Don’t Learn the Wrong Lessons from the Dot Com Crash
In December of 1998, a newly minted Wall Street analyst named Henry Blodget stuck his neck out and declared that Amazon’s stock price was going to $400, a nearly 70% increase from the then current market price. Amazon, at that point just an online bookstore, had gone public the prior year at a price of $9 and was already trading at $240. So with the stock up nearly 2600% over 18 months, Blodget was saying it could rally to $400 for a total return since the IPO of 4300%.
At the time, Blodget was working at CIBC and a more well-known Merrill Lynch internet analyst scoffed at his prediction saying instead that Amazon would drop sharply to just $50.
A month later, as 1999 began and the Dot Com bubble went into overdrive, Amazon’s stock price screamed through $400 on its way to a high of $600. The Merrill Lynch internet analyst left the firm and Blodget was hired to take his place, quickly becoming one of the most prominent cheerleaders of the Dot Com bubble. Blodget’s Amazon call was such a big deal at that time that later that same year, Blodget declared, “I expect my obituary will read, ‘Henry Blodget, he predicted Amazon would hit $400.’”
Now this is the point in the story where things are supposed to go bad. This is when I’m supposed to tell you that Blodget was foolish to think a little online bookseller would take over the world and have its stock price go to the moon. And in fact, Amazon’s share price did collapse. After hitting a high of $600 in late 1999, the stock got absolutely annihilated, falling over 90% as the Dot Com bubble collapsed.
But in retrospect, we know that over the long-term Blodget’s price target for Amazon was too conservative, not too aggressive. If you had bought Amazon in early 1999 when it first hit $400, this is what your returns would have been through the end of 2020 vs the S&P 500.
It is true that many individual internet related companies of the Dot Com era barely even had a real business model and investors in these stocks lost everything. But the flame out of Dot Com stocks obscures the fact that the internet has proven to be a far, far bigger deal than most people thought it would be 20 years ago.
If in 1999 you had predicted that 20 years in the future nearly the entire global white collar work force would pivot on a moment’s notice to working from home on the back of a robust global internet, you would have been seen as a starry-eyed optimist even by the Henry Blodgets’ of the world. Predicting the rise of 7 billion internet connected devices with people from every walk of life carrying an internet connected supercomputer in their pocket at all times would have made even the Dot Com uber bulls blush at your optimism. But this is exactly where we find ourselves today.
So, the lesson of the Dot Com era is not that people came to have irrational beliefs about the future. In fact, investors in the late 1990s underestimated just how big of a deal the internet would prove to be. Rather the massive error that investors made was to incorrectly think that pretty much any company that was operating in internet related industries was a sure thing. Despite the internet proving to be very real, most of these stocks performed terribly with many falling into bankruptcy and never capitalizing on the internet boom.
But don’t get the impression that as long as you pick the right company that everything will work out OK. You couldn’t have been more “right” in 1999 than by picking Amazon as a long-term winner. But even picking the right company was not enough to avoid the Dot Com crash.
While the 20-year chart on Amazon’s stock price above looks like what every stock picker is trying to find, from its all-time high in late 1999 to its low in late 2001, Amazon’s share price fell 94%! It took a decade until late 2009 for Amazon to return to its 1999 high. It took until 2014 before 1999 buyers of Amazon stock had generated 10% annual returns.
Today, we face a market that in total bears no resemblance to the extreme valuations of 1999. While the overall market is trading at a higher price to earnings multiple than average using either 2019 or forecasted 2021 earnings, the S&P 500 is only about 10% more expensive than it was in 2016 and 2017.
Over the last five years the S&P 500 has appreciated by 115%, while in the five years leading up to the peak of the Dot Com bubble, the S&P 500 had appreciated by 225%, meaning the current market would have to appreciate by another 50% overnight to approximate the rate of returns that were seen in the late 1990s. The market would need to see a similar increase in prices to get up to the 30x PE multiple the S&P 500 traded at in 1999.
But there are indeed pockets of what appear to be extreme valuations. Or said more bluntly, pockets of the market where stock prices have disconnected from any rational estimate of the cash flow the companies will produce over time.
For instance, Nikola a company that claims to be making electric vehicles but does not actually have any revenue, traded to a valuation of $30 billion in June, before falling 80% since. And multiple billion-dollar valuations for exciting companies that do not yet have any revenue (not no earnings, but no revenue) is not limited to Nikola.
While fast growing software-as-a-service business models are fantastic and commanded valuations of 10 times revenue prior to the pandemic – or maybe 15 to 20 times revenue for the most promising companies – today, 20 times is the new average multiple with some of the fastest growing at 30, 40 or even 50 times revenue. 10 times revenue is now the average multiple for these types of companies rather than the multiple assigned to the best of these types of companies.
