“Those that fail to learn from history, are doomed to repeat it” – Winston Churchill
“I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.” – Charlie Munger
Whether we realize it or not, history shapes our psychology. Experiences lead to knowledge, which leads to actions, which lead to experiences, and so on. Historical events, whether lived or studied, seem obvious in hindsight and the lessons learned become ingrained. Whether those lessons are the right ones is a different story. Internally, people vow to “never do that (again).” But humans have short memories and overpowering emotions. On the other hand, being too regimented and applying a granular lesson across broad and varying contexts can also lead to trouble. Externally, guardrails in the form of laws and regulations are created to prevent negative outcomes from happening again. Sometimes they accomplish their goals, but often create unintended consequences, particularly when the outcomes are addressed as opposed to the root causes. Deriving the proper lessons is a tricky balance. It’s necessary to understand what happened and why, but the future outcomes change given what already occurred is now known.
There are a plethora of behavioral and memory biases that lead us to more easily recall readily available, salient, and confirmatory information. Further, we tend to remember the conflicts, crises, and crashes more than the boring, incremental progress in between. Most investors know of Black Monday, when global markets crashed and the Dow dropped almost 22% in one day, yet don’t know the Dow ended positive on the year. But such a shocking event is indelible. Similarly scarring was the popping of the tech bubble. And then the Great Financial Crisis. And recently, the COVID-19 crash. Each time, “lessons” were learned, and re-learned, yet the market ultimately climbed to greater heights. But has the market been too resilient this year? Is it now at unjustifiably high levels? There is a growing divide between those who believe:
- The market is in a bubble. This is just like the late 1990’s. Retail traders are enthusiastically driving up prices to unsustainable levels, and the market will eventually crash again. Money-losing companies are soaring to insane valuations, while others that actually are profitable are being left for dead. Investors chasing higher prices are the greater fools. Just take the mega-cap “tech” stocks’ valuation, performance, and market weightings as an example of the absurdity. Oh, and have you seen the economic trends lately?
- The market is not in a bubble. This is not far from the late 1990’s. Some retail traders are being frivolous, but their impact is overstated. Besides, the buyers of dips have been consistently correct while the doomsayers have been consistently wrong. Investors chasing mature, cheap stocks aren’t skating to where the puck is going. Today, unlike two decades ago, technology and the Internet are ubiquitous and essential. Just take the mega-cap tech stocks’ valuation, performance, and market weightings as an example of how integral digital-native companies can become to society. Oh, and have you seen the economic trends lately?
What an exciting time to be investing. Conviction is strong on both sides, but open-mindedness is far superior to dogmatism. In this piece, I’ll explore both to see what I can learn from each, and therefore, have an opinion. Charlie Munger is, after all, a wise man.
The 1’s look at the past and use historical data and analogies to predict the future. What do similar periods in history suggest is likely to happen in the future. In forecasting, they take the outside view and overweight base rates.
The 2’s look at the present and use trends and extrapolation to predict the future. What does the present suggest about the future and how much more room is there to go. In forecasting, they take the inside view and underweight base rates.
Three broad topics usually come up: Value vs Growth, interest rates, and market valuation.
The Value vs Growth debate is never-ending and quite fervent. Personally, I believe it’s completely irrelevant and the categorizations are an unfortunate muddling of semantics, but that’s for another post. Obviously, the 1’s are in the “value” camp and the 2’s are in the “growth” camp. The 1’s are incidental experts in stoicism, but are hardened by the 1000th study on long-term “value” outperformance (how many out-of-sample years are needed for it to be disproven?). The 2’s are incidental expert stock pickers, but don’t really understand and/or care about intrinsic value (how does DBNER or the “Rule of 40” correlate with incremental returns on investment and owners earnings?).
