The Future for Investors

by Jeremy J Siegel

  That the world’s most valuable company would be virtually unknown is unprecedented. In the late nineteenth and early twentieth centuries, Rockefeller’s Standard Oil and Carnegie’s U.S. Steel vied for top honors, and both firms were household names.

  At the peak of the 1929 bull market, General Electric and General Motors joined U.S. Steel to take top honors (the Standard Oil empire had been broken up by then), and both firms were extremely well known. In the mid-1960s American Telephone & Telegraph again dominated the field: Ma Bell, as the firm was affectionately called by stockholders, was the most widely held stock, and most of the U.S. population was a customer of AT&T or one of its subsidiaries.

  IBM dethroned AT&T in 1967. Although most individuals had no idea (and still don’t) how a computer works, everyone had heard of IBM and knew what the computer did. In fact, the term “IBM machine” became synonymous with the computer, as the firm dominated more than 80 percent of the computer market in the 1950s and 1960s.

  General Electric, under the leadership of Jack Welch, reemerged in late 1993 and held the top post until late 1998, when Microsoft, the enormously successful software company, took over. Almost all who had operated a computer used Microsoft’s operating system, if not its word processing, spreadsheet, and graphics programs. When Cisco, a virtually unknown firm, took the lead from Microsoft, it further confirmed that dramatic changes had taken place in the markets. Two and one-half years after Weinstein’s trillion-dollar prediction, Cisco’s market value fell to $50 billion, less than one-tenth its peak value.

  Lesson Number Four: Avoid Triple Digit P/E Ratios

  After my article “Are Internet Stocks Overvalued? Are They Ever” appeared, Internet stocks fell about 40 percent over the next four months. But the fall did little to discourage Internet enthusiasts. As reports of strong online sales growth continued to surface, the Internet stocks recovered and blew past their April highs. In fact, the Street.com Internet Index, after falling from 800 in April to below 500 in August, nearly tripled to 1,300 in early March 2000.

  As the Internet mania raged on, a popular opinion emerged that the equipment providers to the Internet firms would surely make a lot of money even if many of the Internet start-ups failed. As a result, the big-cap technology companies that supplied the Internet and the burgeoning personal computer market also surged to new highs.

  Most investors and analysts who had taken a bearish position on stocks such as Cisco, Sun Microsystems, EMC, Nortel, and others did so because they did not believe that earnings could grow as rapidly as analysts were projecting. But there was another, more fundamental question: did these firms deserve their lofty valuations even if their rosy earnings forecasts were actually met?

  In late February 2000, I researched this question for a presentation that I was to give to the Securities Industry Association, which holds a week-long educational conference every March at the Wharton School. I analyzed the nine large-capitalization stocks with P/E ratios over 100 in March 2000: Cisco, AOL, Oracle, Nortel Networks, Sun Microsystems, EMC, JDS Uniphase, Qualcomm, and Yahoo! What I found was not comforting to the technology bulls. Even if these optimistic earnings forecasts, which ranged from 21 percent to 56 percent per year, were maintained for five years (long-term earnings projections are usually three to five years in the future), the average price-to-earnings ratio of these nine stocks would have been an eye-popping 95. And three of them (AOL, JDS Uniphase, and Yahoo!) would still have price-earnings ratios over 100.

  If these optimistic estimates for earnings growth could be maintained for ten years (and virtually no one believed these firms could maintain those growth rates for so long), the price-to-earnings ratios on these stocks would fall only to the mid-40s, still extraordinarily high. Investors were projecting that tech stocks would totally dominate the market over the next decade and would be valued at two to three times the historical valuation of the S&P 500. This was just not possible. A substantial decline in these stocks was certain.

  Big-Cap Tech Stocks

  On March 8, 2000, I received a call from Max Boot, editor of the Wall Street Journal, asking me if I wished to write another op-ed piece on what was going on in Nasdaq.

  Given the research I’d just completed, I quickly consented and gave my article the innocuous title “The Lessons of History.” It is a standing practice in the newspaper industry for the editors to pick the titles of op-ed pieces, yet I was shocked when I picked up the Journal and saw at the top of the op-ed page “Big-Cap Tech Stocks Are a Sucker Bet.” I always avoid name-calling, and some of my best friends owned these stocks! I thought those who had purchased them might be misguided, but calling them suckers was not right. I prepared apologies to those who might call, explaining that I had nothing to do with picking the word “sucker,” but I received surprisingly little flak about the title.

  On Friday, March 10, two days after I was contacted by the Wall Street Journal, I received a call from Stuart Varney, who had replaced Lou Dobbs on CNN’s Moneyline and wanted me to appear on his show at six that evening to discuss what was going on in the markets.

  Varney started the interview this way: “Let’s hit the nail on the head, shall we. Are you full-out forecasting a huge decline in tech stocks in the very near future?”

