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.
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.
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.