There are two insights from Benjamin Graham’s classic “Security Analysis” that I believe are appropriate to keep in mind today.
- “Putting excessive weight on recent past history, as opposed to a rational prior, is a common judgment error in psychological experiments and not just in the stock market.”
- “Investors may very well equate well-run companies with good investments.”
There is no doubt that we are living through a period of unusually high enthusiasm for investing right now. Based on the 20%+ gain in the S&P 500 in 2017, it would have been difficult to devise a diversified common stock portfolio last year that did not deliver at least double-digit annual returns.
As a result of these recent stellar returns, you are beginning to see extreme enthusiasm for investing in high-risk junk. If the media coverage of Bitcoin in recent months doesn’t strike you as a modern incarnation of what John Maynard Keynes meant when he spoke of “animal spirits”, what would?
A. The Over-Reliance on Recent Stock Market History
I’m glad stock prices went down today. This newfound expectation that the valuations of businesses should increase every day, week, month, whatever is how you set yourself up for disaster as investors take on leverage, deplete emergency funds to invest, and become drawn to high-risk junk merely because it looks like stock prices are going up every day.
It’s just…bizarre. I remember reading articles in 2009 and 2010 where most investors that participated online said that they would never purchase shares of bank stocks again. Now, they can’t stay away because bank stocks have doubled in value since the fall of 2016 and are rapidly increasing their payouts.
B. A Well-Run Company Does Not Equal A Good Investment
Right now, everyone loves Netflix. Young investors probably think, “Hey, I have a Netflix account that takes money out of my bank account each month. All my friends have Netflix accounts. I’ll spend hours at a time using their service. It must be a good investment.” Superficially, it seems to incorporate the Peter Lynch wisdom of “buying what you know.”
But I believe such a theory will prove disappointing over a multi-generational holding period. Most people who analyze Netflix focus on the explosion in revenue from $1 billion to $11 billion over the past the past decade.
That growth is fantastic, but it has to be analyzed in light of costs as well. Netflix is committed to spending $8 billion in developing its own content, and has to pay other content owners of established TV shows and movies approximately $20 billion in total through 2020.
As a result, we have this bizarre circumstance where Netflix earns around $600 million in profits while trading at a valuation of $115 billion. I must have missed the passage in Benjamin Franklin’s “The Way to Wealth” when he mentioned paying 191x earnings for shares in a mega-cap.
Netflix fell from $42 to $9 between the summer and winter of 2011. It can do so again, as it trades at a valuation that is utterly unsupportable. I suppose investors anticipate that Netflix will someday lower its content costs, but I think the opposite is true—content owners will threaten to sell directly to the public and cut out the middleman Netflix if Netflix doesn’t agree to pay the high rates for the content’s usage.
Although I am chiding the re-emergence of extreme investor euphoria, there are two caveats I should add.
The first is that there is a legitimate basis for an upward revision in the calculation of the fair value of American businesses because of the shift in the corporate tax rate from 35% to 21%. That is significant. Business can now retain four-fifths of what they earn for dividends, buybacks, and expansion.
That is why Dr. Pepper is being bought out by Keurig. Dr. Pepper earns about 90% of its profits in the United States (due to an ancient, one-sided licensing agreement in which Coca-Cola would get nearly all of Dr. Pepper’s international rights that led Dr. Pepper to forego international expansion and instead focus on U.S. growth where it got to keep its own share of the profits).
For businesses like Dr. Pepper, the tax cut alone increases the intrinsic value of the stock by 30% or so. That is roughly the premium that Keurig paid to make the acquisition—i.e. the net result is that Keurig was able to scoop up Dr. Pepper by eliding the typical premium-price requirements because they were ahead of the curve in realizing Dr. Pepper’s true value post-tax reform.
The bad news is that almost every business is currently trading above its ten-year average from a P/E point of view. Over super long periods of time, great businesses tend to revert towards a valuation of 20x earnings. If your portfolio is stuffed with businesses trading around 30x earnings and growing profits less than 7% per annum, those holdings will have a significant period of painful readjustment.
Another recession will someday come. The hardest hit businesses are those that got quite overvalued and then saw the stock price transition not only back to fair valuation but undervaluation as well. A stock that goes from 27x earnings to 12x earnings will turn a $10,000 investment into $4,500. I view roaring economies as the season to work hard, earn more, and stockpile cash, and invest in businesses selectively, rather than convert all surplus into business holdings.