I just read an interesting column by one of the best MF columnists. He was talking about bubbles, referring to valuation bubbles as one kind of bubble. He defined a valuation bubble as a good company, which is making money in a sustainable and growing fashion, but where the price is so inflated that all the growth is already factored into the price. (As for myself, I refer to these as “story stocks”.) He gave the example of Microsoft quadrupling their revenue from 1999 to 2010, but having their stock price lose 50% over that time, and said that that is what happens when a stock is at 100 times earnings. For another example, Yahoo was close to the monopoly web search engine in 1999. You couldn’t imagine they wouldn’t succeed big. Fifteen years later they never have gotten back to even 50% of their 1999 peak. I suggest you consider those examples when you are investing in some of the high PE darlings. Monster price-earnings ratios ARE dangerous!
I just saw Denny’s post just before mine where he remarked:
In my fast growers watch list I see that 12 stocks and NASDAQ made new 52 week highs today and 3DP stocks and others made new 52 week lows.
I figured that paralleled my own post, as I had gotten out of all the 3D stocks because of high PE, big hype, and slow growth rates. I looked them up and see that in the past two years:
DDD has fallen from $96 to $14 !!!
SSYS has fallen from $136 to $31 !!!
Those are enormous losses. I know the Fool idea is to hold on and maybe they will come back… but Wow!
Stocks with PE’s in the 20’s have a lot less distance to fall, even if they have bad news. And if their rate of earnings growth is much higher than their PE, that gives you some added protection.
I like to remind myself that just because a stock has gone up a lot does not make it expensive and just because a stock has gone down a lot does not make it cheap.
It’s an interesting thought Saul and a cautionary one.
What I find interesting about those 2 examples is that although the valuation bubble in both came about from the TMT/dotcom boom that then burst leading to the massive capital erosion, the story behind both stocks couldn’t have been more different.
Microsoft stayed the dominant OS gorilla with a monopolistic freehold on the PC business software market and as you say went on to quadruple revenues.
Yahoo lost the plot and Google dis-intermediated it from browsers and ate its lunch relegating it to chimp status.
The point being that no matter how divergent the fundamental business performance was between the two, still the single biggest impact on the SP was the extreme valuation correction.
PE is not the best metric for some companies. There are companies with brilliant leaders who have gone out of their way to make sure that their companies don’t have earning, so that they don’t pay taxes. John Malone did this for a long time with TCI Communications, and TCI shareholders did phenomenally well under his leadership.
In modern times, Amazon is an example, where I believe they work extra hard to make sure nothing is reported as profit, and yet the business has grown from being a small little thing on the Internet to a monstrosity that’s a leader in several different area (e-marketplace, video streaming, cloud services).
Dreman (something like ‘Contrarian Investing something’) and O’Shaughnessy ‘What works on Wall Street’ each wrote books with research into the dangers of high multiples. However, these were written in a different climate and more or less before the phenomenal growth companies of our time.