This Isn't 1999

Monday 04/28/14

     As the year progresses, the gap between value stocks and growth stocks continues to widen. This stands in stark contrast with 2013 when revenue and profits were no match for a good story. While not much has changed with respect to the underlying fundamentals of many of these growth stocks, investor perception is changing. Publilius Syrus a 1st century BC writer of maxims wrote that, “Everything is worth what its purchaser will pay for it.” This is most certainly true when it comes to stocks, so claiming that stocks are overvalued can come across as arrogant, naïve, or as resentment for missing out. I wrote a post back in September 2013 entitled tech bubble 2.0 where I picked a handful of tech stocks with extreme valuations. Shortly after that newsletter, there was a brief selloff, but the basket continued to climb until it peaked on February 27, 2014. Since then it has fallen 27.9% in 57 days and is just now slightly lower than when I wrote about them. This week I want to make a few clarifications since there has been increasing bubble talk and 1999 comparisons in the financial media.
It isn’t 1999
     1999 was a market wide bubble fueled by the commercial potential of the internet. Valuations were extremely stretched and brand new companies with no income were commanding huge valuations. The poster child of 1999 excess was pets.com with its sock puppet mascot. After its initial public offering, pets.com commanded a market capitalization of over $300 million. Pets.com only had sales of $619,000 and yet they spent over $11 million on advertising and lost money on every sale due to the nature of the business—home delivery of heavy low-margin items such as cat litter and dog food ended up costing them a lot more than they could make. Pets.com now holds the dubious honor of being one of the shortest lived public companies with only 268 days on the Nasdaq. It was not unusual for an IPO to “pop” 100% back in 1999. “…this has been the year of the mega-hit. Nationwide, the average IPO rose in price 67% on the first day of trading, and the average gain through Dec. 20 was 170% from the offer price.” according to the Los Angeles Times. The larger technology stocks that had been around for many years like Microsoft and Apple were also major beneficiaries of the tech bubble and their prices rose to record highs during this time period.
     At their current levels, market wide valuations are stretched by most historical valuation comparisons, but they are nowhere near the levels of 1999 according to the Shiller PE ratio. The current market is split between exciting ‘new’ companies like Twitter, Pandora LinkedIn, Tesla, Solar City, 3-D printers, anything cloud, etc. which command enormous multiples while making little to no profits, and boring ‘old’ companies that in many cases are downright cheap. In a recent letter, hedge fund manager David Einhorn called these flashy stocks “cool kid” companies, which is probably more accurate than calling this a tech bubble because many these companies are new ideas based on incremental improvements to old technology. One major difference between 1999, and the current “cool kid” bubble is the market cap of the bubble companies.
     Pets.com had a peak market cap of just over $300 million, but Twitter’s market cap peaked at over $40 billion (it is currently about $25 billion). In all fairness, Twitter is a much more mature company than pets.com, but then that begs the question: Why are investors putting such an enormous premium on a mature company that isn’t making money? Many of these cool kid companies have proven that they have great products, but they have struggled to translate that into real profits. Pandora has been losing money since the last tech bubble, but only IPO’ed back in 2011. These companies are better at managing their cash than pets.com, but every so often they have to return to the market to raise more cash. Companies are maturing in the private market before their IPOs mainly because of changes in regulation since 1999 such as Sarbanes-Oxley.
Everyone is Talking about a Bubble, Therefore There is No Bubble
     The narrative that since everyone is discussing bubbles, there must not be a bubble can be appealing to many contrarians. Unfortunately, it isn’t true. In the year 2000, just before the bubble burst Gallup conducted a poll of individual investors. Investors were asked if they thought stocks were undervalued, overvalued, valued about right, or not sure. 48% of investors surveyed thought that stocks were overvalued while only 3% thought they were undervalued, and 32% thought they were about right. For a more detailed read on this study please read this excellent paper.
     Timing bubbles is an extremely difficult task because bubbles are by definition irrational. There is no rule that stock markets must correct once they reach a certain level. The one thing that seems to correct stretched valuations is time. As enthusiasm for ideas fades investors will eventually return to profitable businesses with bona fide cash flows. This is what we have been seeing so far in 2014.