One way to measure the huge increase in valuations of speculative companies is by looking at the index of unprofitable tech companies that Goldman Sachs maintains. From the index’s inception in 2014 up until the pandemic started, this collection of businesses underperformed the S&P 500 significantly, despite being made up of generally fast growing, exciting, technology businesses.
But extending the chart through today shows the eyepopping increase in valuations that have occurred among speculative companies.
A 300%+ rally over the last year among unprofitable tech companies is an order of magnitude bigger than the rally we’ve seen across the broader market. This sort of increase in valuations has mostly been isolated to truly speculative companies, not those generating tons of cash today even as they grow nicely.
But we can see on the chart that these types of companies are witnessing their first material decline since the rally took off having now declined over 20% from their high. Must a crash in these stocks lead to a crash of the average stock price? While we cannot say for sure, we can say that this did not happen when the Dot Com bubble popped.
In the next chart, we show the performance of the Nasdaq Index (ground zero for Dot Com excess) vs an equal weighted version of the S&P 500 as well as the traditional S&P 500 index. The S&P 500 is market cap weighted, meaning that the index holds larger positions in the biggest stocks and smaller positions in smaller stocks.
Because investors like ourselves do not market cap weight our portfolio, but rather weight our portfolio based on how much conviction we have in a company and how cheap we think it is, regardless of the market cap, when thinking about the available investment opportunity set we are not required to own large stocks regardless of their valuation, the way that passive investors must do.
While the narrative of the Dot Com crash is commonly understood as a market-wide crash, the chart above shows that over the five years after the peak of the bubble, the S&P 500 Equal Weight Index generated a positive 36% return while the Nasdaq declined by 58%. If you look at the white line representing the S&P 500 Equal Weight Index, you’ll see that by the end of 2001, when the NASDAQ had fallen by almost 60%, the average stock was actually up about 9% despite the Dot Com crash and the horrific events of 9/11.
The fact that the market cap weighted S&P 500 declined much more during the Dot Com crash was a function of even the largest, highly profitable companies trading at extreme valuations at that time. As we noted above, the S&P 500 was nearly 50% more expensive at the peak of the Dot Com bubble than it is today.
For instance, Microsoft traded to a PE of 75 in 1999, but trades at a PE of about 33 today. Walmart traded at a PE of 54 in 1999, but trades at a PE of 24 today. Exxon Mobile traded at a PE of 41 in 1999, but trades at a PE of about 24 today, or just 12 times what the company earned as recently as 2018.
The average stock did decline by about 20%-30% in 2002 as warfare played out in Afghanistan, worries about global terrorist attacks swept the globe and the impacts of a recession were felt by many businesses. But this wasn’t about excessively high stock valuations, but about major geopolitical and economic concerns. 20%-30% declines in the average stock happen with regularity.
There was a 20% decline in the fourth quarter of 2018, yet we don’t look back and reflect on a “crash” that occurred. Declines of this magnitude are just part of the price equity investors must be willing to pay in pursuit of strong long-term returns. If they were predictable, it would be great to dodge them. But they’re not predictable, so you must be willing to live through them if you want to enjoy strong long-term returns.
So, let’s step back for a moment to think about what’s going on and how investors should approach the current market. The pandemic has caused a massive acceleration for digital businesses. This isn’t likely to be temporary, as we wrote about as early as May of last year. The pandemic has now lasted long enough for consumers and companies to form new habits and ways of doing business, many of which will stick even as the pandemic fades into history.
The digital acceleration is real. The long-term implications are likely larger than currently envisioned by even very optimistic forecasters. Yet many stocks leveraged to these trends, especially those that are the purest expressions of these trends, are likely overvalued and seem poised to cause heartbreak, or even financial ruin, for investors who mistake an individual stock investment as an obvious way to capture a long-term mega trend like the digital acceleration, or the internet boom of decades past.
It is not enough to recognize a big acceleration of opportunity. The history of the Dot Com era shows us that people at the time were too conservative about their big mega trend outlook. But they were too optimistic in how they expressed those views in individual stock selection. Despite the internet being huge, only a handful of the companies at that time capitalized on them. Some of the biggest winners of the internet age weren’t even public (i.e. Google) or even founded yet (i.e. Facebook) until well after the Dot Com bubble crashed.
The lesson of the Dot Com bubble and crash is not to get out of the market when speculative activity surges. Rather the lesson is to avoid those specific stocks that are speculatively valued and to be highly skeptical of unproven businesses that claim they are sure to capitalize on exciting new trends. It is during periods like these that stock selection becomes extremely important.
So, as we seek to navigate a market in which speculative activity is surging, we will do our best to not be overly skeptical of the big fundamental changes at play, while remaining very skeptical about exactly which companies will capitalize on those trends, and paying extra attention to the valuation paid for the stocks of those companies we think will be the long-term winners.
It is during periods of less rational pricing that active managers have the biggest opportunity to thrive. While danger may lurk in some sectors of the market (as it always does), opportunity beckons as well.
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