On August 9th, 1995, the company behind Internet browser Netscape went public, skyrocketing as people fought to get a piece of the so-called “new economy”. It set off a buying panic among the public that lasted five years; otherwise rational men and women convinced that this time really was different, the mania feeding on itself. Anything and everything related to technology was bid up to the sky with early shareholders enjoying capital gains that should have taken decades to materialize in a matter of months. Boring telecommunication empires long considered “widow” stocks, attractive only for their former 5% to 6% dividend yields, traded at 50x or 70x earnings and yielded a tiny fraction of what a savings account offered. Newly formed corporations with no operating history, profits, or meaningful assets were given multi-billion dollar market capitalizations, blessed by everyone from star Wall Street analysts to the local high school kid who mowed the lawn, the whole country a seeming expert in fiber optic networks and online grocery delivery. Magazine articles ran decrying old-school investors who insisted on traditional valuation metrics such as after-tax profits, calling people like Warren Buffett washed-up dinosaurs who should be removed for gross incompetency (his holding company, Berkshire Hathaway, went into near free fall as stockholders abandoned him for more glamorous enterprises, not content with the torrents of cash being generated by insurance, candy, furniture, and jewelry). Disciplined money management firms such as Tweedy Browne saw client defections due to their refusal to play along with the madness despite watching the stock market indices climb higher year after year.
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The party reached its apex on March 10th, 2000 when the NASDAQ set an intraday record of 5,132.52. According to Timothy Pollard at Pensions & Investments [source], the biggest companies in the tech-heavy stock market index at the time were Microsoft, Cisco, Intel, Oracle, Sun Microsystems, Dell, Qualcomm, Yahoo, Applied Materials, Uniphase, Veritas Software, Juniper Networks, Sycamore Networks, Palm, and Internet Capital Group. The valuation multiples had gone beyond rich, past speculative, and entered the territory of outright deranged. At one point, one of the “cheaper” stocks, Microsoft, reached a p/e ratio of nearly 86x earnings, meaning you could have earned almost 600% more money by parking your cash in Treasury bonds and taking no risk than you could had you acquired the world’s largest software maker lock, stock, and barrel.
It was downhill from there. It took until yesterday for that highwater mark to be exceeded; a decade and a half of miserable waiting and sub-par returns that still haven’t been made up in purchasing power.
The Four Things That Can Happen When You Overpay for an Asset
When you buy ownership of a productive asset for significantly more than its intrinsic value alone would justify, there are typically four things that can happen:
- Someone else, far more stupid, deluded, or blinded by avarice (depending upon what the particular situation may be) comes along and buys it from you at a higher price, bailing you out at a profit.
- The market price of the asset treads water for a long time until the underlying cash generation power catches up with it.
- The market price of the asset collapses to reflect a more reasonable multiple relative to the underlying cash generation power.
- The firm’s cash generation ability is destroyed or never materializes, resulting in wipeout. (If you manage your asset placement strategy wisely, though, even if an asset goes to zero, you should be able to reclaim a lot of the loss in the form of lower taxes on future gains, meaning the government effectively subsidizes your mistake.)
In a situation like 1929-1933, the classic pattern of boom and bust was followed. Stock prices shot up, then collapsed. I’ve written about different industries and how they weathered the worst meltdown in 600 years (see posts like this one and this one). Needless to say, at the bottom of the market in 1933, things were bleak. The stock market overcorrected so far that many businesses traded for less than the cash they had in the bank. One of the biggest energy giants in the world, Standard Oil of California (now known as Chevron), lost 82% of its market value and had a dividend yield of 13.33% at its bottom. The food industry as a whole had a dividend yield of nearly 6.5%. This was in a period of deflation!
The ending of the dot-com bubble was more interesting because some businesses never had the expected crash. Instead, they fell a little bit then treaded water. Microsoft is a great illustration because after an initial decline, the shares barely budged, moving within a narrow range while the after-tax earnings climbed from $0.70 to $2.63, effectively lowering the p/e ratio with each revolution around the sun. (The phenomenon of “multiple compression” isn’t always due to overvaluation. Those of you who have experience in corporate finance are probably familiar with it because you see it naturally at the end of a high growth cycle for businesses that have reached maturity and are going to switch to dividend-paying mode, such as when Wal-Mart or McDonald’s reached saturation in nearly every state. This happens because the lower growth variable in the discounted cash flow formula changes the intrinsic value so that an acquirer or investor must pay a lower price for ownership if he or she wants to generate the same return).
