“This time is different.”
Those are four terrible words.
By now, investors have been told countless times to be aware when those four wretched words are being thrown around to justify beliefs that “this time is different.” By now, the investing community has had decades of access to Warren Buffett’s aphorisms and George Soros’ philosophy. By now they have witnessed the awful consequences of irrational exuberance, animal spirits, and the like. So, why aren’t people more concerned with the insane valuations of so many technology stocks???
2000’s dot-com bubble (and its buildup) has become infamous for investors’ willingness to buy companies without profits – or even an iffy for regarding future earnings. Back at that time, much investing was driven by the prospect of explosive growth in a brand new theatre: the internet. Investors were willing to buy in at high multiples because of the pervading belief that a company’s future developments would eventually justify current prices. There was a problem with this theory, of course, as many such companies would never develop sufficiently to merit such crazy multiples. Once the market figured this out, calamity ensued (see the third chart below).
One of the important takeaways from that crash was the temporary paradigm shift from prizing growth and market share over profits. The two former concepts are certainly positive, but what good are they without profits? Say that the world’s governments granted a company the rights to 100% of the world’s oxygen, but on the condition that they could never charge anything for the oxygen. What value would the company have?
Fourteen years ago I saw the danger in buying something if it requires fundamental change in order to justify its current price. This lesson extends beyond stocks. It’s probably a mistake, for example, to buy jeans that are too small based on the expectation that you’ll lose weight and eventually fit into them. If you lose the weight, the jeans will be worth what you spent. If your weight increases or stays the same, however, then you wasted the money. Skinnier jeans (like exciting tech stocks) may be sexier, but why take the risk? The remedy isn’t difficult; instead of making speculative purchases, just buy things that are worthwhile right now!
Last week marked the 5th anniversary of the market’s bottom in March, 2009. The S&P 500 and the DJIA hit their lows on March 6th; the Nasdaq followed suit three days later. Since that time, the Nasdaq has consistently beaten the other two indices. For the life of me I cannot figure out why this doesn’t get more media attention. The most prominent index funds (such as the famed Vanguard 500 Index Fund) track the S&P 500, which conventional wisdom says is one of the best long-term bets when investing. Indeed, even Warren Buffett has endorsed such S&P index funds for the passive investor. The reality, however, is that the Nasdaq (.IXIC) has solidly outperformed the S&P 500 (.INX) and the DJIA (.DJI) over the past five years:
What concerns me here is that this chart looks somewhat familiar. Of course, these recent years are not identical to 1995-2000. The differentiation in returns between the indices has occurred over a longer period of time, and is not as drastic as it was from 1999-2000. Still, it concerns me, as here’s the chart of the 5 years building up to the dot-com bubble burst…
… as well as the 5 years the followed, when the Nasdaq was pummeled…
It is not a coincidence that many of the notable recent winners trade on the Nasdaq. Netflix, Facebook, Amazon and Tesla are all there, for example, and their recent price surges have helped to fuel the impressive performance of the index as a whole.
On the one hand, I’m not prophesizing a collapse of the Nasdaq à la the year 2000; the index’s average P/E ratio was 42 back then, whereas now it’s at 21 (this level is higher than the DJIA at 16, the S&P 500 at 18, and even the Nasdaq itself one year ago, when it was at 17). I have, however, come to believe that many of these overpriced tech companies are headed for a fall. It’s simple math – their prices relative to earnings are just way too high. Netflix, for example, would have to increase its EPS 10x to reach a historically sustainable level, and that’s assuming the price doesn’t continue to rise! Facebook would likewise need to increase its EPS 5x, Amazon would need a 30x increase, and Tesla would have to generate profits – something it has yet to do for an entire fiscal year.
I don’t hate companies like these; I just don’t like their prices. In order to justify their current values, one of two things must occur. Either the earnings must drastically rise (like I described in the last paragraph), or there must be a permanent paradigm shift in the way we value companies. Neither scenario seems particularly likely. The last time that growth potential and technological market share superseded profitability in the eyes of investors, we ended up with the dot-com bubble.
I’d like to think that I learned this lesson back in 2000 (see the image at the top of the blog). Despite everyone’s’ assurances to the contrary, last time wasn’t different, and I don’t think this time is either. The joyride for these overpriced tech stocks is coming to an end. The question that lingers is if their downfall will take everyone else down with them.
Two posts by Scott Krisiloff of Avondale Asset Management that got me thinking about this topic are here and here. I wrote this post yesterday, before I had a chance to read another piece from Mr. Krisiloff on the subject that makes several similar points to mine.