The Future for Investors

by Jeremy J Siegel

  On the opposite side of the ledger, the materials sector had the greatest loss in market value share, as well as the lowest return. But not all contracting sectors experienced poor returns. The energy sector had the second largest contraction but, as we noted earlier, experienced above-average returns.

  The overall relation between the change in sector weights and returns is only weakly positive. A statistical regression shows that less than one-third of each sector’s return can be attributed to changes in the sector’s share of the market, while two-thirds is attributed to other factors, such as valuation, the reinvestment of dividends, and the entry of new firms.

  FIGURE 4.3: RELATION BETWEEN CHANGE IN GICS SECTOR SHARE AND RETURN FOR EACH SECTOR

  The fact that less than one-third of a sector’s returns comes from the expansion or shrinkage of the sector shows why so many investors fall into the growth trap. They fail to realize that the addition of new firms causes industry expansion, while often leading to poor returns.

  Sector Strategies

  The data show that three sectors emerge as long-term winners. They are health care, consumer staples, and energy. Health care and consumer staples comprise 90 percent of the twenty best-performing surviving firms of the S&P 500 Index. These two sectors have the highest proportion of firms where management is focused on bringing quality products to the market and expanding brand-name recognition on a global basis.

  The energy sector has delivered above-average returns despite experiencing a significant contraction of its market share. The excellent returns in this sector are a result of two factors: the relatively low growth expectations of investors (excepting the oil and gas extractors during the late 1970s) and the high level of dividends. In Chapter 17 I will discuss sector strategies and list the global firms that play an increasing role in these industries.

  Lessons for Investors

  At the beginning of this chapter I pointed out that most investors want to know what the next hot sector is going to be. If you are a short-term trader, that is the right question to ask, since returns and market values are highly correlated in the short run. But if you are a long-term investor, chasing hot sectors will lead to very cold returns.

  The important conclusions from the historical research on sector performance are:

  • Rapid sector growth does not necessarily mean good investor returns. The financial and technology sectors expanded greatly over the past years yet gave mediocre to poor returns. The energy sector contracted sharply yet outperformed the S&P 500 Index.

  • Over the long run, less than one-third of sector returns can be attributed to expansion or contraction of that sector. This means that over two-thirds of the return can be attributed to other factors, such as new firms and dividends.

  • Two sectors, energy and information technology, experienced almost identical bubbles separated by twenty years. Both bubbles popped when their sector weighting reached 30 percent of the value of the S&P 500 Index. The rapid increase in the weighting of a particular sector is a warning signal to investors to reduce their allocations to that sector.

  • New firms that were added to the S&P 500 Index generated lower returns than the original firms in nine of the ten economic sectors. New firms that are added when the sector is expanding rapidly generate particularly poor returns for investors.

  PART TWO

  Overvaluing the Very New

  CHAPTER FIVE

  The Bubble Trap:

  HOW TO SPOT AND AVOID MARKET EUPHORIA

  The meaning of life is creative love, loving creativity. And loving creativity may explain why tech stocks are high and going higher. The Internet revolution is allowing for creativity like never before, perhaps putting more of us in touch with the meaning of life.

  —Merrill Lynch, Global Fundamental Equity Research Department, February 14, 2000

  In the last chapter I described the oil and technology bubbles. Investors lose more money during bubbles and their nasty aftermath than during any other period of the market cycle. For many, losses are so severe that they forsake stocks forever and cling tightly to their remaining savings in low-yielding money funds and bank CDs.

  Is there a way to avoid these episodes of market euphoria? Can investors identify bubbles and avoid being trapped by their enticing promises?

  Alan Greenspan, chairman of the Federal Reserve, who received much heat for not popping the Internet bubble, is skeptical. In a speech in August 2002 he commented, “It was very difficult to definitely identify a bubble until after the fact—that is, when its bursting confirmed its existence.”1

  But I respectfully disagree. Read the quotation at the head of this chapter. It was written by one of the best research departments on Wall Street at the top of the market. When “new age” thinking grips even these sophisticated analysts, you know you are in a bubble.