  I wanted to talk of Cisco and the other overpriced tech stocks, but I didn’t want viewers to think I was just slamming these companies. With memories of the reactions I received from AOL shareowners fresh in my mind, I overstated my admiration for Cisco. I said, “Cisco is a wonderful company. It’s a great company. It’s a super company. I would probably buy it at 80 times earnings, but at 150 times earnings? We have six stocks in the top twenty [market value] over 100. We have had no history of this. Never have stocks been worth over a hundred times earnings once they’ve gotten to the size of these companies.”

  I noted that the valuations of these big-cap tech stocks had increased dramatically in just the last five months, and I didn’t see where the price increases came from, saying, “It can disappear as easily as it came.” I then said that “momentum players,” short-term speculators who ride a trend in price, “are saying that they are going to get off the train before it crashes.” When everyone thinks that way, there can be some very nasty declines.

  Wanting to sum up, Varney asked, “It’s a bubble and the air will come out of it soon and come out of it fast, bottom line?” I answered definitively, “It will come out.… I think we are going to see some very big declines in the sector this year.”

  The day of this CNN interview, Friday, March 10, 2000, the Nasdaq Composite Index closed at 5,048.62. This marked the index’s all-time high and coincided with the absolute top of the technology market. Two years later, Nasdaq was down more than 75 percent.

  During the week of April 10, 2000, Nasdaq experienced a meltdown, falling more than 1,100 points, or almost 25 percent. Moneyline interviewed me again, replaying large parts of my interview from a month earlier. For the next year, Varney showed clippings of that March 10 tape frequently, claiming I was the man who had called the market top.

  It soon became clear that my article “Big-Cap Stocks Are a Sucker Bet” had become my most well-known piece of journalism. When I lecture across the country, investors come up to me holding copies of that article and saying that my opinion convinced them to cash out of the tech stocks, saving their fortunes. Many more approached and commended me on the article, noting wryly that they wished they’d followed my advice.

  Being feted by the news media and investors as a “guru” of the market was a very uncomfortable position for me. The short-run direction of the market is so unpredictable that anyone who calls it right should attribute it to pure luck. The bubble in technology stocks could have lasted another month or another year. But I (along with many others, even those with long positions in these stocks) knew that it had to burst at some point.

  There was another important conclusion that I pointed out in my article that received much less attention: the f
ifteen largest non-technology-related stocks in March 2000 were not overvalued. This was a technology bubble, pure and simple—a bubble that exempted most of the rest of the market. Non-technology-related stocks did not really decline until 2002, when the earnings scandals spurred by Enron and others hit the headlines. The non-tech-related stock averages fully recovered by the end of 2003, whereas the tech sector was still down over 60 percent.

  The Follies of Predicting Technology Earnings Growth

  A year after the “sucker bet” article appeared, Max called me again and wanted to know if I wanted to pen an anniversary follow-up. I did so reluctantly, knowing full well that it was extremely unlikely that I would be able to predict the market as accurately as I had happened to do at the market peak.

  I stated that although the tech stocks had declined markedly over the previous year, the earnings growth forecasts for three to five years out were hardly changed. Given the collapse in earnings over the prior twelve months, I believed it was totally unreasonable to maintain the same outlandishly optimistic forecasts.

  I started my piece this way: “You’d think the plummeting Nasdaq would have wised up Wall Street to the fact that its analysts blew it on the tech sector. But in fact the Street’s long-run earnings forecasts for the big tech companies are still grossly out of line with reality. Even at today’s deflated prices, many of these stocks are still overvalued.” The article was entitled “Not-Quite-So-Big-Cap Tech Stocks Are Still a Bad Bet.” (I had convinced Max to change the word sucker to bad.)

  I indicated how bad Wall Street’s earnings forecasts were. I noted that on January 9, 2001, nine days after the quarter ended, analysts were forecasting operating earnings of the technology sector to come in at $10 in the fourth quarter of 2000. Six weeks later, when all the profits were tallied, operating earnings for tech stocks came in at $7.69.

  If analysts can be off by nearly 25 percent in forecasting earnings of a quarter that has just ended, what confidence can investors have in their prediction for the coming year—or, for that matter, for the next three to five years? The truth is, very little. Earnings estimates in the rapidly shifting tech sector had become a crap shoot. But premium P/E ratios should belong only to stocks that have a reasonable certainty of superior long-term growth. And these certainly were not technology firms.

  Lesson Number Five: Never Short Sell in a Bubble

  After all these warnings, many assumed that I had made a killing shorting those Internet and technology stocks.7 But the truth is that I had no interest in shorting the Internet stocks, and I do not advise the average investor to pursue this practice. Even if the investor is right in the long run, she may be very wrong in the short run.

  As every investor who has studied the market knows, taking a short position in a stock exposes you to unlimited losses, while the maximum gain is the value of the shares sold. The payoffs for a short seller are the mirror image of those for someone who buys or “longs” the stock. The gains for buyers of stock are unlimited, while the maximum loss is the amount invested. This means that a trader who shorts a stock is treated as a margin account, so the brokerage firm constantly monitors the value of the short position and demands additional funds if the price of the shorted stock rises. If the investor is unable to put up extra money, his position is liquidated at the market price.

