Cheap vs Expensive: A Truism

Cheap vs Expensive: A Truism

This past six months brought to mind the truism that stocks that are cheap are usually cheap for a reason, and that barring outright fraud (like Luckin Coffee), stocks that are expensive are usually expensive for a reason.

There were people on our board who thought Crowdstrike was too expensive and overpriced to buy at the beginning of the year. Crowd is up 87% since then.

There were people on our board who thought Datadog was too expensive and overpriced to buy at the beginning of the year. Datadog is up 107% since then.

There were LOTS of people on our board who thought Zoom was too expensive and overpriced to buy at the beginning of the year. Zoom is up 223% since then.

Even Okta is up 55%, for God’s sake.

On the other hand
There were those who bought Nutanix because it was so cheap at the beginning of the year, and they were hoping for a bounce. It’s down 31% year-to-date

And there were those who bought Anaplan because it was cheap, and had pretty good results, so they thought it had to go up. It’s actually down 17%, year to date.

And there were those who bought Smartsheets because it was cheap, so it had to go up. They were right. It’s up all right, but only 2%, year to date.

And there were those who bought Elastic because it was really cheap, and they couldn’t understand why it was staying so cheap in spite of what seemed like good results and good prospects. They were correct too. It’s up 26% year-to-date (With the help of a 6% rise on Friday. It was up all of 20% year-to-date on Thursday). But they could have been up twice as much with Okta, three times as much with Crowd, four times as much with Datadog, and eight and a half times as much with Zoom.

So what’s my point? Look, I’ve made the same mistakes in the past. I got out of Amazon at about $950 a few years ago (after entering at $550), because I figured “Where can it go from here?” It’s now at $2500. Granted, that’s a lot less gain than Zoom has had just this year, and not hugely more than Datadog has had so far just these five and a half months, but I’ll admit that I never dreamed I’d see Amazon at $2500! Never! But, of course, that was before AWS took off.

What my point is, is that the best companies are overpriced for a reason. It’s usually because they are highest confidence positions for a lot of people, who understand the company and aren’t going to get scared out. And cheap companies are cheap usually because they are lower confidence for a lot of people. We were lucky and got stocks like Alteryx before people figured out what was going on, and other SaaS stocks before people understood why they were special. (We put together extreme high revenue growth, very high margins, and recurring revenue with high dollar based net retention rates, and low capital requirements). But most cheap stocks are cheap compared to our companies because people understand that they are not as good as our companies. It’s as simple as that. At least that’s the way it seems to me.

Saul

A link to the Knowledgebase for this board is in the Announcements panel that is on the right side of every page on this board.

For some additions to the Knowledgebase, bringing it up to date, I’d advise reading several other posts linked to on the panel, especially “How I Pick a Company to Invest In,” and “Why My Investing Criteria Have Changed,” and “Why It Really is Different.”

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This isn’t a rebuttal, but more of a why as I know this is something that I have had to rethink over my investment career.

Here are some cheap stock that then were either noticed or performed. They have pretty amazing performance.

fsly 133%
lvgo 139%

But here is the thing. For every turn around, under-noticed stock that you buy you are going to buy you will have a number that don’t work out. So if you bought equal parts fsly, anaplan, estc, ntnx, and lvgo then you would be up 45% The FSLY and lvgo hit feels great. High five yourself. But waiting around for the others really hurts your returns.

On the other hand if you bought equal parts of DDOG, CRWD, ZM, OKTA then you would have earned 118%

Obviously this is a contrived limited selection group of stocks but I think Saul’s point about buying quality and being willing to pay for it is one worth internalizing. I have to fight my, “cheap” nature, and this is a lesson I still am learning. Totally ok to miss out on the beginning surge of a stock and buy it even after it has already run up. As with all lessons there are caveats but this is a good generality.

Best,
Ethan

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Hopefully, it is appropriate to post this. If not, please delete it.

The market is cyclical, and different strategies work in different time periods.

Recently growth has trounced value. If you bought the fifty most expensive stocks in the s and p, and also the fifty cheapest stocks, on January 1st, the most expensive would have outperformed the cheapest by more 30 percentage points. That is the biggest difference in history.

