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A Swarm of Gnats

In our 2Q letter to clients I tried to highlight the activity we see today (mostly related to the pandemic) as opposed to the long-term problems and opportunities for which we’re preparing (beyond the pandemic). It's something that's applicable to enterprise, as owner-operators, as well as our investing focus. It should be clear, both from these writings and our work over the years, that we are less concerned with the topic du jour and more concerned with what’s coming down the pike. To borrow a quote from our 2Q letter:

“Good investing is not rapidly buzzing around the lightbulb like a swarm of gnats worrying about the next three months. As the yoga class teaches, it helps to slow down the breath and pace and think longer and slower than many around you. While industries and events and geo-politics are always changing, we have seen little evidence over history that “people” really change behavior. People do crazy things in euphoria, crawl into self-inflicted holes in a panic, and then swear not to do it again.”1

There's been a lot of "swarm of gnats" action in the financial markets this year. Exhibit A: promotion of Robinhood investing accounts on Facebook using Telsa stock performance…

Many are also concerned about the U.S. election. It’s an important event, but the investing implications are less clear. What we can say with some confidence is that regardless of which party is in power, there will be a lot of deficit spending in the next four years, the national debt will climb significantly, and the Federal Reserve will continue to be directly involved in the financial markets. As one manager said to me last week, “free markets left the building a long time ago.”

Many are also in love with large-cap glamor stocks. The most expensive stocks in the S&P 500 (the top 10% of stocks in that index by price/sales ratio) now trade - as a group - at greater than 12x sales. Compare that to a still very lofty 8x just five years ago, or the median price/sales valuation for the S&P 500 index which is closer to 2x sales2.

These kinds of sales multiples call to mind a famous quote from Scott McNealy, founder and CEO of Sun Microsystems, one of the market darlings in the late 1990s. The quote is often referenced when discussing wildly stretched valuations, but it's fun to revisit so I'll share it again here. At its peak, Sun Microsystems traded at $64 per share, more than 10x sales per share. By the end of 2002, the stock was down to $5 per share. Here is McNealy reportedly speaking to Bloomberg in April 2002:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”3

This is not to say that the same fate is automatically in store for today's market darlings. Different companies, different competitive advantages, and very different cost of money (the 10-year Treasury yield began 2000 at 6.45%, versus roughly 0.75% today, an enormous difference, and significant in that real interest rates are now decisively negative) which is unlikely to change any time soon. But if you are going to pay > 12x sales for a stock, the earnings growth better be outstanding for a long time.

1. http://covestreetcapital.com/wp-content/uploads/CSC-Strategy-Letter-40-June-2020-1.pdf

2. https://www.hussmanfunds.com/comment/mc200901/

3. https://thefelderreport.com/2017/10/26/what-were-you-thinking/

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