Updated: Oct 13
There is nothing more maddening than watching things climb in price that we do not own. Investing is most dangerous when it looks easiest. Even for highly skilled professional investors.
“First, she said we were to keep clear of the Sirens, who sit and sing most beautifully in a field of flowers; but she said I might hear them myself so long as no one else did. Therefore, take me and bind me to the crosspiece halfway up the mast; bind me as I stand upright, with a bond so fast that I cannot possibly break away, and lash the rope's ends to the mast itself. If I beg and pray you to set me free, then bind me more tightly still.” ― Homer, The Odyssey
Imagine the scene, a great warrior and captain tied to the mast of a ship, begging to be set free to dive into the water to his death because of the maddening, sweet song of the sirens. Luckily, in the Odyssey, the goddess Circe warned Odysseus to have himself bound to the mast and gave him beeswax to stuff in the ears of his crew. His orders were clear. He was not to be cut free no matter how much he demanded. When Odysseus heard the siren’s song, he wanted desperately to be freed to join them. Even though his thinking brain knew it meant certain death, his emotional brain took the reins and made him frantic to satisfy this uncontrollable urge. Luckily, his crew were steadfast, and they sailed to safety. His tears let them know that it was safe to set him free. In some versions of the legend, it was the sirens themselves who threw themselves into the sea after having their song heard and being ignored.
The market sirens are singing. There is nothing more maddening than watching things climb in price that we do not own. Having our neighbors and brothers-in-law tell tales of their beautiful song makes our emotional brain fear we are missing something incredible. But we have sailed through these waters many times, and it always ends the same way. When prices detach from value, it is eventually value that wins. This has been the case for centuries going back to the price of tulips in Holland in 1637. The path the song always follows to get through our thinking brain to our emotional brain is the hope that “it is different this time”.
“But how do we know that it isn’t different this time?” you may be tempted to ask. We remain humble given the fact that the “ever enigmatic future” is unknown. We can’t say with certainty that it isn’t different, but what we can say is that it is a very low probability scenario that securities that generate income can permanently grow to infinite levels without a corresponding increase in earnings or cash flow. We know that in the dozen or so times that security prices have become detached from fundamentals their prices have dropped precipitously. We also know that interest rates are like gravity on the prices of assets, and that in the presence of inflation, investors demand higher future returns to compensate for the risk of declining purchasing power, which causes interest rates to rise.
I began my finance career in April 2000, one month after the Nasdaq peaked at 5,048.62. I was 24 years old and had little insight about the stock market, other than hearing my friends talk about all the tech stocks they were buying and making a killing on. Day traders were quitting their jobs and furiously selling pieces of paper back and forth to earn 10 times what they made at their jobs. It appeared that the path to success was simply to sit at your computer and buy things that were going up and sell things that were going down. We were all going to get rich.
But as the year passed, the Nasdaq was no longer climbing. By year-end, it had declined 36.84%, and it felt like a great opportunity to “buy the dip” because surely stocks always rise over time, and these companies were going to change the world. In 2001 the index dropped another 32.65%, and now it was certainly the bottom. But alas, 2002 saw another 37.58% drop, for a total loss from peak to trough of 78%. This means that $1,000,000 invested in these companies with bright futures had been turned into $220,000.
I worked with clients who came in after losing most of their money. What seemed very simple, turned out to not be easy. It became apparent that investing was hard, and that help was required to navigate these dangerous waters. I met many people who had planned to retire, but now had 50% or less of their assets remaining. One gentleman, who had worked as an executive had to trade the suit and tie he had worn for his entire 40 year career for coveralls in his retirement job as a custodian at the local elementary school. Dreams of sitting on the beach sipping cocktails had been transformed into scraping by to make ends meet and continuing to work into old age.
“But maybe this time is different. A lot of those companies had poor business models and went completely out of business. Surely today’s companies are better run and will continue to survive even if the market drops.” Let’s take a look at one company that epitomized the tech bubble. Cisco Systems made networking equipment and was for a brief period of time the most valuable company in the world at $555 billion in market capitalization. They had a fortress like balance sheet, high growth, and demand for their products could only grow. But at 100 times earnings, they would need to do everything perfectly to justify that valuation; they did great, but not perfect. The stock dropped from $82 to $8.12 in October 2002. Since then, Cisco has grown revenue from $19 Billion to $50 Billion per year, which is an incredible growth rate. An investor who bought $1,000 worth of Cisco at the peak in 2000 at $82 currently has about $800, including dividends, 21 year later.
This is not an isolated example. Below is a quote from Sun Micro systems CEO Scott McNealy:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
By the way, the Price-to-Sales ratio (times revenue) of the S&P 500 peaked at 2.2 during the tech bubble. It currently sits at 3.3.
The top 8 stocks in the S&P 500 are currently “tech” stocks. They comprise 25% of the index. I have no doubt that these companies will continue to change the world. The problem is not about whether or not these companies will be successful, the question should be about whether or not they can possibly justify their valuations in a world facing supply shortages, lockdowns, rising interest rates, and increasing geopolitical disturbances.
Investing is most dangerous when it looks easiest. Even for highly skilled professional investors. It seems like earning an extra 5% by stretching into riskier stocks will make all the difference in the world because, as humans, we have a tendency to extrapolate the recent past into the future. This methodology has served us well for thousands of years when it comes to providing food, shelter, and warmth in a relatively simple world. The world is not so simple anymore. We live in an “information” age, and there is a large misunderstanding about the difference between “information” and “wisdom”. Information is pure data; it is worthless on its own. Ronald H. Coase said, “If you torture the data long enough it will confess to anything”; however, in the long-run, wisdom ensures us that the truth eventually prevails.
