Why stocks are not like sardines

The trader bought what appeared to be an extraordinarily expensive tin of sardines. He knew sardines were in short supply because they were quickly disappearing from their native waters in Monterey, California. So like the other traders, he tried to profit from this event by buying up the remaining supply.

Unfortunately he was really hungry, so he opened the can of sardines in front of the seller and began eating.

“I wouldn’t do that”, the seller warned. “Those are trading sardines, not eating sardines”.

The trader immediately fell ill.

This you could say is the true price of speculation.

Here the locals in this story from Seth Klarman’s book “Margin of Safety”, no longer saw sardines as fish – Sardines were now just a price. This was because there always appeared to be a greater fool willing to pay more. And, in this case it was those traders on Wall Street.

Speculation has been a frequent affliction in capital market history. It’s tempting to see stocks as pieces of paper rather than thriving businesses, which can lead to bubbles.

This is because it’s lucrative in a rising market and has an element of excitement to it. Rigorous research goes out the window because prices keep rising, and investors assume that their wealth will continue to rise too.

The first bubble that occurred in my lifetime took place in 1983. There were twelve public Winchester disk-drive manufacturers in the US trading for a staggering $5.4 billion. Furthermore, between 1977 and 1984, forty-three different manufacturers of Winchester disk drives received venture capital funding. It was impossible to say who had the competitive edge.

Soon after mid-1983, the total market capitalisation of these companies declined from $5.4 billion to $1.5 billion at the year-end of 1984. Investors didn’t realise it at the time, but those twelve stocks were trading like sardines.

There is absolutely nothing wrong with investing in innovative new industries, however, irrational exuberance can easily kick-in and the disk drive industry is famous for its rapid pace of change.

In fact, Clayton Christensen in “The Innovator’s Dilemma” referred to them as fruit flies because they are born, mature and go bankrupt so quickly.

There was certainly no margin of safety in holding such stocks because they are valued on the priced-to-possibility, far above their current fundamentals. This was a saturated me-too market driven by speculation.

Of course this is often followed by the phrase, “this time it’s different”. It happening now, 17 years after the Dot-com bubble with a new group of tech stocks called “fangs”.

Don’t worry these stocks won’t bite. They’re represented by Facebook, Amazon, Netflix and Google. And the market can’t get enough of them. They’re so popular that there are now fangs indices and fangs futures.

These stocks have seriously outpaced the broader market and some investors find their performance reminiscent of the Dot-com bubble. However, they haven’t reached the frothy heights of those times. Furthermore, technology is now much more firmly intertwined into our everyday lives so there is a much more rational case for investing in these companies.

For instance, since I joined Facebook in 2005, I’m in contact with distant relatives and have found long-lost friends. I get all my UK-essentials in Switzerland on Amazon.co.uk. Netflix has replaced my regular television viewing. And when I search the web, I don’t use anything other than Google.

We are told that the value of these tech stocks has risen because they are far more important to us now than they were before. And, as you can see in the chart below, they’ve altered the shape of the S&P 500 in an almost unrecognisable way.

Moreover, this is not really where the bubble might be. These tech stocks are not that overvalued versus the broader market. The success of these fangs, is partly due to the enormous profits they have made. Some would argue that they are still undervalued relatively, because their business fundamentals are so strong.

The real worry is that the overall market is overvalued. At present, pretty much every sector in the US appears expensive compared to the rest of the world.

It’s a symptom of insanely low interest rates. As Warren Buffett once explained, “Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices”.

In other words, asset prices are like a helium-filled balloon under ultra-low interest rates. It could pop if interest rates are hiked rapidly and unexpectedly. Yet, it may drift down slowly if interest rates rise gradually and expectedly.

It’s impossible to predict what will happen, which is ironic because these future events will determine whether today’s stock market is overvalued or not. Either way, to say that we are in an “everything bubble” or to deny that we are, is just pure speculation – we just don’t know yet.

What’s really important in this environment is to have conviction. The market price is rarely the same as the intrinsic value we place on a stock, so whether the price goes up, down or sideways is not important. If the business is fundamentally sound, its price should eventually reflect these fundamentals towards the end of our investment time horizon.

Nevertheless, not everyone appreciates the importance of having conviction. For example, the new Vanguard CEO Tim Buckley was recently asked, “What’s your favourite stock?”

His reply was simply, “all of them”.

Perhaps he would be better suited to buying sardines.