It has been this way for 7 years for so.

However, it has not always been that way. In 2000 – 2009, value beat growth, and since 1926, value has also beaten growth.

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“value” has outperformed “growth” since 1926 if you systematically bought and sold annually based on things like book value or P/E.

Actually if you go through the pages of this book

https://www.amazon.com/What-Works-Wall-Street-Fourth/dp/0071…

he found out that the best performers were some combo of “value” and “momentum” and “small cap”

What Saul is talking about is vigilantly seeking out the best companies in the market that are growing at hyper speed and not simply being scared of owning them because they are “over-valued” based on some metrics … and not buying or selling them systematically but instead based on how they are performing in real time. And further doing that research yourself instead of giving your money to a fund manager

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Value can work just as good as growth - sometimes better. Look at CWH as a recent example. It was below $4 in March and has recently been over $24. 6-bagger in 3 months. I could be wrong, but I’m not aware of any growth companies doing that in the last 3 months - not even the mighty Zoom :sunglasses:

There are lots of ways to make money in stocks. I like to try a variety of methods myself. I made my best profit ever last year in 5 months with Bed Bath and Beyond. I sold it in January and bought some back in March. I’m not going to explain why here bc it’s probably OT, but I think it could triple in a year or 2 from my purchase price.

So, growth and value are both proven methods to make profits. It just happens that this particular board is dedicated to growth. So if you want to pursue value, there is probably a board somewhere for that.

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I have to fight my, “cheap” nature, and this is a lesson I still am learning. Totally ok to miss out on the beginning surge of a stock and buy it even after it has already run up.

I struggle with this tendency, too, and I suspect that underlying the pull towards cheap is fear: fear of making a mistake, of losing money, etc. Fear can be a sneaky beast, disguising itself as “conventional wisdom” or “this is what I learned in school”, etc. This board is an antidote to much of that. The title of Saul’s post reminds me of the quote from the Persian poet Hafiz: “Fear is the cheapest room in the house. I would like to see you living in better conditions.” (or, in this case, buying better stocks…)

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What my point is, is that the best companies are overpriced for a reason.

And, of course, they’re not really “overpriced.”

What happens in these cases is often some combination of:

  1. A historical, backward-facing analysis that doesn’t account for future growth.
  2. A forward-looking, growth-anticipating analysis that doesn’t actually foresee the actual future growth.

I’ve seen the latter happen with truly great companies. As much as Mr. Market thinks a great company is going to grow, it ends up growing more and growing faster. Mr. Market just can’t believe the kinds of numbers that great companies produce.

We had a case in point recently with Zoom. As much as Mr. Market thought revenue was going to grow, heck, as much as Saul himself thought, Zoom ended up growing more (only a few percent more than Saul’s high-end estimate, but still). The only reason the stock hasn’t taken off since then, I believe, is due to the conservative guidance given for the future. Thanks to Saul, I was able to look more deeply at management’s comments in the earnings call, where they kept saying how overly conservative they were being. The between-the-lines reading is that Zoom management knows they’re going to grow more than they were saying.

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What my point is, is that the best companies are overpriced for a reason.

And, of course, they’re not really “overpriced.”

What happens in these cases is often some combination of:
1) A historical, backward-facing analysis that doesn’t account for future growth.
2) A forward-looking, growth-anticipating analysis that doesn’t actually foresee the actual future growth.

I’ve seen the latter happen with truly great companies. As much as Mr. Market thinks a great company is going to grow, it ends up growing more and growing faster. Mr. Market just can’t believe the kinds of numbers that great companies produce.

Yes, Smorg, you really hit it with those two points: 1) A historical, backward-facing analysis that doesn’t account for future growth. Yes, thinking of Trailing Twelve Month EV/S ratios make little sense in a company that is growing that “S” at 50%, 70% or 90%.

2) A forward-looking, growth-anticipating analysis that doesn’t actually foresee the actual future growth. Yes again, CFO’s guide ridiculously low so that they can beat and raise, and analysts make believe that they believe the CFO’s because they don’t want to go out on a limb and guide higher than the company does.