  This chapter will teach you how to look for the telltale symptoms of a bubble. But once you have identified one, it does not mean that you’ve found a road to easy profits. Bubbles last much longer than anyone expects, defying the skeptics and boosting the believers. Once the bubble starts expanding, no one knows when it will pop.

  When you have identified a bubble, step back and stop investing in the companies or sectors involved. If you should be so lucky as to hold some of the stocks that are caught in the frenzy, cash in your profits and don’t look back. The stocks you sold will probably rise further before they collapse, but in the long run, you will come out way ahead.

  The Internet and Technology Bubble

  Bubbles usually form after long periods of financial prosperity. This was exactly the setting at the end of the twentieth century, as the United States was well into the longest and strongest bull market in its history. The Internet enabled online trading, which made buying and selling stocks easy and inexpensive. A casino-like atmosphere attracted thousands who would not otherwise have invested in financial markets. Fear of Y2K—the anticipated breakdown of computer systems when we entered the year 2000—pumped capital spending and led to a surge of profits for technology firms.

  Investor excitement centered on the belief that the Internet would change the way the world did business. This excitement caused a sharp increase in media coverage of Internet firms and the stock market. There was a sense, amply reported in the media, that there was about to be a significant shift in the paradigm governing buying, selling, and marketing of all goods and services.

  As my good friend Bob Shiller of Yale University reported in his book Irrational Exuberance, “Although the news media … present themselves as detached observers of market events, they are themselves an integral part of these events. [Speculative bubbles] generally occur only if there is similar thinking among large groups of people, and the news media are essential vehicles for the spread of ideas.”2

  Since the Internet allowed huge markets to be accessed at minimal cost, the prevailing opinion was that the convenience afforded by online shopping would likely dominate all other forms of marketing. “Clicks over bricks” was the rallying cry of the Internet enthusiasts, who foresaw the new medium threatening the very existence of retail firms.

  As the media spread the word, more and more investors, many of whom had never before invested in individual stocks, began to play the market. Prices skyrocketed. In April 1999, after an astonishing 4,800 percent price increase in less than two years, Amazon.com, the online book retailer, had a market value over $30 billion. This was almost ten times the combined market value of its two greatest bricks-and-mortar competitors, Barnes and Noble and Borders, which operated over 1,000 bookstores worldwide apiece. Ironically, Amazon had never up to that point made a profit; in fact, it had losses that year of over $600 million.

  In October 1999 the market value of eToys, an online toy retailer, was more than double the value of Toys “R” Us, the world’s largest bricks-and-mortar toy retailer, which owned more than 1,600 stores worldwide. In that same month Priceline.com, a company that sells cheap airline ticke
ts over the Web, had a peak market value that was more than half the equity of the entire U.S. airline industry. It was only a matter of time before the bubble burst.

  Have Investors Learned Their Lesson?

  I used to think it would take many years before investors’ appetites for such speculation returned. But recent evidence suggests otherwise.

  Fast-forward just a few years to 2003. The biggest gains in the stock market are coming from companies specializing in nanotechnology, the supposed next great innovation that will lead to dramatic changes in our world. Nanotechnology promises “to make supercomputers that fit on the head of a pin and fleets of medical nanorobots smaller than a human cell able to eliminate cancer, infections, clogged arteries, and even old age.”3

  As a Wall Street Journal article reported, nanotech firms such as Nanogen, Nanophase Technologies, and Veeco Instruments all at least doubled or tripled in the prior year. Not one of them had any earnings and Nanogen and Nanophase had little to no revenue.4 Nanogen, a company with a sparse $1.7 million in revenue per quarter and losses of over $7 million per quarter, was trading at $1 per share in March of 2003. But the company’s scant vital statistics did not deter speculators from climbing on board. By early 2004, the company shot up to a high of $14.95, giving it a market value of almost $400 million.