In all seriousness, over the past decade, and especially this year, “growth” stocks have massively outperformed “value” stocks. The divergence is now at historical extremes. Will it mean-revert? The 1’s believe so, citing history. The 2’s don’t, citing a new paradigm. Is it absurd for “growth” to outperform when many of the companies are unprofitable? Not really. Simply because a company is currently losing money doesn’t mean it always will. Many “growth” stocks are usually younger companies, so unprofitability is natural. The 2’s view rapid top-line growth and heavy opex spending as beneficial for achieving scale, eventually leading to massive profits. The 1’s view unprofitability as a sign of an unproven business model, and they discount the future profit expectations as wildly optimistic. But the 2’s don’t want to miss out on a potential multibagger, taking the venture capital playbook to public markets. The 1’s are unwilling to pay up for what could be a tremendous winner when there are plenty of solid businesses priced much more “cheaply.”
What the 1’s should realize is that technology is increasingly impacting all industries and enabling much greater efficiency and productivity. Because software continues to eat the world the opportunities for companies that have built a better, faster, or cheaper mousetrap with customer lock-in and essentially zero marginal costs are massive. Long runways for value-added growth, or in other words extended capital advantage periods with high reinvestment rates of return in large addressable markets, can certainly justify seemingly elevated valuations. Additionally, most “value” stocks have been “cheap” for a while, so how likely is it the market is missing something blatant? Moreover, “value” stocks were supposed to outperform in a recession, yet this year has proven otherwise.
What the 2’s should realize is that a lot can change between the present and future, and that price matters for expected return. In a dynamic capitalistic system, extrapolating current trends can be dangerous. During good times, time horizons become stretched. But they can compress rather quickly, as March showed. Even a slight downgrade in expectations will have a meaningful impact on price when almost all the value is derived far in the future. A company’s prospects might be incredible, but it may already be priced in, which is much harder to decipher. Further, paying a higher price serves to reduce implied returns and, importantly, the margin of safety. Price is pulled towards intrinsic value in the long run. So although DCFs are blunt tools, they are still beneficial for sanity checking the embedded expectations in any intrinsic value estimation. Lastly, how fast a company is growing is less relevant than commonly believed. How efficient it’s growing, and for how long, determines value. Hyper-growth does not mean hyper-value creation.
Valuation is also influenced by a common denominator: interest rates. Interest rates serve as the basis for opportunity costs and discount rates. Lower interest rates denote a lower discount rate, which translates future cash flows into a higher present value. And higher interest rates into a lower present value. In his latest memo, Howard Marks provides a pretty comprehensive, yet somewhat debatable, discussion on the impacts of low rates. It’s well worth a read, though makes some stretch conclusions.
Like Marks, the 1’s believe low rates have distorted the investment landscape causing investors to seek riskier assets in search of higher returns. Low rates offer inadequate returns, so asset allocations must shift up the risk spectrum. Further, low rates coupled with the Fed’s reaction function to cut the Fed Funds rate at any sign of market volatility have lulled investors into complacency. Some even pronounce that markets are dependent on low rates and the Fed. And don’t even get them started about the ballooning corporate debt and federal deficit. Thus, because rates are historically low, they should and will drift higher, leading to lower equity prices.
The 2’s believe low rates actually signify risk aversion because investors are buying risk-free bonds, bidding up their price and down their yield. Further, the downward trend in rates has been going on for decades, so it makes sense to believe low rates will persist. With this extrapolation, growth and long duration assets are much more attractive. Besides, any increase in rates wouldn’t affect their risk appetite nor a hyper-growth business’ value. Both depend on the company’s growth, not the level of rates.
What the 1’s should realize is that the market, not the Fed, prices long-term rates, which are the basis for discounting. The long end of the treasury curve is primarily influenced by growth and inflation, and only marginally by the short end, risk aversion, and supply and demand. Both growth and inflation have been coming down for decades. Further, the Fed was forced into cutting short term rates last year and again this year when the market inverted the yield curve. So the Fed isn’t “suppressing” long-term rates; in fact they are keeping short-term rates low to try to stimulate economic growth and inflation.
