Renowned value investor and Graham-Dodd disciple Howard Marks (Trades, Portfolio) freely shares his investment philosophy by way of his memos to clients of Oaktree Capital Management. Marks' 2017 memo,Â “There They Go Again… Again,” is particularly instructive for investors today as it raised points about risk that many still enamored of the heady days neglect to incorporate into their security analysis. Against a historical backdrop, Marks asked questions concerning risk that many have dismissed as outdated, or irrelevant.
Marks used the lofty valuations of the FAANG stocks to illustrate how investors can miss signals, reliably present in other bull markets, that should inform or guide their investment decisions. In an environment where the market has suffered no prolonged downturns for an extended period, “propositions are accepted that would be questioned if investors were more wary,” he said.
Marks listed several factors that are common to every bull market and that can create the "seeds for a boom.” Their presence makes assessment of the risk-reward tradeoff more difficult. Here are some of the factors that have particular relevance to the valuation levels of the FAANG stocks and whether they are consonant with intelligent risk analysis that underlies all successful value investing:
- A benign environment – good results lull investors into complacency, as they get used to having their positive expectations rewarded.
- A grain of truth – the story supporting a boom isn’t created out of whole cloth; it generally coalesces around something real. The seed usually isn’t imaginary, just eventually overblown.
- Early success – the gains enjoyed by the “wise man in the beginning” – the first to seize upon the grain of truth – tends to attract “the fool in the end” who jumps in too late.
- More money than ideas – when capital is in oversupply, it is inevitable that risk aversion dries up, gullibility expands, and investment standards are relaxed.
- Willing suspension of disbelief – the quest for gain overcomes prudence and deference to history. Everyone concludes “this time it’s different.” No story is too good to be true.
- Rejection of valuation norms – all we hear is, “the asset is so great: there’s no price too high.” Buying into a fad regardless of price is the absolute hallmark of a bubble.
- The virtuous circle – no one can see any end to the potential of the underlying truth or how high it can push the prices of related assets. It’s broadly accepted that trees can grow to the sky: “It can only go up. Nothing can stop it.” Certainly no one can picture things taking a turn for the worse.
It is important to note that Marks didn't denigrate or dismiss outright the viability, growth prospects or success of the tech group:
“The FAANGs are truly great companies, growing rapidly and trouncing the competition (where it exists). But some are doing so without much profitability, and for others profits are growing slower than revenues. Some of them doubtless will be the great companies of tomorrow. But will they all? Are they invincible, and is their success truly inevitable?”
Marks asked an important question that is not inconsistent with the heretofore phenomenal success of the tech stocks: Though the stars of the group for the past decade have been shining the brightest, in part because they have been sector disrupters, is the upward trajectory of the group foreordained or destined to continue forever?
Marks cited the following passage from a company’s 1997 letter to shareholders to help illustrate his point.
“The corporation in question stated that, 'We established long-term relationships with many important strategic partners, including America Online, Yahoo!, Excite, Netscape, GeoCities, AltaVista, @Home, and Prodigy.'”
Marks then asked the following rhetorical question:
“How many of these 'important strategic partners' still exist in a meaningful way today (leaving aside the question of whether they’re important or strategic)? The answer is zero (unless you believe Yahoo! satisfies the criteria, in which case the answer is one).”
The quotes above came from Amazon’s 1997 annual report, and the important lesson, Marks said, is that “the future is unpredictable, and nothing and no company is immune to glitches.” Many analysts covering the FAANG group seem to have forgotten that a technological edge is often evanescent or ephemeral.
The above example incorporates the argument some of the FAANG companies are using to support their contention that anti-trust actions are neither needed nor warranted. As they are fond of suggesting to regulators, today’s Facebook could become tomorrow’s Netscape. Yet it is noteworthy that, a moment after, Facebook conveys a somewhat different message to its shareholders concerning its prospects for the future.
Marks did not buy the notion that the skyward flight of the tech group can continue unabated, saying that “the perpetual motion machine, is unlikely to work forever.” His characterization clearly challenged the “this time it’s different” school of thought, which many analysts subscribe to. It suggests, erroneously, that because of the seemingly gravity-defying rise of the FAANG group, investors should discard traditional valuation measures in favor of novel security analysis that can better fit the group's continued earnings growth projections.
As noted above, this specious argument is one of the seeds of boom that indicates appropriate measures of risk are being ignored.
Marks suggested that some healthy skepticism is warranted when there is euphoria over a group of “super-stocks that lead a bull market:"
"The prices investors are paying for these stocks generally represent 30 or more years of the companies' current earnings. There are clear reasons to be excited about their growth in the near term, but what about the durability of earnings over the long term, where much of the value in a high-multiple stock necessarily lies?"
The approach to investing adopted by far too many investors and analysts is ahistorical, Marks suggested:
“Some of the 'can’t lose' companies of the Nifty-Fifty were ultimately crippled by massive changes in their markets, including Kodak, Polaroid, Xerox, Sears and Simplicity Pattern (do you see many people sewing their own clothes these days?). Not only did the perfection that investors had paid for evaporate, but even the successful companies’ stock prices reverted to more-normal valuation multiples, resulting in sub-par equity returns.”
Although there are significant differences between the internet market boom-bust cycle ending in 2000 and today’s stellar FAANG performance, Marks reminded us that history and human nature are constants. In many cases, they will provide harsh lessons for those who cannot appreciate the folly of trying to predict future value based on backward-looking performance.
By sayings this, Marks is restating the timeless wisdom of Graham and Dodd’s principle that earnings projections far into the future cannot possibly be quantified with specificity nor any measure of confidence, because such an endeavor, in the end, amounts to little more than guesswork.
Marks opined that valuations were already excessive in 2017. His view was colored by the presence in the market of confluent factorsÂ endemic to bull markets thatÂ ordinarily should give experienced investors pause. Instead, they caused many to throw caution to the wind. One likely culprit? "Fomo." Marks correctly noted:
“Fear of missing out – when all the above becomes widespread, optimism prevails and no one can imagine a glitch. That causes most people to conclude that the greatest potential error lies in failing to participate in the current market darling.”
Marks did not contend that “stocks are too high and the FAANGs will falter.” Rather, he noted that in the 10-year-old bull market, disciplined value investors should ask whether the valuation risks are consonant with the potential rewards:
“All I’m saying is that for all the things listed above to simultaneously be gaining in popularity and attracting so much capital, credulousness has to be high and risk aversion has to be low. It’s not that these things are doomed, just that their returns may not fully justify their risk. And, more importantly, that they show the temperature of today’s market to be elevated. Not a nonsensical bubble – just high and therefore risky.”
Using Marks' framework, investors should question whether extravagant valuations of some celebrated stocks in 2019 are worth the risks they may have understated or deliberately ignored.
I have no position in any of the securities noted above.
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