  Just as companies rushed to associate the term dot-com with their names in the late 1990s, companies raced to capitalize on the nanotech craze. One company, U.S. Global Aerospace, changed its name to US Global Nanospace. The company’s stock, which a year earlier was selling at a nickel, shot up to $1.66 after its name change.

  To be sure, the nanotech boomlet was a shadow of the huge Internet bubble that occurred a few years earlier. What is so surprising is that this type of speculation occurred with memories of the last debacle still so fresh.

  But the excitement of the new can obliterate the memories of the old. It is likely that new technologies will be appearing with increasing frequency in the coming decades. As I will detail in Chapter 15, the Internet revolution is likely to accelerate the rate of discovery all across the globe. There will be profound advances in all types of new products and new companies that will have tremendous growth opportunities. But buyers beware. Most of these new companies and new technologies will be over-hyped and overpriced.

  Lesson One: Valuations Are Critical

  AMERICA ONLINE

  Before the Internet mania hit its peak in 1999, I warned in a Wall Street Journal article entitled “Are Internet Stocks Overvalued? Are They Ever” about the unprecedented developments taking place in the markets.5 Using AOL as an example, I showed that the Internet stocks could not possibly be worth the price that investors were paying for them.

  The day my piece appeared, April 19, 1999, the prices of Internet stocks collapsed. AOL fell from $139.75 on the previous Friday to close at $115.88, slicing about $22 billion from its market value. Other Internet stocks were also hit: Yahoo! slid from $189 to $165, and the dot-com index fell from 670 to 560, a drop of almost 17 percent.

  I was shocked at the responses this article received. I traveled from Philadelphia to Chicago that morning, and I was thankful I wasn’t traveling to Silicon Valley. I was sure my article was not the only factor causing the price decline, but all the major television networks, CNBC, CNN, National Public Radio, and the print media wanted to discuss my views.6

  That evening I found myself face-to-face with Henry Blodget, Merrill Lynch’s Internet cheerleader, on Lou Dobbs’s Moneyline. Lou started the interview bluntly: “What in the world—Jeremy, if I may ask, you write one article in the Wall Street Journal, and see what you did! Why did you do that?”

  I explained my reasoning, and Lou then turned to Blodget, who responded that my arguments had been made many times before. In a show of rare candor, he claimed, “These stocks have always been expensive by classical measures; there’s no question about that. Really, our argument has always been that nobody knows what they’re worth.”

  Do not be fooled by Blodget’s response. A firm pioneering a new technology can be priced with the same valuation tools that had priced IBM and other technology giants in the past, and I did so that day in my article.

  I chose to look at AOL, the “blue chip” Internet stock—the only Internet firm in the S&P 500 at the time—and a firm that was making a profit. When I wrote the article, AOL’s market value of $200 billion placed it among the ten largest companies in the United States.

  Yet in the prior year, AOL’s sales ranked only 415th in the country, and its profits ranked 311th. If AOL’s market value ranking was in line with its sales or profits rankings, its market cap would have been closer to $4.5 billion.

  Moreover, AOL’s price-to-earnings ratio, the critical measure of valuation that I discussed in Chapter 3, was over 700 based on its prior twelve months’ earnings and 450 based on projected current-year earnings. For large firms, these valuations were absolutely unprecedented.

  The average P/E ratio of the stock market has been only 17 over the last forty-five years. Chapter 3 showed that the best-performing stocks over the past fifty years had much higher earnings growth than the average stock, but their valuation ratios were only slightly higher than the market’s. Certainly those stocks could have stood a higher valuation than they received, but AOL’s price was out of the ballpark. A subsequent fall in AOL stock was inevitable.

  Lesson Number Two: Never Fall in Love with Your Stocks

  There is another sign that tells investors when stocks are in a bubble. One of the cardinal rules in investing is to never fall in love with your stocks. You must at all times be objective: if the fundamentals do not justify the price, you should sell, notwithstanding how optimistic you are or how much money you’ve made or lost on the stock.

