Financial Euphoria
John Kenneth Galbraith studied every speculative mania between the Tulip Bulb bubble of 1636-7 and the 1987 crash. While each episode had unique external circumstances, he found that their underlying psychology was remarkably similar.
Galbraith found all manias begin when:
Some artifact or some development, seemingly new and desirable captures the financial mind. The price of the object of speculation goes up. This increase and the prospect attract new buyers; the new buyers assure a further increase. Yet more are attracted; yet more buy; the increase continues. The speculation building on itself provides its own momentum.
Charles MacKay made a similar conclusion in Extraordinary Popular Delusions and the Madness of Crowds.
Each age has its peculiar folly, some scheme, project or phantasy into which it is plunged, spurred on either by the love of gain, the necessity of excitement, or the mere force of imitation…. Money has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers and risked almost their existence upon the turn of a piece of paper…. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly and one by one.
When a new invention or trend captures investors’ imaginations, three psychological quirks allow it to persist and grow.
The extreme brevity of financial memory.
Investors quickly forget financial disasters. When similar circumstances repeat, a new, youthful, supremely self-confident generation hails them as a brilliant and new innovative financial discovery.
Galbraith concludes, “There can be few fields of human endeavor in which history counts for so little as in the world of finance.”
George Santayana says, “Those who cannot remember the past are condemned to repeat it.” Perhaps this is why financial bubbles recur about every 20 years?
2. Overconfidence and a lack of self-scrutiny
Investors associate money with intelligence. They revere the wealthy and leaders of industry and blindly follow in their footsteps.
This causes two problems. First, it encourages financial leaders to take on even more risk and leverage. Second, followers quit thinking independently. In both cases, common sense goes out the window.
As Walter Bagehot, the late editor of The Economist, observed, “all people are most credulous when they are most happy.” Nothing lulls an investor to sleep like rising prices. Just ask Bernie Madoff’s clients.
3. Leverage
As confidence waxes and common sense wanes, investors leverage their investments. Remember, it’s hard to go broke without debt.
Galbraith found that all bubbles end the same: with a bang, not a whimper. The fallout follows a pattern too. First, public opinion turns on the financial leaders previously revered. Society needs a scapegoat, and someone has to take the fall. People like Ivan Boesky and Michael Milken go to jail.
Then, the public begins to scrutinize the financial innovations previously heralded as miracles — things like digital currencies, initial coin offerings, SPACs, EV stocks, passive indexing, or algorithmic trading.
Regulators (shockingly) conclude that more regulations will fix the problem. But they never do. Not for long. If they did, bubbles would be extinct.
Galbraith explains why:
What will not be discussed is the speculation itself or the aberrant optimism that lay behind it. Nothing is more remarkable than this: in the aftermath of speculation, the reality will be all but ignored.
Regulations treat the symptoms, not the illness. They affect the means of speculation, not the psychology driving it.
Markets are complex adaptive systems where each participant plays a small but real role. But no one wants to hear that they are responsible in some small way for the bubble. So, the financial innovations and their innovators bear the blame, absolving the ordinary investor.
Investors are told that they’re the victim, not the perpetrator. No one reflects on their actions or learns anything from the experience. And so the cycle is doomed to repeat.
As Rustin Cohle says in the first season of True Detective, “Time is a flat circle. Everything we have done or will do we will do over and over and over again forever.”
Current Examples of Financial Euphoria
While it’s hard to say if the NASDAQ is in a bubble, there are certainly signs of speculative frenzy.
Tesla and EVs
Tesla shares are up 730% year to date. On December 21st, the S&P 500 added the stock to the index. It’s the most valuable company ever added, weighing in at $660 billion. For those still counting, that’s 1,330x earnings. Could this mark the top of its meteoric rise? Will passive indexers be the bagholders? There are challenging (but interesting) questions above my pay grade. I’m glad I don’t have a dog in this fight. The view is just fine from the sidelines.
According to Yardeni Research, Tesla’s $660 billion valuation makes it worth more than the entire S&P 500 energy sector. Tesla is now the 9th most valuable business globally and the 6th most valuable in the US.