What the 2’s should realize is that discount rates incorporate the risk-free rate as well as a risk premium, which should be much higher for younger, less predictable companies than for more mature, stable ones. Sure, recurring revenue is in a sense predictable, but the future growth rate, churn, and incremental return on invested capital are not. Also, if rates were to rise, the tailwind would almost certainly become a headwind even it doesn’t directly affect their risk appetite. Lastly, a rise in rates could come with a rise in inflation, which is likely to be more beneficial for “value” stocks due to the sector bias and greater proportion of tangible assets.
As a consequence, at least partially, of low interest rates, the market is more highly valued than its historical average. The most commonly used metric is the Price-to-Earnings (P/E) ratio, with a common variant being the Cyclically Adjusted Price-to-Earnings (CAPE) ratio. Currently, based on trailing twelve month earnings, which incorporates two quarters of a great economy and two quarters of an abysmal one, the market P/E is around 25 compared to its historical average of around 14 to 16. The CAPE is around 32, and has only been higher during the tech bubble.
The 1’s view the historical analogies and conclude there is only one way for the multiple to go: down. Elevated earnings multiples signify greed and exuberance, and they’ve naturally always given way to fear and reality. Therefore, here we go again.
The 2’s view the current P/E as misleading since the temporary economic shutdown has crushed earnings, leading to a higher-than-otherwise multiple. Once the economy progressively reopens, earnings will rapidly recover and the multiple will come down, without price needing to. Furthermore, unlike during the tech bubble, the technology sector is not built on a house of cards, and the high-growth companies deserve high multiples. At the macro level, compared to history margins and returns on invested capital are higher, inflation is lower, and both monetary and fiscal policy will likely remain stimulative, which should lead to a higher market multiple.
So, who’s right? Well, that’s impossible to know. Probably both; so, neither. In my opinion, “value” will outperform “growth,” and then “growth” will outperform “value.” Rates will rise, then fall. The market multiple will contract, then expand. Human nature, and thus the economy and markets, is cyclical. But let me elaborate.
As it pertains to the “value vs growth” debate, I’m not steeped enough in the academic research of factors to get into the weeds. Nor do I want to. What I can say is that, in general, stocks go up because they surpass expectations and down because they don’t. Michael Mauboussin and Al Rappaport wrote a fantastic and comprehensive book about it. As of late, “growth” stocks have clearly surpassed investor’s expectations while “value” stocks have not. But expectations evolve. The reason why “value” outperforms “growth” over time is precisely because of the fluctuation in expectations. “Growth” multiples can become exorbitant and “value” multiples can become unjustifiably depressed. The subsequent re-rating down of “growth” and up of “value” might be due to a change in company fundamentals, or simply sentiment. In the midst of a trend it’s difficult to predict what will make it reverse and even more difficult to accept that it could reverse if you’re on the winning side. But reversion to the mean is a well documented phenomenon. By how much and when, though, remain a mystery.
That’s why I agree with Joel Greenblatt who when asked if value investing is dead answers, “Yes, no, maybe, I don’t care” since his definition of value investing, like many others, is buying something for less than it’s worth, not buying based on low multiples. The hard truth is that simple fundamental metrics cannot delineate between a good or bad investment and cannot tell you what something is worth. Financial statements provide a generic picture of what has happened, not what will happen, which is where the real value resides. Undoubtedly there will be some massive winners from both the “growth” and “value” categories that will greatly reward investors for hanging on. But the reasons will not be because they were categorized that way.
As it pertains to interest rates, the current levels are abnormally low given the prevalence of negative nominal, as well as real, rates. But nobody can know where they will go, and investing on that basis means you think otherwise. Besides, when rates increased in 2013 and in 2017/18 the market did pretty well. Mathematically, present values are lower with a higher discount rate, but such precision is too simplistic when outcomes are heavily dependent on a multitude of factors. Why interest rates rise matters. Interest rates won’t rise just because historically they were higher; there need to be reasons such as a pickup in inflation or growth. Seeing as the U.S. is a rather mature economy, I’m skeptical we’ll see a material pickup in either. It should be well understood that monetary policy cannot independently generate inflation. Stimulative fiscal policy, on the other hand, might. This year the government has injected an unprecedented amount of money into the economy to fill the economic hole left by the pandemic-induced shutdowns. Modern Monetary Theory has gone from theory to reality very quickly. If the huge deficits persist or if a Democratic government passes tax reform to put more money in the hands of the middle class who are more likely to spend than save, inflation could perk up. In the end, though, forecasting inflation, and therefore rates, is impossible and useless to speculate on.