The overvaluation was so detached from reality that, as the earlier Pensions & Investment article states, only two of those top 15 businesses at the peak have generated a positive return in the subsequent fifteen years, Microsoft and Qualcomm. Worse, neither managed to beat inflation (the only reason they had a compounded return of around 1% per annum was due to the dividend income). To be specific, Microsoft closed March 10th, 2000 at $50.50 per share compared to today’s price of $46.10 per share. Owners received $10.28 in cash dividends along the way. Qualcomm closed at $66.0625 per share back on March 10th, 2000 and is now at $66.88 per share. Owners received $9.32 in cash dividends along the way. (Investors who dollar cost averaged, on the other hand, did considerably better, though still not great, as they were able to take advantage of the periodic market collapses within the narrow trading range, especially in 2001-2003 and 2008-2009, lowering their overall cost basis.)
A Look at What Drove the NASDAQ Recovery
What drove the recovery of the NASDAQ? It was the same mathematics of diversification I laid out in this post. Apple rose 2,800% in the subsequent period, coming to dominate the index with an 11% component weighting, putting it at the 7th highest returning stock in the composite over that time period as it dragged up the overall index value with a gravitational-like force.
Ananya Bhattacharya created a convenient list of the best and worst performing index components that are still around, managing to survive bankruptcy or delisting (there were a whole lot more than went bust and aren’t listed here due to survivorship bias).
According to her calculations, the best surviving NASDAQ components were …
1. Monster Beverage Corp, +52,560%
2. Keurig Green Mountain, +21,914%
3. Tractor Supply Company, +8,459%
4. Gilead Science, +5,315%
5. Express Scripts, +4,260%
6. O’Reilly Automotive, +4,094%
7. Apple., +2,829%
8. Stericycle, +2,813%
9. Ross Store, +2,314%
10. Cognizant Technology Solutions, +2,213%
While the worst surviving NASDAQ components were …
1. Sirius XM Holdings, -94%
2. Akamai Technologies, -74%
3. NetApp, -72%
4. Broadcom Corporation, -66%
5. Applied Materials, -58.3%
6. Cisco Systems, -58%
7. Micron Technology, -56%
8. Yahoo!, -55%
9. CA, Inc., -54%
10. Intel, -45%
There are several lessons we can learn from all of this.
Lesson One: The Two Primary Factors That Matter When Acquiring an Investment
When acquiring an investment, there are two basic ideas that matter.
- Owner earnings (including the equivalent net present value of any assets that can be sold or liquidated – a terrible hotel in the middle of Manhattan might be worth more torn down and sold to a developer)
- The valuation multiple applied to owner earnings
That’s it. The first is a combination of the business itself, the assets on the balance sheet, and the talent and skill of management. Put a retail store in the hands of Sam Walton and it’s going to generate higher and higher owner earnings over time. The second involves a degree of projection, especially in the growth rate or interest rates (which influence the discount rate), both of which are colored by human irrationality; competing emotions of greed and fear. The trick is to make sure both are reasonable. Are you looking at a situation where owner earnings are non-sustainably inflated (e.g., a bank making sub-prime loans that are destined to go bad at the peak of the real estate bubble) or where the valuation multiples have lost touch with reality (e.g., the dot-com bubble)?
Always and forever thinking about asset prices through these two lenses, and realizing they are at the core of the entire game – everything else merely influences them, they are all that really count – is what makes it possible to sleep well at night when a firm like Hershey keeps generating more and more money but experiences a stock price collapse of 55% over the 4 year stretch between 2005 and 2009. It’s also what makes it possible to avoid buying something like Microsoft at the peak of a bubble. If you understand this truth, the first situation won’t cause you any anxiety at all (partly because you were smart enough to pay cash for your stocks, not borrow on margin), while the second would make you break out in cold sweats in the middle of the night, even if your net worth looked like it was higher than ever on paper. You look to the business and the multiple applied to the business, to judge your progress. If the money is real, and you don’t overpay, time solves almost everything. In the cases where it doesn’t, that’s why diversification exists.
My personal strategy for remembering this is to focus solely on the metrics that matter to me. My internal spreadsheets break out how many shares we own of certain businesses, and what our cut of the sales, expenses, taxes, net earnings, and dividends are, just like they were one of the private operating companies we control. The market price is grayed out, barely visible, and is labeled “Mr. Market” from the famous Benjamin Graham allegory, telling me the price at which my fictional business partner is willing to buy or sell more ownership to or from me. Over time, I work to make sure our cut of the net earnings and dividends gets higher and higher, always comparing Mr. Market’s price to what I can get on the risk-free Treasury, in contrast. In fact, I probably can’t tell you on any given day what the market value of our holdings are, but I can tell you what our pro-rata sales, earnings, and dividends are.
Lesson Two: Social Proof, the Madness of Crowds, and Mass Psychology Will Conspire from Time to Time to Try and Make You Do Stupid Things. Be Strong.