But there are actually two more factors

  1. Basing anything on a single statistic like EV/S doesn’t take into account other factors like high gross margins, recurring (guaranteed) revenue, high dollar-based retention rates, and huge RPOs, etc. Statistics like EV/S were created for a different kind of company.

  2. A statistic like EV/S doesn’t take into account the effect of compounding, and especially compounding when you have high gross margins.

A company that can compound even 50% revenue growth for four years will have five times as much revenue in four years. Starting with $100, it will have $506, and with 80% gross margins it will keep $405 of that.

A company that can compound only 20% revenue growth for four years will have only twice as much revenue in four years. Starting with $100, it will have $205, and with 30% gross margins it will keep $62 of that.

Just look at that difference! And yet we still have people on our board who make lists of companies according to their EV/S, and get worried about this statistic that was made for those companies with 20% revenue growth and 30% gross margins, and think EV/S will make sense for the companies with 50% revenue growth (or more), and 80% gross margins.

I hope that this helps,

Saul

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Responding to various posts in this thread,

AnalogKid70 writes

So if you want to pursue value, there is probably a board somewhere for that.

Yes, “Value Hounds” https://discussion.fool.com/value-hounds-118990.aspx?mid=3449482…

I used to visit that board which the founder, LeKitKat, abandoned after she realized that all her wonderful deep dives did not result in great stock market returns

My Area of Expertise:
writing long pointless analyses that no one reads
https://discussion.fool.com/profile/laKitKat/info.aspx


mark19601962 writes:

It has been this way for 7 years for so.

However, it has not always been that way. In 2000 – 2009, value beat growth, and since 1926, value has also beaten growth.

Cherry picking dates with 20-20 hindsight is not a statistically valid method. Books like Stocks for the Long Run 5/E: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies do use a proper statistical method.

https://www.amazon.com/dp/B00GWSXX26/ref=dp-kindle-redirect?..


Saul writes:

This past six months brought to mind the truism that stocks that are cheap are usually cheap for a reason, and that barring outright fraud (like Luckin Coffee), stocks that are expensive are usually expensive for a reason.

The proximate cause of stock prices, like all prices, is Supply and Demand. Usually supply and demand is driven by rational value calculations specially when markets are large such as millions of shares traded by thousands of market participants. On occasion, like with tulip bulbs, 1929, and the dot com era, prices do become irrational. But most of the time prices are rational.

The bedrock of value is the discounted present value of all future cash flows. Back in 1934 when Graham and Dodd published their Bible, Security Analysis, bonds were investments while stock were “speculation.” With bonds you have almost all the data needed to calculate the discounted present value, price, interest rate, coupon dates, and maturity. The risk lay in the ability of the company to pay the dividends and to return the capital. Investors investigated the companies’ cash flow prospects to make sure these outlays were well covered.

The problem with stocks is that the data to calculate the discounted present value of all future cash flows is not available, it’s all future data. To make safe educated guesses investors typically add a risk premium to the interest rate. Interest rate is one of the most influential parameters in the calculation, specially for longer terms, no wonder Albert Einstein called compound interest the strongest force in the universe.

https://www.inc.com/jim-schleckser/why-einstein-considered-c…

Risk averse investors will always underestimate the value of stocks but it gets worse with growth stocks because they simply cannot believe that the growth is possible. You hear refrains like “the price has been discounted to eternity.” What is needed is a better understanding of the business models and growth patterns. This is not the place to discuss them in any detail so let me just suggest some topics:

Complex Systems
Increasing Returns (economic)
Path Dependence (complex systems)
Growth patterns (sigmoid or “S” curve)
Positioning (marketing)

More than a place to exchange goods, markets are information systems that somehow come up with the real price of goods and services. I have no idea how it happens because it was happening for millennia long before our current notion of information systems was born. The most one can do is to accept or reject the proposed price. This acceptance or rejection somehow miraculously propagates throughout the market.