As it pertains to the market’s high valuation, when compared to rates the market is actually historically cheap. The equity yield (inverse of the P/E ratio) and bond yield have historically followed each other pretty closely. But since the mid 2000’s, the equity yield has been persistently higher, meaning that the equity risk premium has been higher than historically and that equities are relatively undervalued. Buffett also acknowledged this when he commented that if interest rates remain low, equities are “ridiculously cheap.” And that was when the 10 and 30 year around 2.25% and 3% respectively. Furthermore, an extraordinary paper by pseudo-anonymous twitter handle Jesse Livermore documented, among other findings, that earnings historically were overstated in periods of high inflation and that the Free Cash Flow-to-Net Income ratio is much higher now than before. In other words, the market looked-through the overstated earnings and didn’t apply a high multiple to them and companies are now generating more cash flow for every dollar of earnings than they did previously. This is also borne out by the Price-to-Free Cash Flow (P/FCF) multiple currently around its historical average, and far lower than it was in the late 1990’s. Shouldn’t investors pay more for current earnings since, ultimately, free cash flow is what matters to valuation?
Additionally, why should the P/E revert to it’s historical average? The economic landscape is completely different now, and so too is the composition of the market. The largest companies in the index have incredibly robust business models, as this year has once again proven, and are cash-generating machines with innovative cultures. Their valuations are not at all absurd; and in my opinion, they look like bargains. Share of mind goes a long way. Additionally, why couldn’t the market consistently trade at a 25 or 30 P/E? If the marginal investor is content with it, nothing. Some investors surely think I’m completely bonkers. Maybe. But I’d guess those investors are anchored to historical data or their lived experience. Negative yields were once thought to be ridiculous too. Yet here we are with a record $17 trillion in negative yielding debt. In my opinion, “because it hasn’t happened historically” is not a strong argument for why something cannot or should not happen. How many historical firsts happen on a daily basis? Norms evolve. Psychology changes. Anchors adjust. Is it dangerous to purely invest on that basis? Yes. But is it out of the realm of possibility? Nope. And I find it interesting to consider.
So, is it different this time or have we seen this rodeo before? Pragmatically, which is not what people prefer, it’s always different “this time” yet also always “rhymes.” Studying history is hugely beneficial for understanding what happened and what outcomes could happen again. Thus, base rates should be used. But no two situations or environments are exactly alike nor is the path of history what obviously should’ve occurred. Preferring to fight the last war or purely looking through the clear rear-view mirror will not lead to success when change is the only constant. Thus, adjustments to base rates should be used. That being said, those adjustments need to be reasonable. Having too much of an inside view or being too caught up in the present trends is equally risky. An investor with software development expertise has a clear advantage when it comes to analyzing the viability and attractiveness of new SaaS offerings, but that may lead to overoptimistic expectations that all or most companies will adopt the ostensibly superior product or service. It’s similar to an industry specialist recommending the best company within the group without adequate consideration that all of them might be overvalued.
The only certainty about the future is that it is uncertain and will bring surprises. Accepting the uncertainty and dealing with the surprises are challenging, especially when money is on the line. To mitigate that discomfort, some turn to past precedent while others extrapolate the present. Whichever side you more align with is likely influenced by your age, personality, and information bubble. Witnessing a market crash is frightening, likely engendering hyper-awareness to signs it will happen again and an inclination to avoid it at all (opportunity) cost. Not experiencing a sustained downturn can lead to a belief that stocks only go up, which could be a very costly lesson to unlearn. Ironically, when it comes to financial markets, the side that has considerably more people is actually more likely to be wrong. Explore opposing views, before it’s too late.