This is the reason you need to make data-based decisions. The people who sailed through the dot-com boom and bust were ridiculed, mocked, and thought of as stupid. Experts who had spent a lifetime analyzing financial statements were suddenly looked down on by minimum wage workers who thought themselves capital market geniuses after they made 500% gains day-trading some new IPO. Nearly every authority, and all institutions, were playing along. Voices of dissent were silenced. When Dr. Jeremy Siegel wrote about the overvaluation of asset prices relative to underlying fundamentals in a major national newspaper, he received death threats from irate investors who thought he was trying to cheat them of the gains to which they were entitled.
Stick to your guns and do what you know works based on evidence, not feeling. History has shown that in the end, time sorts out good behavior from bad behavior and insane beliefs tend to sow their own seeds of destruction. You do you and let the rest fall where it does.
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A perfect illustration: In a twist of delicious irony that is occasionally mentioned in the financial media, Berkshire Hathaway, which was hated and written off by the establishment for its refusal to deviate from focusing on real, cash earnings hit a multi-year low around the same time the NASDAQ was peaking, driven down to the split-adjusted equivalent of around $27.53 per Class B share. Nobody wanted the stock. Regardless, it closed yesterday at $142.67, a return of 518%+, or roughly around 11.5% compounded annually. Ben Graham was proven right, yet again. In the short-term the market may be a voting machine, but in the long-term, it’s a weighing machine. The only thing that matters is earnings and assets. Collect those and everything else will probably sort itself, just as it has throughout most of human history. If the market doesn’t reflect those earnings and assets, you can always extract them from the firm in the form of dividends and other distributions.
Lesson Three: Don’t Dump Your Money Into an Asset Class All At Once
In the real world, almost nobody dumps his or her entire net worth into stocks, bonds, or real estate at once. Portfolios are built over time, piece by piece, at many different average prices. Even if an investor had exclusively bought a NASDAQ index fund, and started investing on March 10th, 2000, he or she would have still done decently had a regular program of dollar cost averaging coupled with dividend reinvestment been followed. That matters a lot but it doesn’t show up on modern stock charts. In fact, this same myth – “it took [x] years for the stock market to recover” – is played out generation after generation. It’s not how productive assets work.
Lesson Four: If You Do Overpay, Choose Assets That Generate a Ton of Cash and Are Largely Immune to Competition
One of the really interesting research findings out of academia over the past couple of decades is that great companies, even when overvalued, can sometimes make up for it if you wait long enough. The Nifty Fifty are one example we sometimes discuss. The idea back in the 1960’s and 1970’s was that you could buy this particular list of 50 stocks, at any price, and never think about them again. Of course, they got bid up to crazy levels and experienced a terrible collapse. Funnily enough, had you bought at the peak and held through the collapse, twenty five years later, you’d have actually beaten the stock market even with several bankruptcies along the way.
The same pattern played out during the dot-com boom. The Coca-Cola, PepsiCo, Disney, and other blue chips of the world that had actual earnings – real cash flowing into the coffers from not-easily-displaced businesses – took awhile to burn off the excess but in the end, you ended up doing fine despite paying eye-popping prices for the firms. There is a powerful argument that a person should dollar cost average, even during insanely high bull markets, into a diversified collection of these royalty-level blue chips via their low-cost DRIPs as the peaks aren’t that bad and the crashes are like turbo fuel to wealth building.
The trick is to be ruthlessly selective, picking only companies that haven’t changed in 100 to 200 years, which haven’t cut their dividend in at least a quarter-century, which have widespread geographic diversification, which enjoy some sort of unassailable competitive advantage not being attacked by technological shifts. Hershey is a good illustration. It looked expensive on March 10th, 2000. The stock price closed at $20.00 exactly. The average p/e ratio for the prior year had been 26.3x earnings. Those earnings were real, though. And they kept growing. Nobody has been able to knock the Pennsylvania chocolate king off its perch in centuries and they were able to raise prices, buy competitors, and expand. Had you bought on the day the NASDAQ hit its high, you’d now have a stock with an $89.04 market value plus you’d have collected $17.80 in cash dividends for a total value of $106.84, representing a total return of $86.84 or 434.2%. That works out to a bit north of 10% compounded during a period where the stock market as a whole didn’t do much even though it wasn’t a steal in the first place. If you’d reinvested those dividends, you’d have even more. (Within the next year or so, you’ll have extracted your entire purchase price back out in the form of aggregate dividends.)
Lesson Five: Index Funds Aren’t Magical, You Still Have to Use Common Sense
I’m a huge proponent of the average person investing in index funds, have written about them extensively for almost fifteen years, and even use them in the family charitable foundation despite not owning any personally. Nevertheless, you need to be aware of their flaws; things like quiet methodology changes.
