Post of the Day
April 15, 1998
Subject: Re: Is it different this time?
"Again, you have TOTALLY lost me. You buy a share of a company so you can participate in its future performance."
Several others have already given excellent explanations of what is wrong with this approach, but I'd like to add a few more comments. Future performance is one of several ways of valuing a company. Of course, a keen investor is going to consider a company's future potential. The problem is when you begin to concentrate exclusively on that element and disregard all others. The Fools foolishly encourage this investment strategy, even though it has never worked --without exception -- despite several attempts dating back centuries.
Graham identified this as the central change in investment strategy (i.e. investment becomes speculation) that caused the stock market bubble in the late 1920's. He also identified many of the symptoms of that bubble that sound very similar to what is going on now.
Graham writes about the traditional method of valuing stocks:
"Investment in common stocks was formerly based upon the threefold concept of: (1) a suitable and established divided return; (2) a stable and adequate earnings record; and (3) a satisfactory backing of tangible assets"
|Once economics, not psychology, rules the market again, investors will shift to stocks that pay high dividends. Amazon does not make any money, so it can't pay any dividends.|
Consider these points:
(1) a suitable and established divided return
What's a dividend, you ask? That's when a company actually pays you to hold their stock. For example, if you held $50 stock that paid you $5 a year, then you'll be making 10% from dividends alone. Dividends are one way that companies return something to the investor. A company gives the investor a piece of profit it has made. You don't pay $95 for the right to own a piece of paper that says AMZN. The owner has to get some benefit from Amazon for holding that piece of paper. The only thing most AMZN longs are concerned about is how much the next Fool will pay for that piece of paper.
Once economics, not psychology, rules the market again, investors will shift to stocks that pay high dividends. Amazon does not make any money, so it can't pay any dividends. That means that investors will want to stay away from a stock like Amazon, decreasing its value dramatically.
(2) a stable and adequate earnings record
Earnings are important too. Graham never said they weren't. But don't forget stable and adequate. Stable -- wouldn't you rather own a part of a company that has made money for decades rather than one that loses increasing amounts of money? You may not care, but other investors probably will. A company needs earnings to survive. Amazon will not make any money this year, nor next year. The next couple of years, if they do make money, will probably be spent paying back the debt they've accumulated. It will be years before AMZN will ever make enough money to return some of it to itself or to the investor. One thing you need to *bear* in mind is that money has Foolishly been flowing into the market for the past few years. Economics says that this money will eventually run out, as stocks become too high for anyone to buy. When that money starts to tighten up, investors will look for companies that are making money. They will want to *invest*, not *speculate* in companies, and AMZN is pure speculation.
(3) a satisfactory backing of tangible assets
Even if a company doesn't make any money, it may still have assets (for example, inventory, real estate, patents, etc.) that it can sell. Even if a company will make $0 next year, it will likely have a lot of assets that it can sell. This gives the company some intrinsic value outside of earning potential. If Amazon was to liquidate all of its assets tomorrow, how much could it sell for? I'd guess $300 million at most, and that's putting a very generous valuation on its "brand" (which accounts for less than 1% of total domestic book sales.) In any case, asset value is a fraction of AMZN's market capitalization.
If we measure AMZN by the traditional system, it is nearly worthless. It doesn't pay any dividends, it will be years before it will make enough money to pay off its debt, and it has insignificant assets. Using this system, AMZN would likely be valued at $15-$20 a share, and even that is very speculative.
|When investors start to base stock prices on future earnings, they will always overestimate the future, because they want to be rich. They will accept any evidence as reason that the stock price deserves to go up. You end up paying more for something than it is really worth. That is the cause of bubbles.|
As I quoted in the last post, Graham wrote:
"Two of the three elements stated above lost nearly all of their significance, and the third, the earnings record, took on an entirely novel complexion. The new theory or principle may be summed up in the sentence: The value of a common stock depends entirely upon what it will earn in the future."
This is exactly what AMZN investors are doing. They are disregarding everything else and basing the price entirely on future earnings. THIS SYSTEM DOES NOT WORK. It has been tried several times before, it has never succeeded and it will not in this case. For examples, such as tulips, read:
Using future earnings as a means of measuring a stock is based completely on psychology. Human nature wants humans to be rich. If the market is ruled by psychology, prices will go up, up, up because everyone wants to be rich. It can govern the market in the short run, thus providing evidence that the system seems to work, but IT WILL NOT WORK IN THE LONG RUN. When investors start to base stock prices on future earnings, they will always overestimate the future, because they want to be rich. They will accept any evidence as reason that the stock price deserves to go up. You end up paying more for something than it is really worth. That is the cause of bubbles. Without any economic value to back up the stock, the bubble will pop.
AMZN is not any different than a tulip bulb. It's price can not forever be based on what the next sucker will pay for it, depending on his or her version of the future. Eventually, the future must happen and that is why it's so important to be skeptical about valuations and consider risks to that version of the future. If you're like any other human, you're willing to believe anything to justify you being even richer. Unfortunately, psychology can not rule the stock price forever. Economics will take over. I'm still waiting for someone to explain the economics of AMZN, not the psychology. One day there won't be any more hyped-up Fools and AMZN will trade for its economic value, not its psychological value.
AMZN is an extreme case of speculation out of control, but I hope you can learn from it to get a better understanding of the big picture, which doesn't look much better IMHO. Don't think that it's different this time because it has never been any different.