What do you get for that $660 billion price tag? $28 billion of revenue and $1 billion of pre-tax income. That those profits came from selling tax credits, not cars, is a discussion for another day.
In 2000 Buffett told shareholders at Berkshire’s annual meeting:
When we buy a stock, we always think in terms of buying the whole enterprise, because it enables us to think as businessmen, rather than as stock speculators.
So let’s just take a company that has marvelous prospects, is paying you nothing now, and you buy it at a valuation of 500 billion.
Now, if you feel that 10% is the appropriate rate of return — and you can pick your figure — that means that if it pays you nothing this year, but starts paying next year, it has to be able to pay you 55 billion in perpetuity, each year.
But if it’s not going to pay until the third year, then it has to pay you $60.5 billion — in perpetuity — to justify the present price.
Every year that you wait to take a bird out of the bush means that you have to take out more birds. It’s that simple.
And I question, in my mind, whether people who pay $500 billion implicitly for a business by buying ten shares of stock at some price, are really thinking of the mathematics implicit in what they are doing.
To deliver, let’s just assume that’s — there’s only going to be a one-year delay before the business starts paying out to you, and you want to get a 10% return and you pay $500 billion. That means $55 billion of cash that they have to be able to disgorge to you year, after year, after year
To do that, they have to make perhaps $80 billion, or close to it, pretax.
Now, you might look around at the universe of businesses in this world and see how many are earning $80 billion pretax, or $70, or $60, or $50, or $40, or $30. And you won’t find any.
So it requires a rather extraordinary change in profitability to give you enough birds out of that particular bush to make it worthwhile to give up the one that you have in your hand.
Investors expecting a 10% return from Tesla need $66 billion of pre-tax income this year, $73 billion next year, or $80 billion in 2022. Tesla’s $1 billion of pre-tax income isn’t even in the ballpark.
Apple, America’s most valuable business, did $67 billion, pre-tax, this year. Toyota, the world’s most valuable automaker, did just $16 billion. Few companies have ever made anything near $66-80 billion pre-tax, let alone in perpetuity. Indeed, no automaker. The odds are stacked against Tesla.
BMW has some of the highest pre-tax margins in the automotive industry at 7%. If Tesla could match this, they’d need $943B in sales to make $66B pre-tax. Assuming the average Tesla sells for $50,000, the company would need to sell 18.9 million cars per year. That would be slightly more than all of the new vehicles sold in the US annually.
As Galbraith found in every bubble, investors herald Elon Musk as a genius that can do no wrong. No one seems to care that he routinely breaks promises to investors.
I want to be clear that I have a lot of respect for Elon Musk. He’s doing great things for society. I don’t think he’s a crook. But I could never get comfortable investing with him at these prices and with his track record of over-promising and under-delivering.
This month, Musk said he’s open to discussing a “friendly” merger with a traditional automaker. A merger could make sense for Tesla shareholders. Tesla’s stock is an incredibly high-priced currency that it could use to acquire the factories it needs. Could a Tesla/GM merger be the modern version of the AOL/Time Warner merger? GM shareholders better hope not.
Tesla isn’t the only EV stock flying high. They all are. This summer, Nikola filed the most unbelievable 10-Q I’ve ever seen. They reported $36 thousand of revenue, an $87k net loss, and yet traded at a $14 billion valuation. Since then, it’s come to light that their prototype doesn’t even work. They rolled it down a hill for their investor video. Despite what looks like fraud, Nikola continues to trade at a $6 billion valuation.
In the short term, Ben Graham said, the market is a voting machine — popularity matters. In the long term, it’s a weighing machine — cash matters.
Sometimes the short-term noise of the voting machine temporarily obscures the long-term signals of the weighing machine. Stock prices can move randomly in the short-term but follow earnings over the long-term.
A heuristic to determine if randomness is present is to ask, “Could I lose on purpose?” If you can’t lose on purpose, randomness is present. For example, if you tried to lose money in the stock market you might buy a portfolio of companies that lose money. In October, Joel Greenblatt told Barry Ritholz:
If you bought every company that lost money in 2019 that had a market cap over $1 billion, and so they’re about 261 of those, and you bought every single one of those companies, you’d be up 65% so far this year.
