Mark Twain told us that history does not repeat but it often rhymes. I want to offer you another data point on the folly of paying high prices for “innovative” stocks.
In 1999, there were 247 stocks trading on the New York Stock Exchange and the Nasdaq exchange with a price-to-sales ratio over 25. That is the sort of “we expect this company to take over the world” valuation. For comparison, the old-school benchmark was that a price-to-sales ratio under “2” signalled fair value and a P/S ratio under “1” was a strong sign of an undervalued stock.
What happened to an investor that bought each of those stocks in 1999 and held through to today? You would have earned 3.5% on your money through today. And if you did not include Nvidia in your holdings, which was the crown jewel performer, you would have lost 7.0% annualized on your money through today such that every $100,000 invested in 1999 would be worth approximately $21,500 today. That is remarkable given that the twenty-year period included tax cuts, falling interest rates, and a bull market at the end.
Similar data plays out with those stocks that traded over 50x earnings. If you built a portfolio of every single stock that traded above 50x earnings in 1999, the results through March 1, 2021 would only be 4.3%. Go-go growth gave you the pace of inflation and maintenance of purchasing power–that’s it.
To maintain perspective, I think it is important to distinguish between the personal sense of time and the market’s sense of time. You might have noticed that a particular stock that was trading high in 2019 went even higher during the second half of 2020 and then rose further so far into 2021. It may feel like a long-time and the rise of a particular stock’s price point over a three-year time frame might even seem to provide some credibility to the prices.
No way. That is not how Mr. Market accounts for time. The 1920s and 1990s in the United States, and the 1980s in Japan, witnessed market gains that were provided over a six-to-eight year period before pricing rationality asserted itself.
I’m not saying there is no role for someone to own nosebleed P/E ratio stocks. I own three, and two of them looked excessively valued when I made the purchase (the third was the Visa shares purchased in 2015 I have mentioned from time to time, which have grown into a lofty P/E ratio). But these types of stocks, on the whole, exhibit characteristics that lead to long-term underperformance. I’d rather own a generic small-town bank stock trading at 11x earnings than the typical CNBC stock trading at 150x earnings. History shows small-town banks get you 8-10% long-term returns which doubles paying the highest P/E ratio for stocks. I am not saying small-town banks are particularly attractive right now, but rather, to provide a specific illustration of generic businesses at fair prices that will outperform enticing businesses trading at generational highs.