I love simple markets like fruit and produce markets where supply and demand are more visible. Once I found a seller with a bargain on bananas. Naturally I returned the next time I wanted bananas but the bargain was gone. The seller explained that the reason for the previous bargain was that it was close to the end of the day, he had sold most of his stock, and he just wanted to get rid of what remained so he could go home. Just how do you factor that into an algorithm? LOL

The only advice I can give is read books, trust your instincts, and learn from your mistakes – may they all be little ones.

Denny Schlesinger

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Basing anything on a single statistic like EV/S doesn’t take into account other factors like high gross margins, recurring (guaranteed) revenue, high dollar-based retention rates, and huge RPOs, etc. Statistics like EV/S were created for a different kind of company.

It might be worth noting that even with a more “regular” company a statistic like this is still one dimensional and thus includes a “all else being equal” assumption. It is easy for any simple measure such as this to give a distorted view when anything is not quite usual … which, after all, is a large percentage of companies. It is just that with companies such as we discuss here that this one dimensional view is way off while with a more “regular” company the distortion may not be as large.

1 Like

What my point is, is that the best companies are overpriced for a reason.

And, of course, they’re not really “overpriced.”

What happens in these cases is often some combination of:

  1. A historical, backward-facing analysis that doesn’t account for future growth.
  2. A forward-looking, growth-anticipating analysis that doesn’t actually foresee the actual future growth.

I’ve seen the latter happen with truly great companies. As much as Mr. Market thinks a great company is going to grow, it ends up growing more and growing faster. Mr. Market just can’t believe the kinds of numbers that great companies produce.

Yes, Smorg, you really hit it with those two points: 1) A historical, backward-facing analysis that doesn’t account for future growth. Yes, thinking of Trailing Twelve Month EV/S ratios make little sense in a company that is growing that “S” at 50%, 70% or 90%.

  1. A forward-looking, growth-anticipating analysis that doesn’t actually foresee the actual future growth. Yes again, CFO’s guide ridiculously low so that they can beat and raise, and analysts make believe that they believe the CFO’s because they don’t want to go out on a limb and guide higher than the company does.

But there are actually two more factors

  1. Basing anything on a single statistic like EV/S doesn’t take into account other factors like high gross margins, recurring (guaranteed) revenue, high dollar-based retention rates, and huge RPOs, etc. Statistics like EV/S were created for a different kind of company.

  2. A statistic like EV/S doesn’t take into account the effect of compounding, and especially compounding when you have high gross margins.

A company that can compound even 50% revenue growth for four years will have five times as much revenue in four years. Starting with $100, it will have $506, and with 80% gross margins it will keep $405 of that.

A company that can compound only 20% revenue growth for four years will have only twice as much revenue in four years. Starting with $100, it will have $205, and with 30% gross margins it will keep $62 of that.

Just look at that difference! And yet we still have people on our board who make lists of companies according to their EV/S, and get worried about this statistic that was made for those companies with 20% revenue growth and 30% gross margins, and think EV/S will make sense for the companies with 50% revenue growth (or more), and 80% gross margins.

I hope that this helps,

Saul


Responding to above messages -

#1 - that is a good explanation. Maybe that is stated somewhere else in your knowledge base summaries, but the way you stated it here made it click for me.

#2 - Has anyone tried making a ranking system to help put a number to different high growth companies for all these key attributes? If EV/S is not great, what is better? I might take a stab at it, but thought maybe it’s already been tried.

Thanks

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At one point even the best stock can be overpriced.

Look at Workday what happened. They increased revenue by a factor of 10 during the last 7 years. But the stock increased only 250%.

Why?

Because the P/S shrank from about 25 to 8 during the 7 years.

Has anyone tried making a ranking system to help put a number to different high growth companies for all these key attributes? If EV/S is not great, what is better? I might take a stab at it, but thought maybe it’s already been tried.

I think the point many of us on this board are making is that the whole idea of a quest for some magic number, while perhaps understandable as to motivation, is misguided. Even with more ordinary companies, simple metrics can miss key information, information you would get if you paid attention to the company, market, product, and growth. With these high growth companies, we know from the start that we are in unusual territory … often near unique contexts. There is no substitute for understanding.

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I think the point many of us on this board are making is that the whole idea of a quest for some magic number, while perhaps understandable as to motivation, is misguided.

