Options and Stock Market Bubbles
A final warning on exotica takes us back to Ben Graham's opinion on options. Even before stock option awards to managers became commonplace, Graham disparaged the instruments on more general grounds.
Options originally were attached to bonds and by the 1920s had expanded as part of other financial innovations Graham regarded as abusive. When they reappeared more widely in the 1960s, Graham regarded "stock option warrants" as they were then called, as "a near fraud, an existing menace, and a potential disaster." He believed they created value out of thin air, had no excuse for existing except to mislead people, and should be prohibited by law or at least capped at a minor part of a company's total capital.
The major negative effects of options are dilution of existing shareholders' ownership interest in the company—including existing earnings per share, sharing in future growth, enjoying dividend payments, voting for managers, and other major corporate changes such as mergers and (a bit ironically) new option plans. Graham could see no purpose in options generally other than to "fabricate imaginary market values." In short, Graham condemned stock options as criminal, a monstrous and "wanton creation of huge paper-money." 10
Buffett echoes the point less vociferously by saying that "the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I'll be happy to accept a lottery ticket as a gift—but I'll never buy one.)" 11 The lesson for investors is clear. Stay away from options and stay as far away as possible from companies in which options constitute a significant portion of total capital.
ALCHEMY
Stock market bubbles occur when aggregate capital invested in equity securities exceeds the amount of profitable deployment opportunities so that prices exceed values by terrific multiples. They result from the hope that the stocks people pick will turn out to be the ones that enjoy the profits. But if, say, $100 billion is allocated to ventures that can only give returns from profitable investments on $10 billion, then $90 billion in disappointment is going to come— 90% of the dollars will be left standing without chairs to sit in when the music stops.
The main difference between the musical chairs of market speculation and the activity at the typical racetrack is that horse races take only about two minutes to separate the gambler from her money. What horse betting and the stock market do have in common, however, is that those who study the horses or businesses and who bet seldom are more likely to be winners than are those who bet on every race or stock. 12 In the early stages of a boom that may bubble, if you can find the cinch stock at a low price and load up on that stock, it is reasonably likely that you will win; if you bet on everything that comes down the track, it is most certain that you will lose.
Those who bet on everything coming down the track add hot air to the bubble. It is a large-scale version of the mania that leads to around-the-block lottery lines during hefty jackpots. What creates most bubbles is the whiff of great riches from something new that excites people and leads them to irrational behavior or at least herd- like behavior.
The wildfire of excitement is spread by unchecked rumors of champagne and caviar dreams come true—stories of riches, reinforced by greed. The frenzy spirals, but ultimately breaks. In reality, only one person wins the lottery jackpot and the multitudes experience the most expensive case of "monkey see, monkey do."
Edwin LeFevre put it nicely: "The appeal in all booms is always frankly to the gambling instinct aroused by cupidity and spurred by pervasive prosperity. People who look for easy money invariably pay for the privilege of proving conclusively that it cannot be found on this sordid earth."
Real investors are not the same people who wait in long lottery ticket lines. They realize that "get rich quick" usually means "get poor quicker."
For a bit of deja vu, consider Graham's observation from the late 1960s: "The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some 'action' in progress. It will fall for any company identified with 'franchising,' computers, electronics, science, technology, or what have you, when the particular fashion is raging."
In Yogi Berra "it's deja vu all over again" style, note this similar vintage Graham lament: "Bright, energetic people—usually quite young—have promised to perform miracles with 'other people's money' since time immemorial. They have usually been able to do it for a while—or at least to appear to have done it—and they have inevitably brought losses to their public in the end. . . . [I]t is probably too much to expect that the urge to speculate will ever disappear, or that the exploitation of that urge can ever be abolished." 15
The urge to speculate endures, with vast numbers of people seeming to accept the declaration of hyperventilating venture capitalists and day traders that the new economy of the late 1990s and early 2000s means that the old rules of the game no longer apply. An extraordinary statement of these times was uttered by the chief economist of a prominent investment research firm who announced to The New York Times that "we no longer think we know how to value companies" (to be kind, that confused confessor shall go unnamed in this book).
Valuation has always been difficult, but how much harder now can it be than it was before? Cash is the ultimate economic payoff. If you can't get to the point of figuring out how long it takes to get cash and what risks may reduce the amount or value of it, then it is not that you don't know how to value companies anymore but that the things you are trying to value are not worth trying to value.
Proponents of financial alchemy shrink from the mind-set of business analysis discussed in this book, presumably deeming its tools conventional, maybe even boring, dull, and old-fashioned. When people want to be rich now, they relegate the idea of a nest egg grown with patient discipline to the dustbin of the older generation's history, alien territory to freshly minted paper millionaires and their envious contemporaries.
Unfortunately, this attitude leads to day gambling on stocks using credit card debt and a "buy now, pay later" myopia that neglects the inevitable day of reckoning. It also leads to the popularity of techniques that enable false positive answers to key questions about a business when traditional tools give negative answers.
In the biotechnology industry in the early to mid-1990s, for example, fewer than 10% of companies generated earnings and few even generated positive cash flows from their operating businesses. But those companies needed new investment. Since the traditional measures of business analysis could not tell a convincing story, they turned to unorthodox measures. The most striking was a measure of so-called performance known as "cash-burn." This was the rate at which a business was "able" to spend cash on new research projects. The more burn, the better the management and the more desirable the investment. Crazy?
