Stocks I'd Avoid
Peter Lynch is viewed by many in the investment industry as the greatest mutual fund manager of all time. It is not difficult to see why. The numbers tell the tale. Lynch managed the Fidelity Magellan fund from 1977 to 1990. Magellan’s performance trounced the S&P 500 over Lynch’s tenure producing an average annual return of over 29% vs the index’s return of 15%. Lynch’s 13-year track record remains untouchable to this day and created a legion of adoring fans who’ve studied his investment philosophy and attempted to replicate it within their own portfolios. Fortunately for his followers, in addition to being a tremendous stock picker, Peter Lynch is also a prolific author publishing three best-selling books. Lynch’s most famous work, widely read by both professional and casual investors alike, “One Up On Wall Street” was published in 1989. The book is full of timeless investment advice and is truly a must read for anyone interested in becoming a better investor.
There is one chapter of Lynch’s 1989 classic that we believe is especially relevant in the investment environment that we find ourselves in today. Chapter 9 is titled, “Stocks I’d Avoid.” Here are the first two paragraphs from that chapter:
“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train and succumbing to the social pressure, often buys. Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there’s nothing but hope and thin air to support them, they fall just as quickly. If you aren’t clever at selling hot stocks (and the fact that you’ve bought them is a clue that you won’t be), you’ll soon see your profits turn into losses, because when the price falls, it’s not going to fall slowly, nor is it likely to stop at the level where you jumped on.”
The definition of “hot stocks” and “hot industries” is open to interpretation. With that said, we have no doubt that many would agree that there is nothing hotter today than artificial intelligence. Over the last few months, it has become almost comical to count the number of times that senior managers mention the term “AI” on their earnings calls. They’ve certainly taken note that even the most peripheral connection to artificial intelligence can equate to billions of dollars of additional market cap for their stocks.
If artificial intelligence is the hottest industry today, then there is only one choice for the hottest stock within the AI world. Nvidia (NVDA) takes the prize hands down. NVDA designs and manufactures specialized computer chips called graphic processing units or GPUs. GPUs have been a hot commodity for several years within high powered gaming computers, but demand is seemingly at an all-time high over the last few months as the AI revolution has begun. According to management, the special capabilities of these high powered (and expensive) GPU chips will be in extremely high demand from cloud service providers as they look to reconfigure and build out data centers capable of producing cutting edge artificial intelligence.
The excitement for NVDA hit an all-time high after management announced Q1 earnings after the market closed on May 24, 2023. When the market opened the morning of May 25th, NVDA’s stock jumped over 24%, which is an enormous one-day move for a company that was already valued at a total stock value of $754
billion at the start of the day. The company added more than $184 billion on May 25th alone, finishing the day at a total stock market capitalization of $938 billion. To put NVDA’s one-day move into perspective, a $184 billion increase is larger than the total stock market value of Nike ($174 billion), Walt Disney ($167 billion) and Texas Instruments ($160 billion).
There are many wall street prognosticators and talking heads who are more than content to ride the exuberance of the AI wave. They would likely claim that we’re simply experiencing a case of sour grapes as we’ve missed out on the almost 200% stock gain for NVDA since the beginning of the year. It is true that recent gains in some of the largest, highest flying, tech stocks have tested even the most disciplined fundamental investors. However, we would also point out that we aren’t the only ones who’ve missed the party. In fact, almost all the forty-six professional stock analysts who follow NVDA and their competitors in the semiconductor industry failed to predict the meteoric rise in value over the past month. On May 24th, prior to NVDA’s earnings announcement, the average price target among the forty-six professional analysts was $305/share. The very next day, following the 24% increase in NVDA’s stock, the average estimate was boosted almost 50% higher to $445/share.
Do we think NVDA’s current stock price of ~ $425/share represents a risky investment proposition? Absolutely, but don’t just take our word for it. Benjamin Graham, who was Warren Buffet’s professor and mentor at Columbia Business School, laid out the potential risks for high-flying growth stocks like NVDA in the 1949 edition of his classic work, “The Intelligent Investor.” In his book, he stated two “catches” to the growth investing approach:
“The first is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgement of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgement as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases it turns downward.”
