Why would you buy expensive stocks?

Formerly high-flying stocks have come crashing down in 2022 and are still nowhere near their highs of 2021. This is nothing new. Every bull market leads to exuberance and investors bidding up prices of already expensive shares to new heights. And professional equity analysts are often taking on the role of cheerleaders, publishing buy recommendations with high target prices for stocks that are already overpriced. How do these analysts justify their recommendations and what can we learn from that?

A team of researchers from Hong Kong and Singapore analysed the research reports of 662 US brokerage firms for stocks from 2006 to 2021. They focused on stocks that were at the time of recommendation in the 10% most expensive stocks in the US and still received a buy recommendation from the analysts. Rationally, such extremely expensive stocks should be avoided since these high valuations come with low expected returns as valuations tend to revert to a lower mean over time. Yet, this mean reversion can take a long time as we have seen once again between 2010 and 2021.

Having said that, the researchers analysed the arguments in the research notes and examined through text analysis if the analysts were recommending these expensive stocks as a safe long-term investment, as a strong growth investment with exuberant forecasts for future growth, or as lottery investments where individual triggers could lead to extremely positive outcomes.

To avoid identifying some research notes as exuberant simply because a particular analyst has a particularly exuberant way of writing, they compared the words used in the notes covering extremely expensive stocks with the words used by the same analyst for the rest of his or her coverage. In other words: was the analyst particularly exuberant about an expensive stock to give it a buy recommendation or not?

The chart below shows that in a small minority of cases, analysts touted these expensive stocks as safe long-term investments. Exuberance, for example by extrapolating recent strong growth into the distant future, was also not a common argument, even though this is what I would have expected as the most common way to justify a buy recommendation. Instead, the most common way to justify a buy recommendation was to bet on a lottery-like event where that could provide a catalyst for significant share price increases.

Reasons for recommending extremely expensive stocks as a buy

Source: Chen et al. (2023)

It is essentially that entire vapid babble about “disrupting an industry” or “revolutionising the way X is done” that created the justification for even higher share prices. Of course, now we know that much of that disruption never really happened or once it happened, it did nothing to lift the share price because it was priced in long ago already. But for the last decade, disruptors like Salesforce, Netflix, Airbnb, and WeWork were all the rage. Of course, these companies did disrupt their industries to an extent, but their share prices have come back down to more normal levels as it became clear that these disruptors were facing increasing competition or that the catalysts investors were hoping for didn’t trigger another share price rally.

And I think this indicates that the bull market of the last ten years was different from the bull markets of the 1990s or the early 2000s in an important way. Back in the tech bubble of the 1990s, I would guess that the key driver of shares climbing to excessive valuations was exuberance. Analysts and investors didn’t know what growth to expect from the internet, so they priced in bigger and bigger growth numbers (kind of what they do right now with AI technologies). Eventually, that growth didn’t materialise and the bubble burst. In 2022, there wasn’t so much exuberance in the growth outlook and more of an expectation of events that would change the rules of the game. And of course, the rules of the game are still essentially the same…