“It’s different this time.” This phrase has likely cost many investors far more than they realize. Each period of time is indeed different. However, there are many insights that we can learn from history that should inform how we invest today. Failing to learn from the past mistakes of others can be hazardous to your wealth.
Q3 hedge fund letters, conference, scoops etc
The 1920s and the Great Depression
Consider these words from Benjamin Graham written in the 1930s in Security Analysis:
Considering the 1927–1929 period we observe that since the trend-of-earnings theory was at bottom only a pretext to excuse rank speculation under the guise of “investment,” the profit-mad public was quite willing to accept the flimsiest evidence of the existence of a favorable trend. Rising earnings for a period of five, or four, or even three years only, were regarded as an assurance of uninterrupted future growth and a warrant for projecting the curve of profits indefinitely upward…
As for the new-era view, which turned upon the earnings trend as the sole criterion of value, whatever truth may lurk in this generalization, its blind adoption as a basis for common-stock purchases, without calculation or restraint, was certain to end in an appalling debacle.
What Graham is referring to is the exuberance of the 1920s when growth stocks, perhaps best exemplified by radio companies such as Radio Corporation of America (RCA), appreciated in price to an unsustainable level of valuation. In the case of RCA the optimism was inspired by a novel technology that promised to change business and in the process produce copious profits for the company. Despite the fact that radio companies went on to a long and profitable future, investors who bought into them in the late 1920s did not do so well. Expectations embedded in stock prices matter.
The 1960s and the “Nifty Fifty”
The 1960s saw a group of companies emerge that became known as the “Nifty Fifty.” These were regarded as one-decision stocks whose businesses were so powerful that all one needed to do was to buy and hold them forever. They included such household names as Xerox, Polaroid, Eastman Kodak and Walmart. Not only did these have attractive growth rates, but they also possessed strong, entrenched competitive positions. In a number of cases the very name of the company became a verb, so dominant were they in their markets.
If you were an investor in the 1960s, you too might be hard pressed to find any flaw in the business models of these companies or any reason why growth might slow in the foreseeable future. By now, the generation of investors who had first-hand experience in the 1920s and the subsequent collapse in the 1930s had largely exited, and once again price had become a distant secondary consideration to the perceived quality of the companies.
Investors were again lured by the appeal of a bright future combined with an easy explanation to their clients as to what was in their portfolios. Who could blame a portfolio manager for owning stocks of such household names with which most clients were intimately familiar? Again investment theses were formulated that described only the quality of the business and its growth prospects, but made no mention of the price and why it offered an attractive return.
Incidentally, one investor was not fooled. His name was Warren Buffett, a young fund manager and Benjamin Graham’s best student, who after over a decade of stellar results wrote to his clients in 1969 and informed them that he was closing the partnership in large part due to a lack of attractive investments. What made him find the qualitative aspects offered by the Nifty Fifty as insufficient to make them attractive investments?
Warren Buffett knew that an investment thesis that can be made without any reference to the purchase price describes speculation, not investing. All investments are unattractive at some price, and the well-regarded companies of the day had reached such a price in his estimation. Thinking from first principles rather than following conventional wisdom is one of the things that the best investors do that the rest don’t.
Just as the 1930s deflated the stock market optimism of the 1920s, the 1970s deflated the inflated valuations of the 1960s. Investors again learned that purchase price matters and that simply buying well-known good companies is not necessarily a path to superior investment results.
The 1990s and the Tech Bubble
Decades passed, and the generation of investors active during the 1960s and 1970s had largely left the markets. Another new technology came on the scene, only this time instead of radio it was the internet. Just like radio, the technology was real and had great potential to create wealth and value for companies and consumers alike.
Again stock prices became secondary and all focus shifted to the growth potential of the businesses of this new age. New business models emerged, in some cases producing very little revenue, much less profits. Unfazed, investors created new metrics to value these new-age champions. For those companies lacking meaningful revenues metrics such as “price to eyeballs,” referring to the number of visitors to their websites, came into vogue. So potent was investor infatuation with internet-related companies that even old-economy businesses received a substantial stock-market boost merely by adding a “.com” after their name, regardless of whether their businesses actually had anything to do with the internet.
Those investors who resisted and insisted on old-fashioned metrics based on profits and cash flows were labeled as dinosaurs who were too set in their old ways to be able to “get it” in this new environment. Their clients deserted them. Their bosses replaced them with more open-minded portfolio managers who were not bent on throwing a wet blanket on the party by reminding those around them that the prevailing prices could not possibly be justified by any reasonable expectation of growth.