That needs to be repeated:

I think the point many of us on this board are making is that the whole idea of a quest for some magic number, while perhaps understandable as to motivation, is misguided.

Shouted!

I think the point many of us on this board are making is that the whole idea of a quest for some magic number, while perhaps understandable as to motivation, is misguided.

Denny Schlesinger

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A tale of 6 stocks. I did little research, because I was curious about the “bad” performance of Workday.

I made a little comparison with 5 stocks. The results:

PAYC, increased revenue by factor 6.5 the last 6 years
TEAM, increased revenue by factor 6
NOW, increased revenue by factor 5.8
WDAY, increased revenue by factor 4.7
VEEV, increased revenue by factor 4
FIVN, increased revenue by factor 3.7

The two top performers after 6 years?

PAYC and FIVN.

Stock price PAYC increased by 1.760%. Stock price FIVN increased by 1.220%.

What about WDAY? Stock price increased “only” by 250%!

Why? Because too much growth was already prices in in the stock price of Workday 6 years ago.

P/S of Workday 6 years ago: 24.4, Today 9.4

But what about PAYC and FIVN?

P/S of PAYC 6 years ago: 4.5, Today 20.4
P/S of FIVN 6 years ago: 2.5, Today 15.9

The lesson: Yes, even for growth stocks valuation is important. If you pay too much today with too much growth priced in, your returns will suffer.

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The lesson: Yes, even for growth stocks valuation is important. If you pay too much today with too much growth priced in, your returns will suffer.

zerohedge12 –

For the second time, we have already fully conceded your point. Valuations for many of these names indeed run quite high. It is up to the individual whether they want to pay it. Maybe you missed that concession the first time around, so here it is again: https://discussion.fool.com/i-only-listed-verifiable-facts-it-is….

As you can see, no one is disputing what you write. In fact, quite the opposite. We’d love to hear whatever technique, process or alternative you might have that mitigates this risk. Preferably, whatever info you provide would apply to one of the numerous stocks discussed on this board. As it is, you have simply provided another unactionable example of a lesson we already understand.

Again, do you have anything else to add? Why do you think WDAY contracted during those six years? Which current name do you think has too much growth priced in and why? Why do you think PAYC and FIVN expanded? Even more relevant, do you have a recommendation for the next PAYC or FIVN? If so, we’re all ears.

I’ll hang up and wait…

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3) Basing anything on a single statistic like EV/S doesn’t take into account other factors like high gross margins, recurring (guaranteed) revenue, high dollar-based retention rates, and huge RPOs, etc. Statistics like EV/S were created for a different kind of company.

Yes! The “metrics” don’t work on high growth companies.

But, even “in-depth analysis” won’t work. Over on the premium board for the stock-that-must-not-be-named we have a revived thread on a DCF (Discounted Cash Flow) analysis that was done about a year ago. It was well-done by a smart and thorough member. But, as some of us predicted, it failed to properly characterize the stock’s future behavior. Why?

The output you get is based on the future-looking guesses you provide. As evidenced by some comments here, some people are looking for an equation that is somehow absolute and predictive. There ain’t no such thing. What’s worse, the danger of doing something as involved as a DCF analysis is that because it’s got formulas, you think the answer is somehow more real.

But, it ain’t. The answer is still wholly dependent on the inputs, and the inputs are literally guesses you make about what the company is going to do in the future. As I pointed out in that thread, I didn’t need to see the math or even the result - just from the guesses going in (and they were guesses) I could tell what the answer would be.

Which ties back to my original point about how hard it is to predict how much or how fast high growth companies are going to grow. Standard metrics and even in-depth analyses will fail on these companies every time. If you want to know what See’s candy is worth, sure Mr. Buffett, go ahead and do a DCF. You can do it today on Apple even (I guess he did that, too, recently). But, it won’t work on the companies we discuss here today.

TMF has a service called “Rule Breakers.” Here’s a blurb: And we’re going to look at some of our better stock picks in Motley Fool history and give out the valuations and some of the traditional metrics where those stocks were trading back then. We’ll be hand-picking, of course, some of our big monster winners to know that despite looking dramatically, crazily, horribly overvalued relative to how most of the world saw them back then, indeed, these stocks went on to be the best stocks, better than any of the other performers.