On March 10, 2000, the NASDAQ was full of total and complete junk trading at prices no rational human with any experience in finance, accounting, or business could justify. The fact that the words “index fund” were affixed to the shares of some of the mutual funds that mirrored the index did not change this reality. Any mathematically literate person could see that they could take the same amount of money and put it in Treasury bonds earning almost 6x more or that they could build an industrial warehouse and lease it out, collecting a 10x cash yield even if they used no debt for the project. Don’t get sucked into the trap of thinking you have to invest in a certain asset class, sector, or market. If nothing makes sense, then nothing makes sense. Don’t try to force deals to happen. Intelligent ideas do not present themselves in an orderly fashion, one after the other. The nature of the world is you’ll go months, years even, with nothing particularly wise to do only to see a lot of opportunity all at once.
How might that look in today’s world? I think it is insane for someone to be buying 20 or 30 year maturity bonds unless there is a compelling asset/liability matching reason. There is absolutely no way that a 30 year bond, purchased today, held to maturity, generates a positive after-tax, after-inflation return. It would take a mathematical miracle, especially when you look at the structural changes that have happened in the currency following the removal of the gold standard (investors have perpetually overvalued fixed income assets, not accounting for the inflationary pressure to overspend in a pure fiat system; bond yields should almost always be a few percentage points higher than they are). Cash is a much better option.
In fact, I think the absolute longest dated maturity I have on anyone’s balance sheet, anywhere, in any account, is a 12-year corporate bond for a major department store, put in a tax shelter as part of a life expectancy maturity ladder. This shouldn’t surprise anyone. Look at what other money managers are doing. Pull the regulatory reports for the insurance subsidiaries of Berkshire Hathaway and you’ll see the fixed income portfolio has declined to an all-time low of 14% of assets. That’s unheard of for an insurance operation in the context of history. The reserves are in cash, instead. Cash, even with the inflation risk, is a better bet. The interest rate environment is not normal. If you’re regularly buying into a long-maturity fixed income index fund … why? Why are you doing it? It’s madness. If you indirectly hold bonds through something like a target date fund and the duration of the bond component exceeds 15 years, again … why? It is a pointless, stupid risk for which you are not being adequately compensated. Stop buying assets because you “should”. There’s no such thing.
The danger in sharing what should be straightforward, basic advice is there are a small minority of investors who are incorrigible gamblers. They’ll see that passage and somehow start market timing their way to poverty. “Stocks look high, we shouldn’t buy”, abandoning their dollar cost averaging program in something like the S&P 500 index fund they hold through their 401(k) at work. That’s not what I’m saying. The moral is that you have to look around at the best, highest-returning, lowest-risk opportunities you, personally, have in your own life. If you see an office building in a great part of town that you understand, that is always leased, and that has other attractive attributes selling at a price that allows an all cash buyer to extract 12% per annum (it happens from time to time still in the Midwest), don’t just ignore it if you’re open to being a landlord. It might not be the dumbest idea in the world to acquire it, using it as a source of fresh money, even if it means lowering your index fund purchases for a few years.
The goal is not to own stocks, or index funds, or office buildings. The goal is to put together a collection of things that generate meaningful, preferably increasing, levels of cash from activities that you understand and can reasonably predict.
Then and Now: How NASDAQ Valuations Compare
Despite boasting the same nominal value, in contrast to March of 2000, the NASDAQ valuation today, while certainly not cheap, is far more reasonable. The highest weighted components are overwhelmingly real operating businesses, making real operating profits, trading, as a group, at not-insane valuation multiples; Apple, Microsoft, Google, Amazon, Cisco, Intel, Qualcomm, Comcast, Gilead Sciences, Amgen, Ebay, Celgene, Mondelez International, Biogen, and Express Scripts make up the top fifteen by market capitalization.
Personally, I’m not sure why anyone would opt to make the NASDAQ index fund their core holding. I’d much rather have the S&P 500 between the two, or even the Dow Jones Industrial Average for that matter. Were I a pure index fund investor, it might be ancillary augmentation but I wouldn’t make it some cornerstone of my financial life.
Reader Comments (37)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Abe
June 19, 2015
Solid article that reminds us of the simple quote that you so often use... "At what terms and what price?"
difff23
June 20, 2015
Hey Joshua, thank you for all you teach us. I discovered your articles first on about.com . And I've been sharing links with friends and referring people to your site. So I'm officially delurking.
Joshua Kennon
June 20, 2015
Replying to difff23
Welcome to the site!
Mr.owenr
June 20, 2015
I've been watching NASDAQ since being introduced to it in college in 2009. I'm finally convinced that it can't go down in price, which means that I'm willing to buy. Knowing how dumb that sounds I just hold cash in a bank savings account and let them invest it for me, even though I discovered they return just .1% per year. Tried starting a Vanguard low cost fund before but they made it too hard to figure out how to open. The thing about not overpaying for an asset is nice, but I would like to have some financial assets. I bet there is a study somewhere that concludes people who own at least one stock, etc make more over their lifetime then people who don't. Wouldn't overpaying for a stock be worth that?
