In a recent article, we discussed a few of the major insights of George Goodman, writing as Adam Smith, about the stock market and its participants. In truth, Goodman’s best-selling books “The Money Game” and “Super Money” are crammed with far more incisive, intelligent and often hilarious observations than could be reasonably fitted into a single online article. Thus, we will be exploring still more of Goodman’s most intriguing and relevant thoughts on the stock market investing game, in what will become a running series.
Today, we embark on the second journey into the wisdom of “The Money Game.” Specifically, we will be addressing three warning signs investors should never overlook.
Avoid high-flying stocks that assume infinite growth opportunity
Some stocks trade at eye-watering multiples to their earnings or revenues. These are growth stocks in which shareholders believe the future is full of promise and growth will continue without fail. Yet, it can prove to be the case that a business faces a cap on its achievable market, and thus a ceiling to earnings growth. But sometimes the market fails to acknowledge that limitation. Goodman provides an illustrative example of this in the form of the rise and fall of Brunswick Corp. (BC, Financial) in the early 1960s:
“Brunswick did have a pretty good lock on the pinspotter business, but the bowling boom contained within it the seeds of its own destruction, like all booms. Bowling alleys proliferated like gerbils, and a location that can support one bowling alley supports none when a second one moves in and they divide the business. Brunswick’s pinspotters had been sold on credit, and when many of their customers failed, Brunswick had a lot of slighted used pinspotters, enormous loss, and that compounded growth rate was at an end; Brunswick managed to make it from 74 to 8 in one of the steepest dives of recorded history. You can look through and find other examples of companies which seemed to have found the golden path of stepladder earnings, only to falter.”
Stocks showing geometric earnings or revenue growth for a sustained period can lull investors into a false sense of security, only to leave them holding the bag when the infinite market opportunities are shown to be very much finite. More recent examples abound, such as that of Crocs (CROX, Financial). When Crocs went public in 2006, sales were booming and it seemed like everyone was buying into the fad. The stock shot off like a rocket, rising more than 400% by late October 2008. Then the music stopped, as tastes shifted, the fad ended and it became abundantly clear that Crocs were not about to become standard footwear across the world. Shares lost 98% in a little over a year.
Look out for irrational faddishness
Similar to the irrational belief in infinite growth, certain industries can find themselves in vogue and, thus, command tremendous valuation multiples. This can be true even of companies only adjacent to the industry, especially if the fad is enjoying mass attention. Sometimes, companies not connected to the trend at all will even try to get in on the action, as Goodman describes:
“There is really no reason why Uncle Harry's bra company cannot be known as Space Age Materials. We are in the space age and it does use materials. Teledyne has a Materials Technology Group that used to be Vasco Metals, and before that Vanadium Alloys Steel, but those are low price- earnings names these days.”
Company names or products that tap into a fad have not disappeared. One need only to look at the recent obsession over blockchain technology and cryptocurrencies to find a powerful example of the market’s hunger to buy a piece of “the future” at any price. Shares of Kodak (KODK, Financial) rocketed up 250% in short order when the company announced the introduction of its own cryptocurrency in January. Those shares have since plummeted back to earth thanks to the belated realization Kodak’s proposed foray into the crypto world was far less than advertised, but the lesson should leave investors sanguine.
Beware of day-traders and dilettantes
When people perceive other people making money, jealousy naturally sets in. During extended bull markets, everyone is making money and that tends to attract a swarm of dilettante investors and day-traders looking to get rich. This is a phenomenon played out during each market cycle, and observing its progression might offer serious investors real value, as Goodman is keen to note:
“Now that you have gotten the feeling of a kids' market, I can go on about the Jericho Indicator. It is related to the number of walls in Wall Street office buildings that come tumbling down. As more and more walls come tumbling down, the Indicator starts flashing. The reason the walls come tumbling down is that prosperity touches Wall Street, the partners have a meeting, they figure they could make twice as much money if they had twice as many registered representatives – brokers – on the telephone. They take over another floor, they move to another building. Tumbling walls are a slightly lagging indicator, but walls never tumble in a bear market.”
We highlighted this Goodman quote in an article back in November 2017, in which we discussed potential methods by which investors might be able to tell whether the stock market is overheating before it corrects – or crashes. But it deserves a further mention here, since it offers a powerful, if tongue-in-cheek, observation about market participants’ behavior during sustained growth cycles. As the good times keep rolling, more novices and dilettantes, many of them dispositionally disinclined to the serious business of investment, get into the market. As they do, more capital is put at risk and, when the correction inevitably occurs, these are the players that get burned. Of course, the days of massive brokerage staffs at banks is largely behind us thanks to the automation of trading and proliferation of simple platforms for amateur investors. But we can look to other signs in the vein of the Jericho Indicator. Certainly, the number of commercials advertising online trading platforms have grown at a worrying rate. Perhaps we should come up with a new and snappy name for the TV advertising indicator.
Disclosure: I/We own none of the stocks discussed in this article.
