I was browsing some of Marty Whitman’s old Third Avenue shareholder letters I had dug up a few years back. The nice thing about these old letters is the ability to go back to see someone’s thought process around bigger market events.
An excerpt (below) from one of those letters stood out for two reasons. First, Whitman wrote it in July 2000, a few months after the peak of the Dotcom Bubble, though nobody knew it was the peak at the time. The opening paragraph shows the juxtaposition of Dotcom enthusiasm versus the ignored value stocks Whitman was buying.
Those ignored stocks were trading at 10x earnings, while the market was going nuts over Nasdaq stocks at 141 times earnings. Even the P/Es of the Nasdaq versus the S&P 500 was hugely distorted.
The idea of paying $141 for $1 of earnings seems insane today, but that was typical back then. I remember friends asking about getting into eToys.com after the IPO. It practically tripled the first day, closing with a market cap 35% higher than Toys R Us despite only having $34 million in revenue and zero profits (Toys R Us had $11 billion in revenue at the time).
Which gets us to the second reason: why would anyone pay so much for so little or no earnings? As Whitman points out, the prospect of growth is alluring. The faster the better when speculation is rampant. Investors have an innate ability to ignore important things like price when staring at a great outlook on “growth” and money can be made quickly.
At August 14, 2000 the P/E ratios, based on latest 12 months trailing earnings, for the NASDAQ 100 was 121.5 times; and for the NASDAQ Composite, 141.8 times. At July 28, 2000 the same P/E ratio for the Standard & Poor’s 500 was 28.8 times. These ultra-high P/E ratios seem to indicate that speculative excesses exist for those common stocks currently most popular with the investing public and conventional money managers, especially growth managers. At the same time, and in sharp contrast, there apparently is little marketplace interest in the common stocks of smaller, mostly old economy, companies selling at under 10 times earnings (and usually at substantial discounts from the NAV that would be realized if there were to be a takeover). This lack of interest for the under 10 times issues apparently arises either because the near-term outlook for these issuers is clouded or because these companies lack general recognition as “growth” companies. I have, for some time, been characterizing these under 10 times earnings common stocks as issues available at 1974 or 1982 prices. TAVF, of course, has been loading up on these common stocks provided the companies are both well financed and well entrenched…
Why would the high-quality common stock issues in which Third Avenue is investing be available at 1974 or 1982 prices in the midst of a roaring bull market marked by more speculative excesses than I have seen in my lifetime? To hazard a guess, it appears as if the speculative excesses revolve around the consideration of only five factors by speculators: generally recognized growth; Wall Street sponsorship; the near-term outlook; macro forecasts whether for stock market indices, interest rates or GDP; and the demand and supply of securities, i.e., technical approaches where the analysts seem to know the price of everything and the value of nothing. If a common stock issue does not look attractive, based on these five oversimplifications, then, except for value investors, there will be scant interest in that security on the part of either the general public or conventional money managers. Bluntly, unless these people see prospects for good near-term price performance, i.e., doing better than a benchmark consistently, they will remain highly unlikely to acquire a common stock, no matter how cheaply priced. The general public and conventional money managers seem to be infinitely more outlook conscious than they are price conscious.
This emphasis on growth as the element in the evaluation of common stocks emanates, at least in great part, from the algebraic formulas in use in academic finance. Indeed, a reading of the leading texts, say Principles of Corporate Finance by Brealey and Myers, or Corporation Finance by Ross, Westerfield et. al., shows that in their methodology for valuing common stocks, premium multiples are assigned only to forecasts of growth. Of course, in the real world there are an infinite number of factors that contribute to appreciation potential for common stocks, and for businesses, over and above “growth.” These other factors include strong basic earning power; readily realizable assets available at a discount; strong financial resources that might be used as a competitive advantage, as a safety haven in troubled times, or funds to pursue a massive common stock repurchase program; and even an apparent absence of fraud or overreaching by managements or control groups. In fact, it seems obvious that, on a long-term basis, far more Wall Street fortunes are the results of financial engineering than are the result of paying retail prices for forecasts of growth.
This wasn’t some new phenomenon either. The Dotcom era was the latest iteration of what happens with every new technology. The uncertainty, influx of competition, and no clear winner(s) makes it easy to forecast “growth” for all of it. And when the Keynesian Beauty Contest takes over, as it always does, speculators drive multiples into the stratosphere.
Note: No posts next week thanks to the holiday. Happy (early) Thanksgiving!
Third Avenue Funds Third Quarter Report 2000
- Defensive Decision Making: What IS Best v. What LOOKS Best – Farnam Street
- US Economy Post WWII: How This All Happened – M. Housel
- The Old Gods and the New – Of Dollars and Data
- One Expert’s Opinion – J. Catherwood
- Balance is Underrated – Intelligent Fanatics
- We’ve Known for 85 Years that Forecasters Can’t Forecast – Evidence Investor
- The Kiril Sokoloff Interviews: Stanley Druckenmiller (video) – RealVision
- 16 Popular Psychology Myths You Probably Still Believe – Nate Eliason
- Common MythConceptions – Information is Beautiful
- Aaaand Now…An Oral History of the Greatest Starting Lineup Introduction in Sports History – The Ringer