What lessons can be gleaned from Professor Graham’s writings almost 75 years ago? Is there a risk that much of NVDA’s potential is already reflected in the current price? Let’s take a look:
The chart above covers a period from mid-October 2022 to the current date. The top half of the chart shows that NVDA’s stock is up over 250% from the Oct 2022 lows. The bottom half provides the 12-month trailing price-to-sales (PS) valuation metric. Is a trailing PS ratio of 41x expensive? We would argue that it is. For comparison, the S&P 500’s PS ratio is currently 2.4x, meaning that NVDA is roughly 17 times more expensive than the stock market. Seems like a lot! Another way to think about NVDA’s PS ratio is that, assuming constant sales, it would take investors, at today’s share price, 41 years to make their money back if the company paid a dividend that was equal to 100% of REVENUE. 41 years seems like a long time to get your money back. Also, how plausible is it for a company to pay a dividend equal to 100% of revenue? Well, according to Scott McNealy, the CEO of one of the late 1990s tech bubble darlings, Sun Microsystems, it’s not too likely. Here is a quote that he gave in a Bloomberg interview post bubble deflating:
“At 10 times revenues, to give you a 10-year payback, I have to pay 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?”
That is a direct quote from someone who lived through a massive bubble and after the fact basically told investors they were crazy to buy his stock at 10x price-to-sales. NVDA is currently four times more expensive than Sun Microsystems was at its peak. While we would not expect the same degree of humility from Nvidia’s CEO, Jensen Huang, if his company’s shares don’t live up to the current level of excitement, we do believe it is instructive to recall historical periods that seem to rhyme with today’s environment. Another case study from the 1990s that we believe is worth reviewing is that of Cisco Systems, Inc. (CSCO). There was building excitement for CSCO shares in the late 90s as a leading provider of networking equipment in a rapidly changing world in which everything would soon be connected to the internet. Here is a chart for CSCO from January 1999 to March 2000:
See any similarities to the NVDA chart? Not only did CSCO experience a similar run toward the end of the tech bubble with its stock rising close to 250%, but it also peaked with a price-to-sales ratio of close to 40x. March of 2000 marked the top for CSCO shares. From there, the share price dropped over 30% to $55/share in May of 2000 only to bounce back 25% to $68/share in early September. Unfazed by the market tremors in the summer months, the CEO of Cisco, John Chambers, told investors that his company could keep growing top-line revenue by at least 50% annually. He argued that “logic would indicate this is a breakaway.” How did “logic” turn out for investors? The chart below shows the performance of $100,000 invested in CSCO shares at the peak in March 2000 held through June 2023.
As you can see, not including dividends paid, the $100k investment in CSCO lost close to 90% of its value by October 2002 and, if held for the last 22 years + would still be worth only $64k.
Does the fact that NVDA sells at close to the same multiple that CSCO did shortly before the tech bubble burst imply that NVDA shareholders are likely to suffer a similar fate and experience a negative price return over the next 20 years? Absolutely not. Further, we don’t pretend to be experts on artificial intelligence. We could not begin to explain all the current and future uses for AI that will no doubt have a meaningful impact on the way we live our daily lives. Rather, our expertise lies in an area that the stock market hasn’t had much use for over the last eight months, fundamental investment analysis. Critics would say that strict fundamental analysis leads to investors missing out on large returns emanating from some of the latest investment opportunities in
life changing technology. Those critics are the same investors on TV who have been touting the “new bull market” in recent weeks. As John Kenneth Galbraith wrote in A Short History of Financial Euphoria, “financial genius is before the fall.” It is easy to jump on the band wagon and look smart when certain areas of the market are seemingly defying gravity. However, from years of reading and studying the history of financial markets, we can confidently say that none of the investment greats that we are familiar with including Peter Lynch, John Templeton, Ben Graham, Jean-Marie Eveillard and a handful of others, who have documented track records of outperformance lasting multiple decades, attribute their success to riding the hot investment wave of the moment. Speaking of investment greats, Warren Buffett is probably the most famous. Buffett further enshrined his status as one of the all-time greats by sitting out the tech boom of the late 1990s. While it proved to be the right call, he was largely criticized in the media in the years leading up to the crash. Here is a famous quote from his 2000 shareholder letter that captured his view of the market environment at the time:
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities, that is continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future, will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands."
Over the last few years, we’ve experienced “doses of effortless money” that Buffett couldn’t have even imagined back in 2000. While we can’t be sure when and how the investment fallout will occur; we do believe it will happen and that it will create tremendous opportunity in its wake. As tempting as it may be to jump into the best performing areas of the market, we understand that air comes out of the balloon much quicker than it went in. Therefore, we chose to be patient, remain disciplined and be ready to strike when the opportunity presents itself.
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