Connelly Barnes
June 22, 2015
Replying to Mr.owenr
I'm surprised you found that Vanguard made it hard for you to open a fund. Many people I know have Vanguard funds and Vanguard is ordinarily friendly and helpful in setting up such funds.
And unlike 99% of Wall Street, Vanguard are some of the rare good guys.
LordSquidworth
June 24, 2015
Replying to Connelly Barnes
Vanguards website sucks, imo. Only thing I can think of. I know I had to call them a couple times to get mine going a couple years ago.
Mr.owenr
June 25, 2015
Replying to LordSquidworth
They kept insisting that I snail mail them information about me, including my name, full social security number etc. It is perhaps irrational of me but I don't see why I should have to mail that information. It was repeated on the online application after all.
Gilvus
June 25, 2015
Replying to Mr.owenr
Hey Mr.owenr, I strongly recommend you check out Joshua's other writings over at Investing for Beginners. He has specific advice on how and where to hold your assets (for example, money market fund vs. money market account, taxable brokerage account vs. IRA), and offers very good general advice for how to save, invest, and make smart decisions.
It might seem silly to go from Joshua's blog, where he writes about pretty advanced stuff, to the "beginners" section. But getting a strong grip on the basics can help you a lot toward reaching your goals.
Mr.owenr
June 25, 2015
Replying to Gilvus
I know but I honestly hate trying to navigate that site. From the lag caused by a million ads to the seemingly one or two paragraphs before having to click through to another one or two paragraphs, etc, etc there is just something fundamentally wrong there that makes me want to read this blog instead.
The main purpose of reading this blog over that one is to overcome my completely pathetic hard wiring by trading my time capital, reading capital, etc for the (what can only be described as Joshua) capital that can be gained by reading and attempting to understand his brain here. If I can manage to learn a fraction of his wisdom then the details and basics will sort themselves out when I have the appropriate hardware/software to use them.
Adrian Burns
June 20, 2015
I know the origins of this blog come from informing your family of your personal activities, but posts like this are why I love your blog so much. Thanks!
Ang
June 20, 2015
I'm really enjoying the pullback on Hershey's lately. As far as I can tell, Mr. Market is worried about sluggish sales forecasts in China. The price is probably still a little higher than fair/intrinsic value, but with a company with fundamentals and stewardship that good , it won't matter 20 years from now.
I feel the same way about Disney - pricier earnings than historically, but management has been so great and the business itself is so excellent, constantly creating fans for life every year. Plus, its sitting on a combined $44b of cash+treasury stock, allowing them to pounce on the next Marvel or Lucas (perhaps Nintendo? unlikely but that would be a dream!)
Erich
June 20, 2015
Interesting post. Maybe one lesson you should have included would be the deals that one could have taken advantage of relatively shortly after the tech bubble burst when tech stocks were, in general, treated with fear and suspicion by investors. Indeed, Templeton's point about "buying at the point of maximum pessimism" rang true again in this case.
JB
June 20, 2015
Nice article as usual! I tried searching the site, but have you ever written about how much of an employer's stock an employee should have in their company 401k? I found the article about the married couple working for Wal Mart but thats not really what I was looking for.
Ang
June 20, 2015
Replying to JB
Hey JB, see this old article: https://www.joshuakennon.com/factor-in-your-income-sources-when-seeking-diversification/
That might be as focused on your specific question as it gets, but Joshua will sprinkle in a sentence here or there in a lot of his articles about how you should have as many different sources of cash flow as possible - private business, stock, real estate, etc. Including in this article: "The goal is not to own stocks, or index funds, or office buildings. The goal is to put together a collection of things that generate meaningful, preferably increasing, levels of cash from activities that you understand and can reasonably predict."
John Tate
June 20, 2015
Replying to JB
I would be very, very hesitant to put that many eggs in one basket. Having your primary income source act as any significant part of your retirement plan would make me very nervous.
JB
June 20, 2015
Replying to John Tate
Exactly. Ive read numerous accounts of how some Enron employees had 100% of their 401k in Enron stock and were thus wiped out when Enron went under. Personally, I have about 5% of my current 401k going to company stock but am curious to see if Joshua had written anything discussing that.
Joshua Kennon
July 21, 2015
Replying to JB
I briefly touched on it years ago at About.com in an article called, appropriately enough, Investing In Your Employer's Stock.
The reality is, there's no easy answer. If you're 25 years old, working in Silicon Valley, think you have a chance at life-altering wealth, and understand the risks, it might not be the dumbest idea in the world to overexpose yourself given if it all goes against you, you can probably find another job at decent or excellent pay and recover due to your youth and lack of financial responsibilities (you aren't raising four kids or anything). In terms of risk/reward there are a lot more foolish things to do in life.