  I soon realized that thousands of investors had fallen in love with “their” AOL. After my article appeared in the Wall Street Journal questioning AOL’s valuation, I received scores of angry e-mails from people claiming that AOL was in fact undervalued and that I was completely out of touch with reality. Quite a number forwarded me a response article, published by Kevin Prigel of StreetAdvisor.com, who claimed my piece “was the most flawed piece of literature the Journal has ever run.”

  Many e-mails were sent to the dean’s office of the Wharton School recommending that I should not be teaching at Wharton—or at any other business school, for that matter. One wrote, “Not only is this guy a dinosaur, but he knows absolutely nothing about Y2K and forward business models.… I hope that he may soon retire from dear old Wharton … or to the funny farm—whichever comes first. He is nuts, period, and should have a muzzle.” Another wrote, “My regard for your school has lessened. Siegel needs to retire. Ultimately it is the school that suffers when it harbors this sort of individual. Check out the article from StreetAdvisor.com.”

  But the cake goes to the following e-mail, forwarded to me by Kirsten Speckman, a spokesperson for Wharton Public Affairs, who told me they had been getting a number of messages similar to this one at their general public affairs e-mail address.

  Good morning, Mr. Siegel. I hope you’re happy. You cost me $14,000.00 for no reason! What do you have against this mammoth company? Are you jealous because you didn’t get in on the run-up? Did you want to buy in cheaper? You have no business making decisions like this. After all, you’re still a child when it comes to Internet knowledge. You’re a preschooler in diapers when it comes to recognizing opportunities. By the way, when was the last time you got laid? You’re a party pooper. Thanks a lot, jerk. I suggest you go to the StreetAdvisor.com to read about why you’re so wrong, idiot. Do you even know how to get to a Web site, you child?

  I recently checked out StreetAdvisor.com. It is now an inactive Web site up for sale to the highest bidder. In February 2003, Sanford C. Bernstein & Co. estimated that if AOL Time Warner were broken up, the America Online unit would be worth $5.78 billion, 97 percent less than the value when I wrote the article. Other analysts called th
at estimate far too optimistic.

  The emotions and passion for Internet stocks displayed by the Internet enthusiasts proved that these investors were not judging their investments rationally. Most Internet investors were convinced that “this time was different” and were in no mood to hear otherwise. They had made the fatal error of falling in love with their stock.

  Lesson Number Three: Beware of Large, Little-Known Companies

  Another sign of a bubble is the enormous valuations placed on little-known companies. On February 11, 2000, I saw a headline scrolling on my Bloomberg Terminal, “Cisco May Be Headed for $1 Trillion Market Value.” David Wilson, author of the article, quoted Paul Weinstein, an analyst at Credit Suisse First Boston, who said that Cisco’s market value could reach $1 trillion dollars in two years. At that time its market value was just over $400 billion, the highest in the world. Five years earlier the market value of all stocks listed on Nasdaq had not been worth $1 trillion, yet Weinstein was predicting Cisco alone might reach that level in two years.

  There is no doubt that Cisco did well for its investors. The company was founded in 1984 and went public on February 16, 1990, when it sold $50.4 million of stock. By February 2000 those who invested $1,000 into its IPO would have made $1 million—a return that doubled the initial investment on average each year.

  Cisco vaulted into the position of being the world’s most valuable stock just two days before the Weinstein prediction was released. Cisco overtook General Electric, a company that had been around for more than a century and had one of the highest name recognitions in the world. But Cisco was different. It was astounding that the vast majority of Americans, including many (if not most) shareholders, had absolutely no idea what Cisco did. When I asked some of my friends what Cisco Systems made, many shook their head and recalled Crisco, a popular shortening produced by Procter & Gamble that was heavily advertised in the 1950s. When I said that 70 percent of Cisco’s sales are for switches and routers for the Internet, most had no idea what switches and routers did.