The Foregone Riches of Blue-Chip Value Investing

There are some people who look at The NASDAQ Index taking fifteen years to pass its 2000 highs and conclude that is some proof that the stock market is “rigged” or a “casino.” After all, if buying the largest technology names and holding them for fifteen years earns you 1% nominal returns (because of the dividends) and -2% actual returns (because of the inflation), then it seems to follow that a super-long period of no wealth-building would result in some skepticism about stock market participation in general.

This particular fear can easily be conquered if you come to appreciate that: (1) even dominant enterprises can become so overvalued that they will deliver disappointing returns even as profits continue to grow at a fast clip, and (2) a basic P/E ratio analysis will tip you off that something is unhinged about the valuation.

Out of the ten largest NASDAQ holdings in 2000, only Microsoft and Qualcomm delivered a positive return to the present day. What is especially burdensome is that Cisco was far and away the largest holding, with Intel and Oracle also being top weightings. Everything: HBO, Netscape, Comair, Autodesk, Lincair, Tech Data, Rexall, Petsmart, Glenayre, Komag, Viking Office, Gartner, DSC, The American Greetings Corporation, Adtran, Sybase, Phycor, Pairgain, Oracle America (not to be confused with Oracle), Worldcom, Dell, and Ericsson prevented you from making money with the index over the past fifteen years.

The most important reason why The Nasdaq Index managed to break even from 2000-2015 is because the index contained five heroes—Monster Energy, Keurig Green Mountain, Express Scripts, Gilead, and Tractor Supply which delivered returns between 4,000% and 52,000% and came to be important parts of the index, eventually offsetting things like the Worldcom bankruptcy.

I would find it incredibly obnoxious to be right about a company’s long-term future but to earn subpar returns because the point of purchase price was too high. Imagine if you found Cisco attractive fifteen years ago. You would have seen the company earning $0.38 per share and concluded, “This tech giant is going to grow very fast over the long term.” You would have been absolutely right. It made $2.06 last year. You saw profits increase five-and-a-half fold during the fifteen years.

Under normal conditions, those are the kinds of insights that can rapidly advance your financial circumstances in life. But Cisco did not turn $25,000 into $137,500 over the past fifteen years (plus whatever dividends you would have collected) as you might expect. No, you would have turned $25,000 into $12,500 because the stock traded at $82. It is at $27 now. People paid 215x earnings for the stock fifteen years ago, and now they have lost half their money fifteen years later even though the business growth has been excellent.

For a non-cyclical enterprise, you rarely want to go beyond 20x earnings. If you pay 20-23x earnings for Hershey, Colgate-Palmolive, or Brown-Forman, things will work out fine because of the superior business quality and high revenue growth that continues decade after decade. Those are unusual circumstances. Maybe the highest you would ever, under any circumstances, pay for a stock might be something like Visa where you could get away with paying 25-27x earnings because the revenue growth is in the double-digits and the earnings per share growth is around 13% to 15% for the long haul.

But the overall rule is this: Try your best to avoid the habit of paying over 20x earnings for a non-cyclical business, and only the truly high-quality growth options should take you a bit beyond it. If you can name more than three dozen businesses that deserve valuations over 20x earnings, you’re probably being too generous in your assessment of business quality or the likelihood of growth prospects. I can think of almost no situation where it would be advisable to pay over 30x earnings for a large, non-cyclical American company.

This strategy is useful because it ensures that your actual investment returns will bear a close relationship to the performance of the businesses that you own.

But I should mention that it is a strategy that will lead to foregone wealth when you try to remove the risk of overpaying for stocks from your portfolio. For the past ten or fifteen years, it has been incredibly obvious that Amazon was a special company that was building as strong of a moat as you can find in the online marketplace.

People have grown used to making purchases online by now, and it easy to forget that Amazon was one of the first companies that made people feel safe about entering their financial information as payment through online transactions. Amazon was the first mover, and established payment credibility before almost any of its peers (eBay/Paypal somehow factors into this analysis, though.) It had scale, speed, and a diversity of goods available for sale that made it large enough to scare Wal-Mart.

Potential investors acting on this fact would have made wheelbarrows full of Benjamin Franklins as revenues have grown by 28.5% annually over the past 10 years and the stock has delivered 28.4% annual returns in the past decade alone as the stock went from the $20-$35 range to $435 per share. A $100,000 Amazon investment in 2005 would have given you $1.2 million in net worth today, with no tax payments required until the moment you decide to sell.

Following my writings will never lead you to that type of writing. My knowledge of the 2000-2015 Nasdaq period prevents me from ever recommending something like Amazon for purchase because the stock price is not backed up by profits. The stock trades on revenue growth, not profit growth. The history of replacing cold, hard profits with other valuation metric is one of disaster. Amazon lost $240 million last year, and is expected to make $200 million in profit this year. The relationship between the $200 billion and the $200 million in profits put the valuation of the stock at about 1,000x earnings. In no way can I relate to that.

Coca-Cola, which is now smaller than Amazon at $170 billion, gives you almost $10 billion in annual profits. The growth component premium of Amazon stock is far too excessive to be justified—yes, Amazon may grow faster than Coca-Cola for the next decade—but not enough to offset the discrepancy created by the $10 billion/$200 million difference in current profits. The reason why Nasdaq investors spent fifteen years treading water and made no wealth with buying-and-holding a basket of Nasdaq stocks over the past fifteen years is a result of paying absurd valuations.

I think long-term value investing operates from the assumption that avoiding bad deals is just as, if not more, important than finding good deals. If anything smells just a little bit funny, it is best to be avoided. But still, you should know what you are giving up when you follow the path of blue-chip value investing. You are probably never going to own something that compounds at 25% annually for a decade. But there is a reason why that potential outcome is deliberately foregone. The truly long-term history of companies with valuations of 50x earnings, 500x earnings, or 1000x earnings is one of mediocrity at some point. People may enjoy it because the excessive overvaluation may last so long that people come to consider it permanent, but eventually, the golden carriage turns into a pumpkin when you least expect it.


Originally posted 2015-07-01 22:21:41.

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