Read transcript or watch video (premium subscription NOT required): https://www.fool.com/investing/2019/06/06/rule-breaker-inves…

I’m not equating what is done on this board with what TMF’s Rule Breakers does, but just to show that there is support for how to hand higher growth stocks beyond what’s discussed on this board. There are some unique aspects to the discussions here, but the vanilla strategy of ignoring standard metrics and equations is not itself unique or really that controversial.

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“Look at CWH as a recent example. It was below $4 in March and has recently been over $24. 6-bagger in 3 months. I could be wrong, but I’m not aware of any growth companies doing that in the last 3 months - not even the mighty Zoom 8-)”

Over the past couple of months, I have seen many references in which the argument is anchored on a company’s performance since that particular company’s Covid induced low of March '20 (i.e. the disastrous “Covid Correction”).

Personally, I find this to be somewhat of a false argument; given the overwhelming performances of many companies that have seen dramatic recoveries since their Covid Correction bottoms. We witnessed a historical collapse of many companies at the height, or should I say depth, of the Covid Correction. Since, we have now seen the historical rebound of many of these same companies. Not solely based on fundamentals, but based on exterior forces that crushed the market in March, coupled with an unprecedented recovery that has taken place in the market in part due to the Feds interference. Some of these companies have even benefited further due to various Covid created tailwinds, such as “Work From Home” or “Work From Anywhere”.

I am not convinced that the example used above (“CWH”)is a true reflection of a value play; I see it as a market timing play. In my personal opinion, CWH should be measured on Pre-Covid vs. Post-Covid for purposes of price appreciation bragging rights. At the height of the S&P 500 (Feb. 19, 2020) CWH was trading at $15.88/sh. It’s most recent close as of Friday was $23.37/sh. That tells me it has appreciated 47.2% since that Pre-Covid price and 64.8% YTD, not bad, but certainly not a 6-bagger. I would present that much of this price appreciation is primarily due to tailwinds related to “get out and go” “on the road” travel growth in a Post-Covid society. By no means can it be considered a 6-bagger. Based on this argument, we should have all sold our portfolios and purchased Wayfair in March, which is up nearly 690% since its Covid Correction bottom in March '20.

I don’t begrudge any investor their phenomenal returns had they purchased CWH at the March low; I just don’t think it is an argument made fairly against Saul’s initial point outlined at the beginning of this thread.

Respectfully…Harley

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What about WDAY? Stock price increased “only” by 250%!

Why? Because too much growth was already prices in in the stock price of Workday 6 years ago.

That’s not what I see when I look at the record.

I see a company whose stock price suddenly stalled in July 2019 and hasn’t recovered. What I see is that Revenue growth had slowed to 32% while operating expenses increased more than that.

If you were to pick an end time of July 2019 (when the CEO sold $1.4M of stock), you would have seen a better CAGR for the company.

And remember, here’s a 15-year old company with a market cap of $40B with slowing revenue growth and still wasn’t profitale - and you wonder why its stock price hasn’t done well this past year? Kind of amazing it did as well as it did previously.

The lesson here isn’t that Workday was over-valued before, it’s that its growth prospects were limited. Many stocks can be overvalued - it’s the high growth ones that aren’t really. Workday wasn’t one of those.

If you want to look at the record, just look at Saul’s monthly summaries. See the stocks that were bought and what their valuation was at the time they were bought. Then see what he sold them for, often when growth started slowing. You can’t argue with the factual history.

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Zerohedge, as a number of annoyed board members have pointed out, you seem to be here just to argue with us and claim over-and-over that our overvalued stocks are going to do us in (in spite of our own extraordinary results with them for years).

Why don’t you tell us what YOU have been investing in? And describe them and tell us WHY you are investing in them? And what YOUR results have been? In other words, add something to the board instead of trying to disrupt it.

Zerohedge, this is the second time I’ve called you out, and I promise you, if you continue on this path I will commence deleting your posts.

Saul

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