
Said differently –
You would be better off taking no risk than holding 96% of the US stock market since 1926.
This tells us that:
Chance dominates your realized return.
As investors, your realized return is a combination of the expected return plus your unexpected return.
Where a stock's expected return depends on what the company owns versus what it owes (this is known as the book value of equity) as well as a discount rate demanded in aggregate by market participants who hold shares of the company.
A stock’s unexpected return is the excess cash flow generated over and above the applied discount rate. This makes the company more attractive to investors and prices rise as investors incorporate this information into current prices.
While the magnificent 7 have returned 54.60% collectively throughout the year, much of that return was unexpected as the surprise of these companies rippled through the markets.
This then leads you to wonder what you can do as an investor to better identify differences in expected returns to capitalize on your investment to generate high rates of return.
Valuation theory works silently in the background of investing and argues that a stock's expected returns are driven by the prices investors pay and the cash flows they expect to receive.
You can then use this idea to identify how expected returns differ based on company’s fundamentals.
While beyond the scope of conversation today:
Stocks with a lower relative price, a smaller market capitalization, and high profitability are characteristics that have been shown as factors that deliver higher expected returns through research by Eugene Fama and Ken French.
We can see low relative price played out below:
Price-to-earnings looks at earnings relative to current price. So if a stock earns $1 and the stock trades at $17/share then its price-to-earnings is 17.
This chart looks at the forward price-to-earnings ratio relative to the realized return experienced by the S&P 500.
Looking at every peak & trough, the higher the forward price-to-earnings ratio becomes, the higher likelihood your expected return is low (& vice versa).
We can also see valuations across the globe aren’t the same:
As you plot this out over a trend, you see the following:
There’s a negative correlation between price and return.
High prices today, mean lower expected returns in the future (& vice versa).
So, while it's reasonable to entertain the idea that companies with a high price relative to their earnings will have a lower expected return, to make asset allocation decisions on valuation spreads could be risky (think about the investors who shorted Tesla back in 2020).
Remember:
Chance dominates your realized returns.
So what does this mean as an investor?
Ten things come to mind:
Embrace market pricing (Markets process billions of dollars of trades - the price is right)
Don’t try to outguess the market (active managers underperform)
Resist chasing past performance (Odds of picking winning stocks are dangerously low)
Let markets work for you (invest with a long time horizon)
Consider the drivers of returns (equity = size, value, profitability | fixed income = term, credit, and currency)
Practice smart diversification (global diversification improves reliability of returns)
Avoid market timing (you don’t know which asset class with outperform)
Manage your emotions (markets don’t care about your feelings of stocks)
Look beyond headlines (financial news is about capturing your attention, not educating you)
Focus on what you can control (actions, desires, value judgements)
Nobel Prize winner Robert Shiller has an explanation regarding these run ups in price which he coined as irrational exuberance described as unfounded market optimism that lacks a real foundation of fundamental valuation, but instead rests on psychological factors.
Could this be Nivida?
Maybe.
Could it also not be Nvidia?
Maybe.
So do you buy or sell?
Good question - what’s your investing goal?
Is it to hit home runs and have something sexy to talk about at the cocktail party?
Or is it to produce consistent, predictable, and reliable rates of return over long periods of time?
If the former, Nvidia looks like a great story and history has proven that story to be correct.
If the latter, Nvidia looks concerning as history has shown the realized future return to be low.
But just remember if your belief is the former:
“Risk is what’s left over after you have thought of everything”
How much risk do you need to take to reach your goals?