Stock markets at historical valuations

Quarterly Letter

Stock markets at historical valuations

Overall stock market indices keep marching on after a wonderful year in 2013 and delivered roughly a 5% increase for the first quarter (in CAD). As a reminder, March 2014 is the five-year anniversary of the February 2009 market bottom.

During this 5 year period, we have experienced a non-functioning congress, a downgrade of the US Treasury, mass unemployment, exploding deficits, record debt, a possible dissolution of the European Union and a slow motion stock market crash in China and the emerging markets, and perhaps more bad news that have slipped our minds! As if all these events are not frightening enough on their own, the thirst of the mainstream media for attention, coupled with the rising popularity of social media, has managed to amplify this series of bad news to an even higher level. We are not even including all the charlatans who see bubbles and crashes at every turn of the financial markets and do not hesitate to publicize their so called “expert opinions”. In short, it has not been easy to be invested in the market over the last 5 years. Your ability to ignore the sirens and stay the course is to be commended and we thank you for your trust and courage.

One of the most important contributors to successful long term investing is asset allocation. Long term data clearly demonstrate that stocks, though more volatile than bonds, have rewarded investors with higher returns. Obviously, if one could avoid the losing years, returns would be dramatically higher than the buy-and-hold strategy. With this in mind, many investors try to time the markets and many so called experts sell them their forecasts, despite the fact that study after study has concluded that the timing exercise is futile and costly for most.

What amazes us most is that despite all the evidence that stocks outperform most assets classes in the long run and despite all the evidence of the futility of market timing, the financial media still has this obsession about forecasting. What is even more absurd is the fact that CNBC is one of the most popular business channels in the US and Jim Cramer (its star commentator) et al have a pretty big following. It makes us wonder sometimes about the sanity of people.

By the way, since 1926, the S&P 500 has had 24 down years, i.e.27% of the time. Next time when someone asks you what your prognosis is for the market, just say it will be up. Chances are you will be right 73% of the time …

After a 125% rise from the bottom, we recognize that stocks are not unusually cheap anymore. However, most valuation metrics are consistent with historic averages and “average” is not a good enough reason to be bearish. As always, our message is to be selective, prudent and most of all, ignore all forecasts and predictions and focus on a firm’s fundamentals. As Ben Graham said so well: “Investment is most intelligent when it is most businesslike”.

Our two cents worth ….

We concentrate our efforts on identifying good companies selling at reasonable prices. Although we find that bargains are scarcer than they were a few years ago, we have not observed major overvaluations in our selection universe ….yet! However, one should always remember that if a storm does arise (and they always do at some time or another), good companies can always survive.

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Most of you probably remember the Internet Bubble and subsequent bust in the late 90s and early 2000s. Interestingly, Twitter went public at $26 a share with a market value of $18 billion. It had gross revenues of $665 million and net operating losses of $645 million. If you thought that the valuation was insane, it promptly doubled, hit a high of $73 last December and is now currently trading at about $42 a share.

Here is a short table that illustrates the extraordinary speculation in high tech companies today:

Note: Simplistically, the price/earnings (p/e) ratio is an indication of the number of years it takes to recover the initial investment from current earnings. A company with a very high p/e ratio is indicative of investor expectations of high growth rates in earnings in the coming years. With a lack of, or lower-than-expected growth in earnings, the stock price collapses. The same can be said for the price-to-sales ratio.

  Market Cap. P/E ratio Price to Sales
(USD billions)
(# shares x price)
(price div. by earnings) (price div. by sales)
Social Media  
Twitter 39 (loss) 38X
Netflix 27 186X 6X
Facebook 174 116X 21X
LinkedIn 24 887X 15X
Yelp 7 (loss) 27X
Yandex 12 33X 11X
Tencent Holdings 159 59X 16X
Other Tech/Web  
Groupon 6 (loss) 2X
Service Now 10 (loss) 22X
Salesforce.com 38 (loss) 9X
Netsuite 9 (loss) 21X

How is it going to end for the above-mentioned group of stocks? Probably very badly. When? No idea!

The Claret team