If you're 45 or 50 ... it depends. If there's a free matching component or discount such as through an ESOP or ESPP, I'd certainly take advantage of it. At the very least, I'd hold it long enough to arbitrage the profit, move the after-tax differential gain to cash reserves, then reinvest the principal in an S&P 500 index fund or something. That way, the cash reserves that were established and growing would be "do it yourself raise" courtesy of my employer. Look at Home Depot. If you go down to HR, you can sign up for the ESPP on top of your 401(k) and have up to 20% of your paycheck withheld to buy ownership in the firm. Even better, you get a 15% discount on the stock relative to the market price. I'm in the middle of a game of Civilization V but I found a post that explains how it is really a much, much higher return on capital, which you can read here.
In general, though, I think it's best to put the bulk of something like a 401(k) in a diversified collection of low-cost stocks, bonds, real estate, and cash but I'd be willing to own some of my employer's stock. I can't say I'd establish some hard and fast rule because I am an entrepreneur in a family of entrepreneurs. The idea that your wealth and job are tied to the same firm isn't that daunting to me provided you are diversifying a decent amount each year, building money away from the enterprise. If I were working at General Electric and saw Jack Welch doing what he was doing ... I'd probably have had over 50% of my net worth in the place. If I were working at Enron? I couldn't understand the 10-K disclosures so I wouldn't have bought any no matter how good things looked because I have to understand what I'm buying otherwise I wouldn't be able to sleep at night. The problem: Worldcom would have gotten me. They just lied on the numbers by capitalizing operating expenses. I'd (most likely) be able to tell something was up now that I'm much more experienced with forensic accounting but a younger me, and the typical worker, wouldn't be able to do so nor should they have to worry about it. It's the Worldcoms that are the problem.
Bottom line? I wouldn't risk anything I couldn't afford to lose. That would be the North Star. And it depends. The more I think about it, I might give in and reserve a certain portion of my capital - saying, "I'll never let [XYZ] go over 40% of my holdings", selling it off if I absolutely could not live with a total wipeout in some remote probability event. Sure, I'd lose a lot of wealth in opportunity cost if it turns out I was working for an early Wal-Mart but in absolute terms, I'd end up much richer so it's not like it's a Greek tragedy. Plus, I'd have a lot less stress along the way.
It's varies by person, experience, situation, and opportunity cost (e.g., if the company's shares are at 70x earnings and Treasury yields are at 6%, I don't want the stock). Sorry I can't be more help.
JB
July 21, 2015
Replying to Joshua Kennon
Joshua, thank you for taking the time to write a reply. I like your bottom line; it meshes up with my belief. On a side note, how bad were the Enron 10k's?
Joshua Kennon
July 21, 2015
Replying to JB
This should give you some perspective: On March 5, 2001, Bethany McLean wrote an article in Fortune about the darling stock of Wall Street, trading at 55x earnings, with ever-growing EPS figures.
The question she wanted answered was simple: "How exactly does Enron make its money?"
Nobody could answer it.
It almost sounds like the punchline to a joke but it's not. Later, experts who spent all day long buried in the 10K called it a black box that they had to take on faith; that the 65% annual growth rate in sales must be happening because management told them it happened even though they couldn't prove it like they could with other businesses.
This was a firm that was ranked 7th in the S&P 500. Even the credit analysts who examined bond ratings couldn't tell you where the cash was coming from to repay the coupons! The passage in the story (which you can read in full here) says:
Enron's CEO called the reporter unethical and three Enron executives flew to New York to try and stop the story from running.
Warren Buffett admitted he couldn't make heads or tales of the explanations of transactions, later told recounting to stockholders after the fact as to why Berkshire never bought any, "if I can't understand it, the management probably doesn't want me to understand it", "And if management doesn't want me to understand it, there is probably something wrong going on." He later confessed that even after the full extent of the fraud was revealed, and the dirty laundry uncovered in court, it "still baffle[s] me".
Go pull the 1999 10-K and check out Exhibit 21 to get an idea of the complexity. That's a list of its subsidiaries and limited partnership stakes. All of these transactions between all of these entities, with the head people serving as partners in them and nobody having any explanation of what was occurring. It wasn't like Berkshire Hathaway where you can point at Nebraska Furniture Mart and see the square footage, estimate the inventory, count the cars in the parking lot, examine the property tax records, etc. All anyone cared about was "new economy, new economy, new economy". It was numbers being pushed around as energy was bought, sold, traded, and manipulated.
There's absolutely no way a person could have come up with an intrinsic value calculation from them. If they believed otherwise, they were kidding themselves. But the funny thing is, almost nobody did (believe otherwise). They were just attacked if they asked questions.
