Price didn't matter in 2020, as investors bet on the fastest-growing companies. It wasn't so long ago that paying 20 times annual sales for a money-losing software company seemed crazy.
After a furious rally last year and despite a recent sell-off, some software stocks are fetching far higher price-to-sales multiples. Snowflake goes for over 100 times sales, for example, even as the company posts massive losses.
Some non-tech growth stocks are being valued at sky-high sales multiples, as well. Fake-meat pioneer Beyond Meat trades for around 20 times annual sales, despite a barrage of competition and the fact that its products are aiming to replace real meat, which is largely a commodity. Electric-car company Tesla is valued at over 20 times annual sales, while automotive giant Toyota goes for just 0.9 times sales.
Prices for some growth stocks are so high that it really doesn't matter how the underlying companies perform. Shares of Cisco Systems soared during the dot-com bubble, at one point reaching a price-to-sales multiple of a few dozen. The stock crashed when the bubble burst and still hasn't reclaimed its all-time high despite two decades of market dominance and consistent growth. The priciest growth stocks of the pandemic era could suffer the same fate.
Instead of betting that expensive growth stocks will become even more expensive, it may be a good time to focus on value stocks. Growth stocks have already begun to falter as interest rates rise and the pandemic runs up against widespread vaccine availability. Given how richly valued some growth stocks have become, it's a long way down from here.
Two value stocks worth considering are telecom giant AT&T (T -0.12%) and tech-giant International Business Machines (IBM -1.57%). These are unloved stocks, for sure, but I'm betting that both will outperform growth stocks currently trading at nosebleed levels in the coming years.
AT&T's efforts to become a media giant have not gone well. The company took a big loss on its DirecTV acquisition, selling a stake in the pay-TV business this year at a big discount to what it paid in 2014. The jury is still out on its other big media acquisition, Time Warner, but these deals have put a tremendous amount of debt onto AT&T's balance sheet. The company had total debt of about $157 billion at the end of 2020.
The good news is that AT&T generates a ton of cash from its core wireless business. The company produced free cash flow of $27.5 billion in 2020 and expects to produce around $26 billion of free cash flow in 2021. Along with asset sales, the company will be able to continue to whittle away at its debt load.
AT&T's balance sheet is certainly a risk factor for investors, but the price is right. AT&T is currently valued at around $220 billion, just 8.5 times free cash flow. The stock also sports a dividend yield of nearly 7%, and the company expects the dividend to eat up less than 60% of its free cash flow this year.
AT&T is unlikely to produce much in the way of earnings growth in the near term. But given the rock-bottom valuation, the stock can still do well if investor sentiment shifts in a positive direction.
IBM has a new CEO and an aggressive strategy built around leading the hybrid cloud-computing market. Arvind Krishna, formerly the head of IBM's cloud and cognitive software business, took the top job at the century-old tech giant last year. The company is aiming to leverage its $34 billion acquisition of software company Red Hat to go after what it views as a $1 trillion hybrid cloud market.
Part of the strategy is to get rid of a big chunk of slow-growth revenue. IBM announced last year that it planned to spin off its managed infrastructure services business by the end of 2021. That business generates around $19 billion of sales annually, but the move will shift IBM's business model toward higher-margin software and solutions.
Services currently account for over 60% of IBM's revenue. Once the spin-off is complete, software and solutions will be the biggest component.
IBM's results have been less than stellar over the past few years as the company focused on growing its cloud-computing and artificial intelligence businesses. That performance has earned the stock a pessimistic valuation. Analysts are expecting IBM to produce adjusted earnings per share of about $11 this year, putting the price-to-sales ratio at just 12. The stock also has a dividend yield of nearly 5%.
If IBM can return to consistent growth, driven by its bet on hybrid cloud computing, a combination of earnings growth and earnings multiple expansion can drive the stock much higher. That's not a guarantee, of course, but investors are being paid a nice dividend to stick around and see if the hybrid cloud strategy pays off.