  It is very possible to be 100 percent correct that a stock is overpriced. But being right in the long run doesn’t guarantee being right in the short run, and if you are short on a stock, you might be unable to continue to feed sufficient money to the account if the price continues to rise. In fact, there is evidence that short sellers get squeezed in all bubbles. Some investors begin shorting the stock as it goes above its “justified” price, and if the correction occurs quickly, they make money. But bubbles usually last much longer and go to much greater extremes than most short sellers expect. Most shorts cannot hold out as the price continues to rise and eventually cover their position at a loss.

  Covering the short position, which involves buying back the borrowed stock, provides more buying pressure on the shares that are already being forced higher by momentum investors who long ago jumped on the bandwagon. This adds fuel to the fire, often causing an explosive upward movement in the price of the stock.

  It is often said that bubbles peak when all the bears have thrown in the towel and covered their short position. In the meantime, bears with plenty of excess liquidity and nerves of steel who can hold through the euphoria will eventually be rewarded. For the rest of us, the best advice is just to stand back, enjoy the show, and refuse to play.

  Recommendations for Investors

  Just as a doctor uses symptoms and lab tests to diagnose a disease, investors can watch for telltale symptoms of a bubble. These include wide and increasing media coverage, extraordinarily high valuations based on concepts and names instead of earnings or even revenues, and an unwavering belief that the world has fundamentally changed and that these firms cannot be measured by traditional means. If you diagnose a bubble, the best advice is to stay away!

  Remember, valuations always matter, bubble or no bubble. Markets will ultimately deal a severe blow to those who believe that growth is worth any price.

  CHAPTER SIX

  Investing in the Newest of the New:

  INITIAL PUBLIC OFFERINGS

  Most new issues are sold under “favorable market conditions”—which means favorable for the seller and less favorable for the buyer.

  —Benjamin Graham, The Intelligent Investor, 1973

  In January 1999, Alan Greenspan, responding to a question from Senator Ron Wyden of Oregon, said, “Investing in Internet stocks is like playing the lotteries; some may succeed, but the vast majority will fail.”

  In a lottery, the odds are clearly stacked against you. Yes, there will occasionally be a $100 million winner who will receive huge publicity and whet the appetites of others. But the overwhelming majority of those who regularly play their lucky numbers are guaranteed to be throwing away their hard-earned money.

  Yet when Greenspan made this statement, buying newly issued Internet stocks was far better than playing the lottery. In 1999 virtually none of these initial public offerings (IPOs) was a loser, and many investors had made tidy fortunes buying these stocks, which soared after they hit the public markets.

  It was widely believed that the old “bricks and mortar” companies were going to be destroyed by these up-and-coming start-ups. Excitement was high and money was being thrown at any new company with a dotcom in its name.

  Others realized that most of these new ventures would fail, yet they eagerly bought these new stocks, claiming that anyone who owned just one big winner could suffer dozens if not hundreds of losers and still come out ahead. These investors were certain that one or two of these new firms would inevitably become the next Microsoft, Intel, or Dell Computer.

  There is an element of truth in this observation. Big winners can indeed compensate for many losers. One thousand dollars invested in Microsoft when it went public in 1986 was worth $289,365 by the end of 2003. Intel, which went public in October 1971, is an even better example. One thousand dollars invested in what is now the world’s largest chip maker would have turned into almost $1.9 million by the end of 2003. You could survive many failed startups if you had invested in one of these successes.

  What Does This Mean for Investors?

  Does the prospect of finding these few diamonds in the rough justify investments in initial public offerings in general? Should buying these newly issued companies be part of a sound wealth-building strategy?

  The extensive research conducted for this chapter indicates that investing in IPOs is much akin to playing the lottery. There will be a few huge winners, such as Microsoft and Intel, but those who regularly invest in all IPOs will fall significantly behind those who invest in stocks that are already trading in the public markets.

  I examined the buy-and-hold returns for almost 9,000 initial public offerings t
hat have occurred since 1968. I assumed that investors purchased the IPOs either at the end of the first month of trading or at the IPO offer price and held these stocks until December 31, 2003.1

  Although there were a few big winners, there were far too many losers. IPO investors generally lagged the market by two to three percentage points per year. Here again, we find an illustration of the paradox of creative destruction. While all the new products and services these IPO firms create are vital for the economy, buying them when they are issued is not a good way to build your wealth.

  Long-term IPO Returns

  There is no question that the losing IPOs far outnumber the winners. Figure 6.1 shows that nearly four out of five newly issued firms have subsequently underperformed a representative small stock index measured from the IPO date through December 31, 2003.2 Of these, almost half have underperformed by more than 10 percent per year; more than one-third have underperformed by more than 20 percent per year, and 1,417, or almost 17 percent, have underperformed by an astounding 30 percent per year or more.

  FIGURE 6.1. PERFORMANCE OF 8,606 IPOS FLOATED 1968–2000

  In contrast, only one-fifth of the IPOs have outperformed the market. Less than 5 percent have done so by more than 10 percent per year, and only forty-nine, or one-half of 1 percent have outperformed by more than 30 percent per year.