It's worth reading the case studies of the warning signs and how they were ignored. For example, here is one that makes for an interesting read [PDF].
innerscorecard
July 22, 2015
Replying to Joshua Kennon
Ironically, if there was a holding company holding 10 Enrons, I bet a lot of value investors would be interested since they could do a "sum of the parts" valuation that would reveal a juicy "holding company discount", even if they couldn't otherwise value the company (I have recently realized that I am often tempted by this kind of utterly dumb logic.)
Ang
July 22, 2015
Replying to Joshua Kennon
Joshua, just wanted to give a quick thanks for taking your time to come back through comments and answer reader questions. I think someone pointed out in the comments at some point that they learn almost more in your discussions in the comment section than the original articles.
I think of it like this - the articles are the refined, edited versions or the textbook where you do your assigned readings, and then the comments are where you teach us how to think, akin to a great professor who doesn't only go by the book and actually encourages his students to think a few levels deeper. I think the reason Munger is so highly regarded is also because of this fact. So again, thank you for spending your precious time with us readers!
Anthur Ardersen
July 22, 2015
Replying to Ang
Joshua Kennon
40% finance blogger
28% professor
22% motivational speaker
13% life coach
07% cheerleader
I Enron'ed the numbers a bit. I can't math.
innerscorecard
July 22, 2015
Replying to Joshua Kennon
Uh oh, Beyond Earth must really suck if you're still playing Civilization V!
Joshua Kennon
July 22, 2015
Replying to innerscorecard
It needs refinement like Civ V did when it was first released. The trade routes are tedious to manage, it lacks the depth of game play, there need to be more civilizations from which to choose, there need to be different maps without the single color scheme that makes it boring after awhile (compared to Civ V where you can have desert, jungle, islands, highlands, marsh) ... there is a big expansion coming later this year that will be the first, so things should get better. Go over and look at Reddit's Civ Group and it's almost all Civilization V for the same reasons.
Kapitalust
June 20, 2015
For the line "Nobody has been able to knock the Pennsylvania chocolate king off its perch in centuries" did you mean decades?
Also, regarding Hershey's and the point of DCA vs. lump sum: I've been buying Hershey's over many months and each month the purchase price has gone from $102 to $97 to $94 to $90 to $89. Sure wouldn't have wanted to lump sum everything in at $102.
Lump sum can make sense - in the Munger sense of betting big when the opportunity presents itself - but for mere mortal investors, DCA'ing into a position is psychology an easier way to go about it.
Joshua Kennon
June 20, 2015
Replying to Kapitalust
That would have worked, too. We're technically into the second century of operations and the third absolute century of sales from one Milton enterprise or another but I was being loose with the phrasing. Though Hershey sold his first chocolate bar in 1894, it wasn't until he sold his caramel company for around $30 million in inflation-adjusted terms and dumped into the chocolate empire in 1905 things really took off. In terms of market share, for the past 110 years, it's been all but impossible to wrestle sales away from them once they capture a given geographic area. The only serious competitor is Mars as the two have settled into this Coca-Cola/PepsiCo duopoly of sorts. You might be able to make an argument that the tipping point was the 1920's when sales exceeded $30 million not-inflation adjusted, which was a huge figure back then, already making it a part of nearly every household.
The biggest problem they seem to have is translating that advantage to outside of the United States. I think they'll solve it, even if it means acquiring non-Hershey products like they did with Reese's back in 1963. My hunch is it's the butyric acid, which causes those who didn't grow up with it to associate the flavor with vomit in the same way non-French people recoil in higher numbers from expensive cheeses, which can come across as repulsive. Who knows? Maybe, someday, Hershey will buy Lindt or another brand outright, operating duel arms. It wouldn't be unthinkable. Nestle owns Cailler and Hershey already owns Scharfenberger.
On the valuation front, if you want to get an idea of how emotional the capital markets can be, look at The Hershey Trust assets during the 73-74 crash. The trust had 80% of its holdings in Hershey stock and the portfolio collapsed from $224 million in 1970 to $76 million in 1974 despite business being fine. Of course, the people running the trust knew that so they held on and today the trust has $12.5 billion in assets. They've done a reasonably good job of diversifying over the decades following that experience, using dividends and negotiated share repurchases to the point that by the year 2000 or so, they had only 50% of trust assets in the chocolate company, the theme parks and other holdings having grown in relative importance.
Just think about it though ... imagine buying Hershey in 1970 and then watching it go on to lose 2/3rds of its market value over several years. It makes me laugh. Relative to today, that'd be something like $29 per share. Can you imagine? A perfectly fine operating environment, a perfectly fine market share, a perfectly fine income statement, and yet a near 7.5% dividend yield? I'd sell the furniture.
Kapitalust
June 20, 2015
Replying to Joshua Kennon
As a history nerd, I really appreciate the in depth reply.
