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Hit the Books: This Time Is Not Different

“To be ignorant of what occurred before you were born is to remain always a child.” – Marcus Cicero

A recent column by Barry Ritholtz in the Washington Post highlights the many hats that great investors need to wear. Since investing “isn’t a traditional academic discipline” and because most business administration undergraduates take courses on how to run businesses and not in how to invest in them, many graduates don’t have the necessary disciplines to become great investors.

The bottom line in becoming a great investor is to buy low and sell high. It doesn’t get more complicated than that. In order to consistently buy low and sell high, an investor needs disciplines outside the field of business to become successful. With regard to the five disciplines that Ritholtz talks about — historian, psychiatrist, trial lawyer, mathematician, and accountant — I’d like to focus on the importance of history.

Bill Gross, co-founder of global investment manager PIMCO, reaches for the history books when the future looks cloudy. He said, “There is no better teacher than history in determining the future... There are answers worth billions of dollars in a $30 history book.”

Not knowing history cost Inca emperor Atahualpa $76 billion, and his life.

The Spaniards Are Coming

The first meeting between Spanish conquistador Francisco Pizarro and Atahualpa took place at the Peruvian highland town of Cajamarca on Nov. 16, 1532. Atahualpa was the absolute monarch of the largest and most advanced state in the New World. He was in the middle of his empire, surrounded by millions of his subjects and an army of 80,000 soldiers.



Caption: Atahualpa: Last sovereign emperor of the Incan empire

Incan Pizarro had with him a ragtag group of 62 soldiers mounted on horses and 106 foot soldiers, in unfamiliar terrain and far beyond the reach of reinforcements. Yet within only a few minutes of meeting Atahualpa, Pizarro captured him and extracted the biggest ransom in history: enough gold to fill a room 22 feet long by 17 feet wide to a height of 8 feet. Based on $1,520 per ounce of gold, that works out to a total of $76 billion! Pizarro later reneged on his promise and executed Atahualpa.

How did Pizarro and 168 Spanish soldiers crush a Native American army 500 times more numerous and not lose a single Spanish soldier? Jared Diamond, author of “Guns, Germs, and Steel,” gives several reasons for Pizarro’s success. Among them: military technology, infectious disease, maritime technology, and the centralized political organization of European states.

But one overwhelming factor related to Pizarro’s success was the existence of writing, which made information spread more widely, accurately and in more detail than information transmitted by mouth. Pizarro modeled his ambush of Atahualpa on the same strategy Spanish conquistador Hernan Cortes used to capture Aztec ruler Montezuma in 1519.

Although the Spanish conquest of Panama began in 1510 — 17 years before Pizarro reached Peru — Atahualpa remained ignorant of Spain’s conquest of Central America.

This time is different?

For Atahualpa, not being able to access history and see how events similar to his own had transpired eventually cost him his wealth, empire — and life. If you know the past, your net worth won’t have a similar fate.

During times of market extremes — euphoria in bullish markets and gloom and doom in bear markets — experts claim, “This time is different.” Rules of valuation no longer apply and the new situation has broken all the previous models. In other words, market history is irrelevant and bears no similarity to current events.

At the tail end of the Great Recession in 2009, two leading economists wrote “This Time Is Different: Eight Centuries of Financial Folly.” They researched financial crises over the past 600 years and 66 nations. Their conclusion: financial crises share three characteristics. Even though the financial crisis of 2008 seemed to be an outlier, this time is not different.

Valuations matter

Market history has taught us that, at the end of the day, the return you get on an investment boils down to the price you paid. Periods of booms and busts will always be a part of markets, but it’s what you do during those times that decides your financial future.

During the dot-com boom of the late 1990s, experts said that valuations no longer mattered. The technology and Internet era was upon us, and traditional ways of determining the value of a business were no longer valid. Experts were telling us that we were in a “new paradigm” and this time was truly different.

Human nature is such that we suppress bad experiences and are instinctively drawn to greed. Each new paradigm ushers in a new set of investors who use the most recent past to project the future. During the dot-com bubble, a survey showed that investors could not conceive of stock returns ever being below double digits — heaven forbid the thought of them ever going down. And most recently, investors and experts never modeled a world where, gulp, housing prices could ever fall.

Both assumptions led to disastrous outcomes.

Over the past few months, it seems we are forgetting that history does repeat itself and past patterns tend to recur. Companies that are going to improve the way we use the Internet have had initial public offerings. It is very telling as to how investors view risk by observing the first day of trading.

The five companies listed in the table saw their share price pop on their first day of trading by between 40% and 134%. I took a look at these companies on May 31, several weeks and in some cases months since their IPOs. Two of the five companies reported losing money over the trailing twelve months (ttm), and the most “conservatively” priced stock, Yandex, had a P/E of only 71!

Five Hot Internet Companies

Market Cap
Company Ticker ($billions) EPS (ttm) P/E
Qihoo 360 QIHU $3.0 $0.08 348
LinkedIn LNKD $7.7 $0.07 1,217
Yandex YNDX $10.7 $0.47 71
Youku YOKU $4.5 -$0.63 NMF
Renren RENN $5.0 -$0.94 NMF
Source: finance.yahoo.com as of May 31, 2011

Investors are willing to pay a very dear price for future expectations. Market history has taught us that the majority of the time, overpaying for future expectations has been a bad bet.

The darlings of Wall Street during the tech bubble over a decade ago were also priced at unreasonable valuations. Investors priced in a future of rosy expectations at the height of the mania.

The Tech Giants of the Dot-com Bubble

Company Average P/E 12/31/1999 05/31/2011 Return
HP 33 $39.15 $37.38 -5%
Intel 55 $34.46 $22.51 -35%
Microsoft 50 $46.16 $25.01 -46%
Cisco NMF $53.37 $16.80 -69%
Note: Average P/E was the highest annual P/E in the years 1999 to 2001.

If you had been caught up in the frenzy and bought any one of these stocks, you would still be holding onto losses more than a decade later. Even great companies purchased at high valuations make terrible investments.

Stock prices fluctuate over the course of a year like no other asset class. Since no one knows what a company’s earnings, cash flow, sales, or growth rate will be in the future, some investors price in an optimistic future.

Just because a stock was once a high flier and we avoided it because of its sky-high valuation doesn’t mean we’re never going to be interested. On the contrary. Now that some of these same companies are trading at valuations that are pricing in no future growth expectations — they are certainly of interest to us.

For example, we added Intel (INTC) on Jan. 18 at $20.83, when it was trading at an attractive valuation (P/E 10), and most recently added Microsoft (MSFT) on May 31 at $25.01 when it too was attractively priced.

We love to buy companies with bright futures and the promises of higher growth —but we don’t want to pay for it. When we select stocks for IWP, we are basing our valuations on what the stock is worth today and try to pay next to nothing for future growth. As long as we keep buying financially strong companies at bargain prices, good things will happen.

About the author:

Charles Mizrahi
Charles Mizrahi is editor and publisher of Hidden Values Alert newsletter, which focuses on finding stocks trading significantly lower than their underlying business value. He has over 30 years experience in the financial world as a money manager and investor.

Visit Charles Mizrahi's Website


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Comments

sdwolff
Sdwolff - 2 years ago
Nice article and history lesson!

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