Bipolar Markets - and Ideas to Keep Sane

Over the years, The Applied Finance Group has made thousands of calls regarding stock valuations and whether they should be buy or sell candidates. More often than not, our calls have tended to work out and add value to our clients’ portfolios. Chart 1 below shows the cumulative performance of theoretical portfolios that consist of the most under and over valued stocks in the Russell 1000 and Russell 2000 indices. The main takeaway is that over time our valuation approach has delivered superior results identifying Buy and Sell candidates for professional investment managers.

Chart 1

While our results are impressive, we have had periods of poor performance, most notably during the period of irrational exuberance of the late 1990s, specifically from January 1999 to June 2000. During this period, chart 2 summarizes our performance over this time period. Notice that this period, “over-valued” stocks performed much better than “under-valued” stocks.

Chart 2

Proudly, I can say we never panicked about our under-performance during this time period. Unlike many investment research firms, we did not justify crazy company valuations. Back then, new research firms sprung to life everyday preaching how the world was fundamentally changing, and declaring that measuring corporate performance and understanding valuation were relics of the past. As irrationally optimistic about a “new world” as the market was then, today’s market suffers from excessively irrationally pessimistic beliefs about the future. As a picture is worth a thousand words, we thought it would be instructive to show our Intrinsic Value Reports for numerous high profile firms in early 2000. Understand that these charts are the exact charts our accessed in April 2000. While it is easy now to say Cisco (CSCO) was overvalued, our work showed how nutty that market really was back then when even dentists gave you a hot stock pick with every cleaning.

The following charts display our intrinsic value estimates for a number of high profile firms in April 2000. Looking at these charts, it is easy to understand why our research underperformed during this time period. Charts 3, 4, 5, and 6 show our January 2000 Intrinsic Value Reports for Cisco, ADBE, IBM, and Oracle.

Chart 3

Chart 4

Chart 5

Chart 6

Notice that prior to 1999, our estimate of these firms’s intrinsic value (the green square) and their annual trading range (blue bars) closely followed one another. Starting in 1999, the valuations for these companies far exceeded our estimates of their intrinsic values. In almost every case by 2000 these firms traded at over three or four times our estimate of their intrinsic values.In the case of Cisco, we estimated its value in 2000 at approximately $11 a share, but during the year it traded over $80 a share. Once during a meeting with a “new age” portfolio manager, after pointing out how crazy Cisco’s valuation was he said to us: “AFG has 1 vote regarding Cisco’s valuation, the market has placed over 500 billion (he was referring to Cisco’s market cap, with each dollar being a vote) votes saying AFG is wrong”. He then promptly said, “You are wasting my time” and asked us to leave.

As mentioned earlier, It is easy to see how our research under-performed during this time period. We said Cisco was worth $11 a share, and in the course of two years it went from $11 a share to $80 a share. While we did not panic, we certainly were not very popular in the money management community, but we stuck to our guns and continued to advise clients and prospects to reduce their positions in these shares. Fortunately, by 2001, Cisco’s stock price corrected to our intrinsic value estimate of less than $10 a share. The same pattern was evident for each of the other firms charted above. The excessive valuations exhibited by these firms in 1999 and 2000, corrected towards their intrinsic value by 2002.

Let us examine the market, and revisit the above companies in today’s environment. The graph below shows the sales expectations priced into the S&P 500 over time. What is interesting is how pessimistic the market is today relative to the past ten years. Notice that in 2000, it was priced to generate sales of over 18% annually, today it’s only price to grow at -5% annually. This implies that five years from today, the typical firm in the S&P 500 will have 25% lower sales than they do today! That seems a bit harsh.

On a company specific basis, Charts 7, 8, 9 and 10 show our current Intrinsic Value Reports for ADBE, IBM, and Oracle.

Chart 7

Chart 8

Chart 9

Chart 10

It is interesting how the market has come full circle since 2000. Back then, the market refused to believe that the excess profits firms generated during those heady days would eventually mean revert towards their long-term average of zero. Today, the market refuses to acknowledge that the negative economic profits many firms currently generate will tend up towards their long-term average of zero. While the market’s valuation level is very different now relative to March 2000, one thing remains certain – following the market’s manic ways rather than thinking rationally on your own will consistently result in sub-par returns for your portfolio.