Consider the following response by one of the true investing greats, Stanley Druckenmiller, to the question “What is your greatest investing mistake”:
“Well, I made a lot of mistakes, but I made one real doozy. So, this is kind of a funny story, at least it is 15 years later because the pain has subsided a little. But in 1999 after Yahoo and America Online had already gone up like tenfold, I got the bright idea at Soros to short internet stocks. And I put $200 million in them in about February and by mid-March the $200 million short I had lost $600 million, gotten completely beat up and was down like 15 percent on the year. And I was very proud of the fact that I never had a down year, and I thought well, I’m finished.
So, the next thing that happens is I can’t remember whether I went to Silicon Valley, or I talked to some 22-year-old with Asperger’s. But whoever it was, they convinced me about this new tech boom that was going to take place. So, I went and hired a couple of gun slingers because we only knew about IBM and Hewlett-Packard. I needed Ventas and Verisign. So, we hired this guy, and we end up on the year — we had been down 15 and we ended up like 35 percent on the year. And the Nasdaq’s gone up 400 percent.
So, I’ll never forget it. January of 2000, I go into Soros’s office, and I say I’m selling all the tech stocks, selling everything. This is crazy. Cisco at 104 times earnings. This is nuts. Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two-gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day and I’m out [of the market]. It is driving me nuts. I mean their little account is like up 50 percent on the year. I think Quantum was up seven. It’s just sitting there.
So, like around March I could feel it coming. I just – I had to play. I couldn’t help myself. And three times during the same week I pick up a – don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So, maybe I learned not to do it again. But I already knew that.”
Sometimes, the song can even be too sweet for the greatest investors in the world. We have to use our thinking brain and learn to ignore the emotions of questioning common sense when the music is playing, and it looks like making money has suddenly become easy.
We are not in the business of predicting market corrections. We are humble evaluators of security prices who try to buy securities earning high income in relation to their available prices, and that are considered undervalued based on discounted cash flow. We have followed this discipline since our founding, and we will not waver based on current fads or magical thinking about an unlimited future. Trees have never grown to the sky, and value has always eventually won out, even if it took months or years to develop. In the meantime, we are earning an adequate return, based on your needs, and are finding opportunities to put capital to work in securities highly likely to perform well over time. If given the choice between looking you in the eyes while explaining why we only got 7% when your neighbor got 12%, versus losing half of your money and that you need to go back to work, we will choose the former every time.
I want to be clear that this is not 2000. The amount of euphoria about the future was nothing like the global pessimism we see now. Interest rates were significantly higher, so the stretched valuations were much more amplified on a relative basis. But as Mark Twain may have said: “History doesn’t repeat, but it does rhyme”.
I am also not proposing we liquidate our securities and sit in cash while the party rages on without us; I am simply exercising caution. Our allocations still average somewhere between 40-50% equities, depending on your personal circumstance. If you are very young this may be significantly higher, if you are retired, this may be lower. We are also focused on companies trading at discounts to fair value, not trendy tech stocks at nosebleed prices. This may hurt our short-term performance, but over your lifetime, avoiding large drops is much more impactful than transitory spikes in portfolio value.
You may notice we are holding a lot of cash. This is not meant to be a permanent position; it is simply an alternative to bonds that pay very little interest for high short-term risk. Credit spreads are very tight, real interest rates are negative, and if rates begin to rise the income we earn on cash can rise without a corresponding drop in asset value. If the market does drop, we have cash to deploy into securities at much lower prices. If we buy a stock at a 30% discount instead of at fair value, that provides 20 years of interest at current rates in 10-year treasuries: a prospect worth waiting a year or two for.
We are also holding precious metals and other alternatives. This is something we have not done in the past, but holding gold and silver are meant to hedge against the possible risk of printing massive amounts of dollars in the form of both monetary policy and fiscal policy. We are simply attempting to maintain purchasing power in these assets, not looking to outmaneuver stock traders. It is always important to remember that risk means that “more things can happen than will happen”, and that the prices of precious metals are volatile and will show gains at times and losses at times.
We are holding energy securities. There is a large shortage of energy inputs in both Europe and China. As we shift to electric vehicles, energy production will need to rise significantly to make up for the increase in demand on power grids; those vehicle batteries must be charged somehow, and there is no divine green energy source to power them. The electricity used to charge vehicle batteries comes from the same natural gas, coal, nuclear, and wind power that runs your refrigerator. In addition, cryptocurrency is powered by the same global power grid. It takes as much power to process a single transaction in Bitcoin as it takes to run a home for a month, or to process 500,000 credit card transactions, and this number is climbing.
If the dynamics of the markets change, our allocation will change. We are not clinging to the hope that we are right, we are simply responding to the information we have and making decisions that put you in the best position to be successful over your lifetime. As prices of certain stocks continue to rise, it is important to note that they do not become less risky, the potential for future calamity only compounds. Equity price increases are not coupons to be clipped, they are reversed just as easily as they are attained. It is much more important to own securities that are becoming more valuable, even if the price does not reflect this fact immediately.
We are not the hero in this story. You are. We are the crew with our ears stuffed with wax, furiously rowing to get past the danger. You are tied to the mast, listening to the song the market sings, and wondering if it wouldn’t be better to just jump. We will continue doing our job to make sure that your assets last for the rest of your life regardless of market dynamics or inflated stock prices. This is a promise we have made to all our clients.