It was only a couple of weeks ago that I recommended Square (NYSE:SQ) for growth investors. Since then, Square stock has rallied slightly over 20%.
I did not bring up that call to pat myself on the back. Rather, I want to highlight how dramatic a move that surge actually is.
In a full year, slightly over 20% is an excellent return, and in three and a half weeks, it’s astounding. Yet in the context of this market, the gain hardly stands out.
For instance, as of last Friday, there were 20 stocks with a market capitalization over $300 million that have quadrupled or better so far in 2021. (That list, by the way, no longer included GameStop (NYSE:GME).) There are four large-cap (companies whose market capitalizations are over $10 billion) names that doubled in the year’s first six-plus weeks. Square’s 24% rally in 2021 barely breaks the top 100 of that group, which historically has been far less volatile than smaller companies.
These moves, in which returns that had previously taken years to accumulate are attained in months or weeks, have become almost common. Skeptics would argue that they’ve become too common. But until those skeptics are proven right, it’s hard to see what can keep Square stock from posting more impressive, market-beating returns going forward.
The High-Flying Market
Particularly after the spike of the last couple of weeks, it’s relatively easy to make the case that Square stock simply is too expensive.
For one, its rallies over multiple time periods have been extraordinary. Over the past year, the stock has rallied nearly 226%, and it’s up over 740% from its March lows.
But those gains have not been that unusual. Among large-cap stocks, as of Friday, Square’s 12-month return ranked 37th of roughly 850 stocks. Five of those names had produced returns exceeding 1,000%.
Second, Square stock looks awfully expensive. It now trades at about 140 times analysts’ average 2021 earnings estimate for the company.
There are, however, some mitigating factors. As I pointed out last month, Square’s earnings this year will be depressed both by the novel-coronavirus pandemic and by its investments in initiatives like Cash App.
But the P/E ratio of SQ stock doesn’t necessarily stand out. According to finviz.com, there are 26 large-cap stocks with higher forward P/E multiples.
And Yet…
The large number of high-flying stocks makes it difficult to recommend that investors rush to sell Square immediately. After all, if an investor is going to dump the stock simply because of its massive rally since March and its high forward valuation, she almost certainly has to avoid exposure to a decent chunk of the tech sector.
And that chunk has been the best part of the market for at least a decade. With the exception of obvious bubbles, it’s been a mistake to sell a growth name because of the underlying company’s past performance or the shares’ valuation.
That recent history makes it hard for a writer like myself to argue too strenuously against holding Square stock. Writing “sell this stock; it’s too expensive” has been an easy way to look foolish. I have some experience in that area.
All that said, Square’s rally has to at least be considered mildly concerning. That’s especially true because the company has reported little news since Jan. 22.
But during that time, the shares have benefited from the rise of the price of Bitcoin (CCC:BTC-USD). Given Square’s crypto ambitions, it’s surely not a coincidence that the recent jump of Square’s shares has coincided with a surge in the value of Bitcoin.
But it’s hard to argue that the Bitcoin rally alone justifies the recent gains by Square.
A Potential Negative Catalyst for Square Stock
And so an investor can reasonably look at Square and see a case for caution, if not alarm. At a certain part, it would seem, the rally has to come to an end. That end would seem likely to follow a spike like the one we’ve just seen, in which Square’s valuation rose substantially for reasons that seem at best incidental to the business.
But an investor or a writer could have had similar thoughts about dozens of the market’s best stocks over the past few years. That aside, there’s a real question as to what, exactly, is going to stop Square.
A Bitcoin crash certainly could do the trick, but there are many other stocks with far more exposure to that currency. Square’s earnings are due out on Tuesday, and its results have been dicey in the past. But this market seems willing to give growth companies the benefit of the doubt.
Given the widespread change in market sentiment., Square’s outlook is still as attractive as it was four weeks ago or a year ago. All that’s changed is the price.
The good news for Square in the short-term is that its higher price doesn’t seem as yet to be alienating too many investors. But in the long-term, the stock’s high valuation may indeed scare some of them.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.