This is an example of a bad process (overpaying for businesses), leading to a good outcome (investment profits). Like Joel Greenblatt says, it’s “like running through a dynamite factory with a burning match. You may live, but you're still an idiot.” Good decisions in uncertain environments don’t always produce immediate payoffs. Casinos have no idea if they’ll win any single hand of blackjack but know they’ll make money over time.
Like a casino, we focus on process over outcome and think long-term. Just because some people are playing the financial equivalent of Russian Roulette — and winning! — doesn’t mean we are tempted to join in.
Stock Issuance
Market tops often see lots of stock issuance. Companies and insiders cash in on their high-priced shares by selling them to the public. For example, Tesla did two $5 billion share offerings this year. If you are buying, it pays to consider who you are buying from and why they are selling.
This summer, Hertz tried to issue shares while in bankruptcy. They stopped because the SEC made them, not because there wasn’t investor demand for the worthless shares.
Andrew Walker observed that AMC Theaters sold 67 million movie tickets this year and issued 56 million shares of stock. Almost a one-for-one ratio. They’ve since registered another 200 million shares for issuance. Despite burning $1 billion this year and a business model facing existential threats, AMC’s enterprise value (market cap plus debt) is higher today than in 2019!
Last week DoorDash and Airbnb IPO’d and promptly doubled. Barron’s wrote:
DoorDash and Airbnb started the week as private companies last valued at a combined $34 billion. They ended the week as public companies together worth nearly $170 billion.
In case you’re wondering, neither company has ever produced a net profit.
Return of the Retail Investor
When stimulus checks arrived, there were no sports to bet on. So, the money flowed into brokerage accounts. In many cases, RobinHood.
George: Maybe I'll go down to the track. Put it all on a horse...
Jerry: Why don't you put it in the bank?
George: The bank? This is found money. I want to parlay it. I wanna make a big score!
Jerry: Oh, you mean you wanna lose it.
RobinHood targets young investors. They have a slick app that encourages frequent trading, particularly in options. Massachusetts securities regulators recently filed a complaint against them for their “gamification” of investing. According to Bloomberg, “One Robinhood customer with no investment experience made more than 12,700 trades in just over six months.” That’s about 100 per day!
As Buffett says, “The stock market is a device for transferring money from the impatient to the patient."
Unrestrained Optimism
Pitch decks are always optimistic. But this one, from a recent SPAC, is my favorite. It’s raising money to grow cucumbers in a greenhouse and promises 17% unleveraged returns.
While I’m hardly a farming expert, I find it hard to believe that the US government would need to give farmers $102 billion of transfer payments annually if farms generated anywhere near 17% unleveraged returns.
How did this end last time?
These anecdotes beg comparison to the late ‘90s. In 1999 two different investment managers gave two very different speeches on the state of the stock market. One was Jim Cramer, and the other was Warren Buffett.
Cramer titled his speech “Winners of the New World.” He names his ten favorite stocks and says:
Most of these companies don't even have earnings per share, so we won't have to be constrained by that methodology for quarters to come...
We don't use price-to-earnings multiples anymore at Cramer Berkowitz. If we talk about price-to-book, we have already gone astray. If we use any of what Graham and Dodd teach us, we wouldn't have a dime under management...
We have to look for the fastest-growing industries and then select the companies that can make the infrastructure happen the fastest and the cheapest in those industries. The growth must be positively organic, if not viral.
Does this sound familiar? A preference for “new economy” growth stocks over “old economy” stocks that generate free cash flow? The expectation that these companies will be our new economy’s infrastructure? The belief that valuation is irrelevant? The conviction that previous stock performance foretells future stock price growth?
Warren Buffett struck a different tone. He said investors tend to extrapolate recent history when they should anticipate mean reversion. Extrapolating the past is like driving while looking through the rearview mirror instead of the windshield. No wonder it leads to crashes.
He also pointed out that technological innovations that are good for society aren’t always good for investors.