Angelo
June 24, 2015
Replying to Joshua Kennon
Joshua, I note that the price of Hershey shares is close to the 52 week low, but how do you justify buying it when the P/E ratio is 23.77? That ratio is way higher than P. Morris or Berkshire Hathaway!
Kapitalust
June 25, 2015
Replying to Angelo
Joshua can correct me if I am wrong, but I believe the consistent high valuation of Hershey's is a reflection of:
a) the high quality of their assets
b) the high quality of their earnings
c) the consistency in which they churn out high quality earnings like clockwork
For example (and Joshua mentions this in one of his articles on Hershey's), if you strip out the intangible assets and calculate the net earnings over the tangible assets, you get figures in the 16-20% range consistently year after year after year. Compare that to Mondelez or Tootsie Roll which manage ~10% on tangible assets.
That's just one figure. ROA, ROIC, ROCE, ROE are all substantially higher than Mondelez or Tootsie Roll. Hershey's dividend payout has grown by about 9% on average each year for the past 17 years (data I have easily available through Value Line). It's a reflection of the underlying power of the economic engine of Hershey's.
Those reasons - and many others that one couldn't get into without writing a very long essay - are why it is always priced at a premium.
*I wonder if Joshua could answer this one: when you look at operating expenses to revenue for Hershey's, Mondelez has ~10% higher operating expenses and Tootsie Roll seems to have ~4-5% higher operating expenses to revenue. Is this just a reflection of Hershey's efficiency? I find it astounding that Mondelez can have almost 5 times more revenue than Hershey's but Net Income is only ~2.5x Hershey's net income.
Stephen H
August 9, 2015
Replying to Kapitalust
Exactly. Looking at Hershey's earnings relative to PPE is pretty amazing. What a yummy, almond filled gold mine.
Joshua Kennon
July 21, 2015
Replying to Angelo
There isn't a huge difference between Berkshire Hathaway's, Hershey's, and Philip Morris International's intrinsic value at the moment, at least in my opinion. I already own a ton of the former, and I'm more convinced of the long-term viability of Hershey both politically and in a pharmaceutical sense than the latter, so the tobacco giant gets pushed to the bottom of the list. I have Philip Morris, as well as several other tobacco firms, in the portfolios of family for whom I run their accounts, using the dividend stream as an internal funding mechanism to buy other holdings and serving to fulfill their mandate of widespread diversification (they want 50, 100+ stocks).
Regardless, the p/e ratio is not particularly useful for this list of firms. It's all but worthless for Berkshire Hathaway unless some adjustments are made to account for things like the derivative mark-to-market inputs and the retained earnings on the non-control positions, which add billions of more in capital to the income statement if they were properly recorded; plus, it significantly understates owner earnings in the case of Hershey and Philip Morris, both of which are more profitable than they appear, a necessary caveat being the potential liabilities of the latter.
Berkshire's the cheapest out of all of them. At least, again, in my opinion, but not enough to matter.
Eric
June 24, 2015
Replying to Joshua Kennon
Lindt & Sprungli's refusal to be purchased for 170 years is one reason to justify their consistently sky-high valuation. I doubt Lindt would ever be purchased by Hersheys. If they did get purchased it would be by Nestle to retain the Swiss corporate culture.
Joshua Kennon
July 21, 2015
Replying to Eric
... I could live with that.
Niket Dhruv
June 22, 2015
Hi Joshua,
Thank you for another Classic Article. Very true those days Technology valuations were absurd.
The same can be said about today's so called "Disruptive" companies like Amazon,Uber,Flipkart ( India ), Zomato ( India & not acquiring companies in US and other global markets ) and numerous companies like these.
The investors have been insanely pumping money into these companies ( not to forget the losses of these companies just keep getting bigger )
It will be exciting to watch what happens with these companies in the time ahead.
Thanks,
Niket
Jeff
June 22, 2015
Given the shenanigans in Shenzhen this is a very timely article! It is scary to watch developments over there. Yowza.
Joshua Kennon
July 21, 2015
Replying to Jeff
I think a general rule in life is anytime you see people who have no idea what they are doing quitting their day job to camp out in a broker's office, run for the hills. Some of the stories I've read out of the region ... it's crazy. Otherwise (you would think) sane men and women spending a lifetime of earnings on these stocks they don't understand and with very little relationship to the underlying net assets or earnings power. If I lived in a world where things were perpetually overvalued to that extent, I'd skip the asset class altogether and own strip malls or timber rights or something.
innerscorecard
July 22, 2015
Replying to Joshua Kennon
The stories are no exaggeration. The lobby of my building (I do NOT work in finance) has a big stock ticker. It is like 1999 in the US.
Well, it was. Since the collapse, the times I hear people in the office, elevators and on the street talking about stocks has lessened considerably. Funny how that works.