The Greates Risk to Investors

20 August 2020
Market Insights

“The greatest risk to investors is overpaying for what you own.”

John Templeton

John Templeton is recognized by many stock market historians as one of the greatest investors of all time. During the 38 years that he spent at the helm of the Templeton Growth Fund from 1954 to 1992, the fund averaged an annual return of 16%. His track record eclipsed that of the world stock market index over that period by 3.7% per year. At first blush, an outperformance of 3.7% per year may not seem like a lot, but when that incremental return is compounded over 38 years, the difference in ending value for an investor is enormous. For example, a $100,000 investment in the world stock market index in 1954 would have grown to approximately $8.2 million (12.3% average return) by 1992. Comparatively, an investment of $100,000 in the Templeton Growth Fund in 1954 would have grown to a value of over $28 million, almost 3 ½ times the value of the index investment.

John Templeton was not only one of the greatest investors of all time, but he is also one of the most widely quoted. Versions of Templeton’s Investing Maxims can be found in various books, magazines, investment literature and websites. While the list of maxims is truly required reading for investors at any level, there is one quote that we believe has particular value in the current environment. Here is a paraphrased version of that quote:

If 10 engineers tell you to build a bridge a certain way, then that is how you should build the bridge.
If 10 doctors provide the same diagnosis, then you should follow their recommended treatment.
However, if 10 investment analysts tell you to buy a particular stock, then that is the last stock that you should invest in.

What exactly does that mean? Did John Templeton believe that investment professionals, who spend all of their time researching markets, industries and specific companies, have no idea what they’re doing and that their analysis is worthless? We don’t believe so. Rather, we believe that he was acknowledging a pattern that has been repeated time and time again in financial markets. That pattern is simply that the more excited investors become about a particular stock, the more they buy the stock. As the stock is purchased, the price of the shares goes higher and higher. The rising price causes other investors to buy the stock as well, as they don’t want to miss out on the strong investment gains. Ultimately, you are left with a stock price that is significantly above what the company’s sales, earnings or cash flow could possibly justify. At that point share prices are based on hopes and overly

optimistic predictions about the future, and investors are unwittingly exposed to the potential of significant drawdowns and massive disappointment.

So, what does that have to do with the current environment? As we all know, the first 7 ½ months of 2020 have been extremely volatile in the stock market, but as we sit here today most investors are in good spirits given that the broad measure of US Stocks (S&P 500) is up over 5% for the year and the tech-heavy Nasdaq 100 is up over 30%. The news outlets have been riddled with worrisome headlines in recent months. Looking specifically at the stock market, it is not difficult to find anecdotal evidence of extreme speculation and elevated risk. Some examples include:

Massive increase in retail day trading reminiscent of late 90s tech bubble

E-Trade’s daily trading activity was up 267% in the second quarter over last year
Enormous adoption and growth of phone app trading platforms such as Robinhood

Hertz Rental Car Company

Hertz filed for bankruptcy on 5/22/2020 as a result of the pandemic induced devastation to the travel industry
After hitting a low price of $0.40/share, Hertz common stock surged over 475%
The company tried to issue more shares of stock to raise capital even though they admitted in a regulatory filing that the shares would likely be worthless as a result of the bankruptcy process

Meteoric rise of Tesla stock

TSLA is up over 350% YTD making it the highest valued car company in the world (Toyota is # 2)
Toyota had revenue that was 10x that of Tesla in 2019
Toyota made $19B in 2019, Tesla LOST $862M in 2019
Toyota sold 10.7M cars worldwide in 2019, Tesla sold 368,000

While human nature makes is easy to get caught up in the hype and excitement of some of the hottest stock market trends, most prudent investors are able to take a step back and understand that the hottest investments will most likely flame out and end in disastrous losses. For that reason, we don’t expect these often-cited pockets of speculation to result in significant damage for the larger investment population. However, there is an area of the stock market that most investors have significant exposure to and that may result in financial pain in the months and years ahead. Unlike some of the ridiculous examples outlined above, the area that we are most concerned about is one in which most investors, both retail and professional, deem to be completely safe and void of risk. The area of the

market that we are referring to is affectionately known as the FAAMG stocks (Facebook, Amazon, Apple, Microsoft and Google). That’s right, the big tech stocks that play a major role in our everyday lives. The common response is, “how can that possibly be? Everyone I know owns an iPhone. All of my neighbors have five Amazon packages on their doorstep on a daily basis. The word google is a verb that is defined in Webster’s dictionary as the act of looking up information on the internet. How could the stocks of those companies pose any serious risk to investors?” There are two important elements of risk that we’d like to review; the concentration of exposure and the price paid for the stocks.

First, the overall market exposure to the big five tech stocks is enormous. Four out of the five stocks are valued at over $1,000,000,000,000. The largest, Apple, is valued at almost $2T. Never mind the fact that Apple earned more than $5B LESS in operating earnings (EBITDA) in 2019 vs. 2018, and approximately $2.5B less than it earned in 2015. Yet, the stock has risen 337% since 2015. The combined value of the FAAMG stocks is currently valued at just under $7T. That is 35% larger than the entire Japanese economy. These companies are so large that almost every investor has massive exposure to them, whether or not you own the individual stocks. There has been a significant move toward index investing over the past 10 + years with the rationale that active investors can’t beat the market and the index provides broad diversification. The main index that is used in many 401k plans and brokerage accounts as a proxy for domestic stocks is the S&P 500. That index contains over 500 different companies, so on the surface it is well diversified. However, given the fact that the S&P 500 is a weighted index based on the market capitalization (total value) of each stock, the big five tech stocks make up an oversized segment of the index. The FAAMG stocks represent 1% (5 / 500) of the number of companies, but account for approximately 23% of the value. Therefore, as the big tech stocks go so does the index. Does that mean that active managers have less exposure? Not necessarily. Many mutual fund managers have been piling into the big tech stocks in recent years. There is probably an element of FOMO given the undeniable outperformance in recent years. Another element that comes into play for the largest fund companies is that the sheer size of their assets under management forces them to own large portions of the biggest companies. Those fund companies have so much money to invest that they simply cannot take a meaningful position in smaller stocks.