Take automobiles first: I have here one page, out of 70 in total, of car and truck manufacturers that have operated in this country. At one time, there was a Berkshire car and an Omaha car. Naturally, I noticed those. But there was also a telephone book of others.
All told, there appear to have been at least 2,000 car makes in an industry that had an incredible impact on people's lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, "Here is the road to riches." So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies--themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America--and also an enormous impact, though not the anticipated one, on investors.
Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then--it's better sometimes to turn these things upside down--and that was to short horses. Frankly, I'm disappointed that the Buffett family was not short horses through this entire period. And we really had no excuse: Living in Nebraska, we would have found it super-easy to borrow horses and avoid a "short squeeze."
U.S. Horse Population
1900: 21 million
1998: 5 million
The same thing happened in aviation. Few industries transformed our world as much as airplanes. An investor who saw the potential at Kitty Hawk might have salivated. But profiting from that foresight would have been a herculean task. The competition was too fierce. Buffett continues:
As of 1992, in fact--though the picture would have improved since then--the money that had been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero.
Sizing all this up, I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did.
I won't dwell on other glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the manufacture of radios and televisions, for example. But I will draw a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
Is Valuation Irrelevant?
Cramer said price didn’t matter. Buffett said it did. Who was right?
Let’s look at one of Cramer’s top picks. There’s only one left, so we’ll choose that. It’s Verisign, a stock I’ve written about and admire. The stock peaked at $250 per share in 2000 and has yet to eclipse that peak.
Source: Author, data from Google Finance
Investors also heralded Microsoft as an “inevitable” “one-decision” stock that you should #neverSell in 1999. It was growing 40% per year and traded at 77x earnings.
Source: Author, data from Google Finance
Microsoft was a great business. Just not a great stock. Its growth inevitably moderated, and its stock collapsed. It took 17 years — until 2016 — for the company to grow into its 1999 valuation. Investors who bought in 1999 spent 17 years underwater. How many of them do you think stuck it out?
A few years ago, there was a mania in marijuana stocks. Prices flew to the moon, just like EV stocks today. Last week the two largest Canadian producers announced a merger. How did they fare?
Source: Author, data from Google Finance
Despite gaining 30% on the news, Tilray shares are still 90% below their peak.
Valuation matters, even for wonderful businesses. Investing is not as simple as always buying the best companies, regardless of price. Nor is it as simple as buying the statistically cheapest securities. Investing requires judgment: what are you getting for what you’re giving?
Warren Buffett gives us the closest thing finance has to an iron law of physics:
The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.
How To Avoid Bubbles
You might think that I sound bearish, but that’s not my intent. The mania is isolated to pockets of the market. Our portfolio has performed well and continues to generate excellent returns despite owning “old economy” businesses like home builders, hotels, insurers, banks, an ice cream company, and a railroad. We invest for profits, not excitement.
We don’t need to choose between participating in manias and sitting on the sidelines hoping for a crash. There’s a middle ground: buying simple, predictable, profitable, and replicable businesses with strong balance sheets at reasonable valuations. It’s a market of stocks, not a stock market, and we don’t need to buy every stock or even have an opinion on them all.
In 1991 Seth Klarman told Barron’s:
One thing I want to emphasize is that, like any human being, we can discuss our view of the economy and the market. Fortunately for our clients, we don't tend to operate based on the view. Our investment strategy is to invest bottom up, one stock at a time, based on price compared to value. And while we may have a macro view that things aren't very good right now -- which in fact we feel very strongly -- we will put money to work regardless of that macro view if we find bargains. So tomorrow, if we found half a dozen bargains, we would invest all our cash.
Eagle Point Capital operates exactly like Klarman’s Baupost Group: bottoms up, one at a time, based on price versus value.
In his recent CalTech speech, Munger pointed out that he didn’t make his fortune predicting the economy better than anyone else. He just “kept swimming” — valuing businesses, one by one, looking for bargains. Sometimes the economy provided a headwind—usually, a tailwind. In the end, time in the market mattered more than timing the market.
Howard Marks similarly advises investors faced with uncertainty to “move forward, but with caution.” That is precisely what I will do in 2021.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.