Behold the 'New Era'
Nearly a century ago, Benjamin Graham, father of value investing and mentor to Warren Buffett, wrote:
One of the striking features of the past five years has been the domination of the financial scene by purely psychological elements. In previous bull markets the rise in stock prices remained in fairly close relationship with the improvement in business during the greater part of the cycle; it was only in its invariably short-lived culminating phase that quotations were forced to disproportionate heights by the unbridled optimism of the speculative contingent.
But in the 1921-1933 cycle this ‘culminating phase’ lasted for years instead of months, and it drew its support not from a group of speculators but from the entire financial community. The ‘new era’ doctrine – that ‘good’ stocks were sound investments regardless of how high the price paid for them – was at bottom only a means of rationalizing under the title of ‘investment’ the well-nigh universal capitulation to the gambling fever.
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The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic1
Much has been written about how a handful of tech stocks (the “Magnificent 7”) have been responsible for the majority of gains in the S&P 500 index over the past year. But Graham’s ‘new era’ doctrine - that ‘good’ stocks are sound investments regardless of how high the price paid for them - applies to far more than the Magnificent 7.
Take Costco ( COST 0.00%↑ ), for example. By almost any metric, it’s as expensive as it’s ever been in history:
It currently trades at a 38x multiple of estimated 2026 earnings. Its current earnings yield is 1.95% when you can buy risk free 10-year treasurys yielding 4.177%.
Even assuming operating profit margins remain at record highs (nearly 10% higher than the highest levels ever reached pre-Covid), if sales grow at the expected ~6.5% / year it would take >10 years to merely reach the earnings yield that risk free 10-year treasurys currently yield!
Everyone knows that Costco is a good company. But does it make sense that “‘good’ stocks [are] sound investments regardless of how high the price paid for them”? Is it likely that nobody else has figured out these stocks are “good”?
You don’t need a calculator or spreadsheet to realize that this seems like a bad bet, yet there are countless other companies, outside the much talked about “Magnificent 7”, that seem similarly overvalued. Quite simply, the companies that everyone knows are “good” appear to be the most egregiously over-priced.
AI
Replace “good” with “AI” in the quote above - does it make sense that “‘AI’ stocks [are] sound investments regardless of how high the price paid for them”? Whether or not you believe AI is real, hype, or somewhere in-between, price should still matter.
ARM Holdings ( ARM 0.00%↑ ), a semiconductor company whose designs power most of our smartphones, currently trades at 40x sales. Analysts expect it to grow 23% next year. This is a higher valuation than Cisco, the poster child of dotcom bubble, was trading at during the peak of the bubble, except that Cisco was growing faster and was far more profitable.
Cisco has grown revenues and profits nearly 3x since 2000, yet its stock price is still 36% below its bubble peak:
Sun Microsystems was also a darling of the dotcom bubble and traded at 10x sales during the peak. Afterwards, the CEO said:
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?
Currently, 62 companies in the S&P 500 trade at >10x sales and 25% of the companies in the NASDAQ-100 trade at >10x sales. Not all of those companies are necessarily overvalued; but, if in hindsight, 10x sales was “ridiculous”, what is the word for ARM Holdings trading at 40x sales?
Price matters. It seems odd that something so uncontroversial needs to be said, repeated and relearned every generation. The same investor who would gladly pay 10x the price (of a traditional auto maker) for Tesla stock would be unlikely to pay $500,000 for a Model 3. But, as John Kenneth Galbraith famously said:
There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of the those who do not have insight to appreciate the incredible wonders of the present.
Current Portfolio
Despite my curmudgeonly inability to appreciate the “incredible wonders of the present”, I have found a few new promising companies. My current portfolio is:
BUD
EBAY
Sega Sammy Holdings (TYO:6460)
Fevertree Drinks PLC (LON:FEVR)
BrainPad Inc (TYO:3655)
Kakaku.com Inc (TYO:2371)
Fuji Corporation (TYO:7605)
Okamoto Industries (TYO:5122)
BEENOS Inc (TYO:3328)
WingArc1st Inc (TYO:4432)
Seria Co Ltd (TYO:2782)
Cash (63%)
Some of these companies (like BrainPad Inc) were acquired at far lower prices, and it’s less obvious that they represent good value or have any margin of safety today. But others, like Sega Sammy Holdings Inc, appear to be both high quality businesses and extremely cheap to me.