What could possibly go wrong? Well, we believe there is some merit in the age-old wisdom, echoed by John Templeton and many of the other investing greats throughout history, in that no company is so good that it is a good investment at any price. Apple’s current stock price seems too high to us, but if Mr. Market believes that $2T is a fair price, then what price is too high? Is $3T too high? How about $4T? Never mind the fact that their main revenue generator is the saturated iPhone market and that the company makes less money now than they did 5 years ago. What about Amazon? Amazon must be a good investment because we see a new package from them on our doorstep every day, right? What

some investors do not realize is that the majority of Amazon’s profit up to this point has nothing to do with their online retail operation. Rather, it comes from Amazon Web Services (AWS) which provides cloud hosting solutions to companies and government agencies. AWS growth has been strong, and that strength is likely to continue given the accelerated adoption of remote and hybrid working environments. Strong cloud services and the reliance on technology has also propelled Microsoft’s stock to new highs. While this environment clearly favors these stocks over other segments of the economy, we are not convinced that their businesses are completely impervious to the prospect of a drawn-out period of slower global growth and/or recession. In fact, there was an article in the Wall Street Journal last week that highlighted some of the cost pressures that are starting to show up for cloud service providers. The article specifically mentioned the efforts of Audi, a division of automaker Volkswagen, to reduce their ongoing AWS spend by 30% as part of their overall cost cutting measures. The article also mentions a larger travel planning company based out of Norway that saw its cloud usage plunge more than 50% as a result of the pandemic. Therefore, while it’s easy to craft a story as to how these companies will benefit from the acceleration of online services, we don’t believe that there are any areas within a company that are completely immune to cost cutting pressures, and that includes the IT department.

What does this mean for investors? Even if the big tech stocks are not completely recession proof, aren’t they still better off than most other sectors of the economy? Don’t they represent the “nicest house in a crummy neighborhood.” From a business perspective, we would say yes. These companies seem to be well positioned to whether the storm. From an investment standpoint, on the other hand, we believe there is significant risk harkening back to Templeton’s quote that the greatest risk to investors is overpaying for what you own. To be succinct, we believe there is potential to lose money on these stocks over the next five to ten years even though the individual businesses continue to thrive and grow their revenue and profits. While that may seem crazy on the surface, there is some historical context for exactly that type of scenario. In the late 1960s to early 1970s, there was a grouping of stocks deemed the Nifty Fifty. The Nifty Fifty were 50 dominate titans of industry. They represented some of the biggest and most well-known companies of the time and many of them are still around and thriving today. Names like McDonalds, Coca-Cola, Proctor & Gamble and Walt Disney were among the Nifty Fifty. From and investment standpoint, the Nifty Fifty were talked about as “one-decision stocks.” That simply meant that they were stocks that should be bought, and never sold (sounds familiar). The problem was that the higher the prices of the Nifty Fifty stocks went, the more investors bought them. The prices eventually got so high by the early 1970s, and so out of touch with business fundamentals, that investors ended up suffering a long period of significant losses.

The chart below shows a hypothetical investment of $10,000 in five of the Nifty Fifty stocks from December 1972 to March of 1982.

As you can see, this sampling of Nifty Fifty stocks all lost money over a period of 10 years. Coca-Cola and Disney lost over half of the initial investment. Some of the Nifty Fifty stocks fared better. The most notable outlier to the positive side was Walmart. Many of the Nifty Fifty stocks fared as bad or worse. The worst performer of the group was Polaroid which suffered a loss of 91% from its high. Hardly “one-decision” after all. While 2020 is very clearly a different world than the early 1970s and all of the facts and circumstances of the Nifty Fifty don’t align exactly with today’s market leaders, we do believe there are some important lessons to learn from that period. As Mark Twain is quoted as saying, “history doesn’t repeat itself, but it does rhyme.” From our perspective, there is a familiar ring to the market sentiment that these technology juggernauts will grow to the sky and that investors cannot lose.

We are certainly not the first to raise concerns about today’s market leaders. In fact, many market commentators have talked about tech stocks being overvalued for years. Amazon is the biggest example of a stock that has been doubted and completely defied gravity for the last 5+ years. Another important investing lesson that investors have learned repeatedly throughout history is that popular stocks or hot areas of the market can completely detach themselves from fundamentals for an extended period. Even John Templeton was not immune to the harsh realities of that lesson. Notwithstanding Templeton’s untouchable 38-year track record managing the Templeton Growth Fund, there were numerous periods when his fund underperformed the general market to a significant degree. The most extreme example came after Templeton unloaded his investments in Japanese stocks in the early 1980s based on valuation concerns only to watch as Japanese stocks continued to stay red hot through the second half of the 80s. At the worst point, Templeton trailed the world index benchmark by over 100% over a 5-year period. It was certainly a trying time for Templeton and his team, but their patience was ultimately rewarded when the Japanese stock bubble burst. Here we are in 2020, over 30 years later, and the Japanese stock market has still not recovered to its peak in 1989. We believe investor patience will be rewarded once again.

We will conclude our discussion where we started, with another of Templeton’s famed investing maxims.

“To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude, even while offering the greatest reward.”

Investment Decisions