In an April speech before the New England Pension Consultants' Client Conference, Vanguard Group founder John Bogle asked this pointed question: Are big-cap stocks "sucker bets"? His speech, entitled "Risk and Risk Control in an Era of Confidence (or is it Greed?)," is not so much "bearish" (a term I increasingly despise) as it is foreboding. Bogle uses mathematical reasoning, data mining, and economic realities to take dead aim at the overconfidence of today's average investor. To quote Bogle: "My point is not that we are now caught in one of those periodic snares set by the limitless supply of stupidity in human nature. Rather, my point is that we might be." Strong words, indeed.
The premise of the article is that investing has four key elements surrounding it: risk, reward, time, and cost. Of these four, only one is absolutely outside of our control -- reward. We can control the time element by being mindful of the period until we know that we will first need a distribution of income. We can control cost, by choosing our trading and tax efficiency by buying and holding equities over the long run. We can reduce (or add) risk by selecting securities in such a way that we reach a comfort level with the potential for loss of capital.
But there is no way that any of us can control our reward from investing. The reward is not guaranteed, it is also unknowable. Investing in expectations for the future is vastly different from investing in the realities of the future. Past performance does not predict future performance for any company or any portfolio, much as we would like it to. To this end, Bogle states "the stock market is not an actuarial table."
Yow. But what is this about big cap tech stocks being sucker bets? Every time I mention the word Cisco (Nasdaq: CSCO) someone reflexively says "great company." Same with Intel (Nasdaq: INTC). Same with Nokia (NYSE: NOK), Yahoo! (Nasdaq: YHOO), and JDS Uniphase (Nasdaq: JDSU). Heck, these are RULE MAKERS, right? What is Bogle's problem?
Bogle's problem is that the valuation for such companies (in aggregate) has nothing to do with assessments of quality, and everything to do with the fact that the rewards of investing must be based upon future cash flows. And that's the rub. Bernstein Research broke down the publicly traded securities on the U.S. Stock exchanges into "old economy" and "new economy," and found that the aggregate values of each were $10.6 trillion and $6.7 trillion, respectively. Realizing that stock values are based upon the expectations of future earnings, the stocks of the new economy were valued at 101 times earnings, while the old economy stocks were valued at 25 times.
Remember the eternal rule for stock values -- that the market exists to provide liquidity to companies in exchange for the promise of future cash flows, allowing investors to realize the present value thereof at any time. That is what stocks are valued on, they always have been, they always will be. Think about it, when stock prices go up based upon some piece of news, they are rising because the expectation of future cash flows has just improved as a result.
The new economy companies, which in aggregate earned $66 billion in profits last year, must earn in 2009 just shy of $1 trillion to provide an after-tax return to investors of 15% per year. That's profit growth of 31% per year, something that certainly can be done, but is by no means guaranteed. Bogle quotes Professor Jeremy Siegel of Wharton School of Business and author of Stocks for the Long Run, as pointing out that no stock that sold above a price-to-earnings ratio of 50 has ever matched the S&P 500 over the next quarter century.
Thus, his conclusion that big cap tech stocks are a sucker's bet, because most of these companies have P/Es that are double the floor set by Siegel for his research. And since all of the above companies have P/Es many times that floor (Intel is the closest with a P/E of 54, JDS Uniphase is not profitable yet), they certainly would be included by Siegel, and Bogle, in this list.
So let's look at some of the Rule Maker Companies and figure out what they are going to have to earn in the next few years to give us 15% share value growth. The 15% growth data point is fabricated, but it makes for a good minimum level of expectation. I'll then use the average expected growth rate as the multiplier (found on the Fool's earnings estimates page)
Cisco: Current P/E: 156 Current Earnings: $2.47 billion Estimated Growth Rate: 30.2% Earnings in 2010: $34 billion Ending Market Cap: $1.6 trillion Ending P/E: 48
Yahoo!: Current P/E: 508 Current Earnings: $124 million Estimated Growth Rate: 53.8% Earnings in 2010: $9.8 billion Ending Market Cap: $254 billion Ending P/E: 27
Nokia: Current P/E: 80 Current Earnings: $3.04 billion Estimated Growth Rate: 27.8% Earnings in 2010: $35 billion Ending Market Cap: $991 billion Ending P/E: 28
Intel: Current P/E: 54 Current Earnings: $7.8 billion Estimated Growth Rate: 19.5% Earnings in 2010: $46 billion Ending Market Cap: $1.7 trillion Ending P/E: 36
Seem daunting? No company on Earth today makes more than $12 billion in profits per year. We're asking Intel, Cisco, and Nokia to earn in excess of $34 billion a decade from now, and in the case of Cisco, to still have a huge P/E. And one more thing, the above exercise is only for operations and for shares that exist today. So any further dilution from options, or any shares added through acquisitions would not count. These numbers assume that the sharecount stays the same, which they won't.
All of this speaks to one thing: investors today are extremely confident about the potential returns from these companies. Historically so. It may very well work out that way; after all, we should rightly expect to pay dearly for the rights to the future cash flows from Rule Makers. But how much is too much? It defies business sense to say that you should pay for a quality company no matter the price.
I don't know the answer to this. Nobody does. But as Bogle so ably points out, those who are confident of the superiority of their positions in big cap tech companies are clearly on the wrong side of history. Myself included. This is OK, as long as we are going into these investment positions with eyes wide open to the outsized level of risk we are taking.
What do you think? Is the Rule Maker Portfolio overweighted in sucker's bets? Let's talk about it on the Rule Maker Strategy discussion board.
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