This irrational exuberance however did not extend to many old-economy companies whose stocks languished, and were available at attractive valuations. Who would want to invest in these companies? They had nothing to do with the excitement of the internet and offered only moderate growth prospects. Yes, their stocks were inexpensive, but could one really afford to let their friends or clients at a cocktail party know that their portfolio was full of these industrial dinosaurs rather than the exciting new businesses that everyone else was gushing about?
We know how this ended. For some companies it turned out that eyeballs were not quite enough because they never translated into real profits due to flaws in the business model. For others, the companies did well, but just like in the 1920s and in the 1960s the expectations embedded in their stock prices were simply too high. Good company performance did not translate into good stock market returns. The old-economy companies that were steadily growing profits and inexpensively valued were once again appreciated by investors after many suffered severe losses in 2001-2003.
The Housing Bubble and the Great Recession
This time it didn’t take decades for new excesses to appear in the capital markets. Lower interest rates, which were implemented in part to limit the damage from the collapse of the internet bubble, quickly led to inflated stock prices. These low rates created a new bubble – in house prices.
Investors correctly observed that house prices had never declined substantially at the national level. Therefore it was perceived that what had never happened could never happen in the future. And since housing prices couldn’t decline, housing-related securities could be levered using various financial engineering techniques in a way that amplified both the returns and the losses, should the latter materialize.
Everyone played along – the investment banks, the rating agencies, the banks, the government and the investors. After all – it’s land, and how could land decline in price since they don’t make it anymore? Warning signs, such as the rapid rise of speculation by the public which started buying and flipping second and third houses were ignored. Credit standards were relaxed so that anyone could get a mortgage. The originators of these mortgages had even seemingly gone out of their way to sell mortgages that the customers had little realistic hope of ever repaying them based on their income. Why should the banks have cared? They weren’t going to keep the mortgage and be on the hook for any losses, they were going to pass it along to others through various derivative securities backed by these mortgages and spread them far and wide throughout the investment world.
The big underlying assumption – that house prices could not decline at the national level – was the mantra on which the whole house of cards was built. But what is true at one price is no longer true at another. House prices had never severely declined in the past – that was true. However, house prices had never been so high relative to various measures of affordability, such as income, nor relative to alternatives, such as rent. What was true at one price was not true at another, much higher price.
The subsequent collapse in house prices almost destroyed the financial system because of the various derivative financial instruments that magnified its impact. A number of financial companies failed or were sold off at deeply distressed prices as a way to limit the damage. The recession that ensued was accompanied by stock prices changing from exuberant to distressed. Investors were yet again reminded that the purchase price of an investment always matters, no matter how attractive the underlying business or asset.
The Current Investing Landscape
It’s easy to talk about the past, hindsight is 20/20. More than a decade since the Great Recession of 2008 began, the environment has again changed from despondent to very optimistic. Are we in a bubble? Are stock prices highly irrational? That is always very hard to know in real time. Yet there are some signs that we can use to determine where we are in the cycle for asset prices. Consider some of these recent phenomena:
- New, previously unseen business models have once again emerged and are widely considered to be nearly unstoppable
- The price of investments is once again considered secondary by many, as long as the underlying company is one of these few, inevitable businesses whose scale and economic characteristics seem to guarantee growth and dominance for decades to come
- New, speculative instruments are being created and eagerly traded by investors-turned-speculators. Initial Coin Offerings (ICOs), anyone?
- Overall valuation levels are substantially above long-term history on many metrics
- Few legitimate bargains can be found in the stock market that combine both sufficient business quality and a margin of safety in the form a price that is at a meaningful discount to the intrinsic value of the underlying business
- Interest rates, held low for many years, have been rising
- The economy has been very healthy for a number of years, with resulting cyclically high levels of profits for many industries
Conclusion
It is different this time. It is different every time. The exciting new industries change. The specific macro-economic circumstances vary from one period to another. The speculative asset du jour is different, as are the specific reasons behind prevailing market optimism that increases prices to high levels.
Here is what is not different: the price of an investment always matters. It matters for new business models that are growing rapidly and it matters for old mature ones. It matters for companies that appear completely dominant in their markets and for those that have a less entrenched competitive position. It matters for assets that have previously declined in price and for newly minted asset classes whose history is short. Any time you are considering making an investment without taking into account both the quality of the company or asset being considered and the purchase price of the investment, beware – you may be putting your wealth in jeopardy, as many have done in decades past.
Note: An earlier version of this article was published on Forbes.com and can be found here.
Article by Behavioral Value Investor