It is not much crazier than the similar move made in the Internet and high-technology industries of the late 1990s and early 2000s. These financial entrepreneurs jettisoned the traditional metrics of performance and value based on earnings and cash in favor of new ways to look at these questions. Take market share, for example.
Entrepreneurs say, "Look, we have 60% of the market in selling flowers (or whatnot) over the Internet, and you should give us credit for that." Or, more optimistically yet, "We have 10 million 'hits' on our Internet site every month. Even though we don't make money, that's 20 million (or so) eyeballs, so we must be good, we must have value, and you should invest with us."
People do in droves, following a monkey see, monkey do mentality. For most—though not all—of those businesses, the flood of funds is unjustifiable in a business analysis mind-set. (The next growth industry is likely to be Internet bankruptcy law firms.)
Every frenzy is accompanied by rational-sounding new rules that attempt to explain the irrationality. In the last century alone, a "New Era" bull market culminated in the 1929 crash (fueled by the spread of wonderful new technologies such as cars, electricity, vacuum cleaners, washing machines, radio, and talking movies), a "Second New Era" flamed out in 1962's "New Panic," and a "New Performance Phenomenon" preceded the implosion of markets and mutual funds in the late 1960s. The stock market bubble in Japan in the 1980s was fueled by the widespread belief that Japan had created a "new" economic model that defied the historical principles of economics. Market share was king, and companies were rewarded if they had it and rewarded more if they got it at the price of having no or low profits, much as in 1990s—2000s U.S. markets. 16
This is not to say that market share is irrelevant. Market share is a standard and useful indicator of the relative performance of Coke compared to Pepsi, for example, and something both these companies pursue aggressively in their competition in the beverage marketplace. And it is significant that Cisco has 80% of the router market and 30 to 40% in network switches and that DuPont dominates global markets in nylon and Lycra. That kind of market scale enables a company to lower the cost of sales and general and administrative expenses, which translates into higher profits.
But Coke, Pepsi, Cisco, and DuPont make money in their markets. A larger share of a profitable market is certainly desirable and a good indicator of strong business performance. The same can hardly be said for a larger share of an unprofitable one. On the contrary, the greater your share is, the more money you lose.
Aggressive accumulation of market share can be perfectly disastrous for a business. Look at what happened to the airline industry after deregulation. Intense competition for market share drove nearly all the profits out of that business. The same thing occurs in the submarkets where Coke and Pepsi compete, driving profits at bottlers for those brands close to zero in some places.
Nor is this to deny that technological changes from the 1980s to the 2000s produced significant shifts in the economy. Rising oil prices, for example, historically throttled the economy, sponsoring the recessions of 1973, 1980, and, to a lesser degree, 1990. Yet when oil prices more than doubled during the late 1990s and early 2000s, inflation remained quite low and no threat of recession loomed. Part of the reason was a shift to natural gas and greater use by major oil consumers (such as airlines) of hedging contracts that reduced their exposure to such price increases.
But a major part of the reason is econographic shifts from oil- consuming manufacturing operations to oil-independent service businesses, including those run on the Internet. Manufacturing operations as a percentage of the economy shrank from 22% in 1977 to 17% twenty years later. The share of gross domestic product (GDP) allocated to oil purchases fell from 8.5% in 1981 to about 3% in the late 1990s. The Internet is surely part of this shift, as it enables the conduct of sales and distribution businesses at far lower cost than traditional means. 17
Even so, oil prices above some level will still trigger such mac- roeconomic problems. Indeed, the plunge in the Dow by nearly 4% in March 2000 was led by a 30% drop in the stock price of Procter & Gamble. That company issued a warning that its quarterly earnings were going to be way lower than those in the same quarter of the prior year and much lower than analysts expected. The company cited as one cause of that disappointment the rising cost of oil, which it uses in many of its products.
Another part of the shift is surely the increasing value attached to intellectual as opposed to physical capital. Businesses producing and selling software or on-line services can grow more quickly and at lower cost than can those producing and selling automobiles or oil. Far less investment in factories, plants, and equipment is required.
There is no reason to believe, however, that those companies as a whole can grow any faster than the economy overall is growing. In the end, the old-fashioned companies (the so-called old economy companies) are the major customers (and beneficiaries) of the tech upstarts (the so-called new economy companies), so how much faster can the latter group grow than the former? Some companies might, but not forever or just because they have in the past (indeed, the bigger you get, the harder it is to grow). Even if outsized growth is possible, it cannot be guaranteed.
Even with these shifts, the new economy does not change the basic facts of business life that call for investing based on an understanding of a company's business climate; some key ratios must be in the tool box of all smart investors. Even if some of the new economy business metrics are used, they should be analyzed critically. Ignoring losses is foolish, but ignoring signs of endurance is downright stupid.
If you accept growing market share as an indication of future value, for example, you also have to recognize that slowdowns in customer growth are a sign of reduced future value. You must agree that when revenues per new customer fall while costs per new customer climb, you go from uncertain to bad. These facts are characteristic of many Internet companies whose stock prices actually rise on this kind of news. These companies include some of the best names in the "space," giving reason to think that the new economy may just be a wolf in sheep's clothing. After all, something that seems too good to be true usually is.
People talk of the new millennium and the unmatched pace of technological change, but this impression is mistaken. If you comb through the annals of economic and investment writing over the centuries, you will discover repeated periodic references to the rapid pace of technological change and declarations that nothing like it has ever been seen (historians dubbed the late 1890s and early 1900s the Age of Optimism, imbued with technological excitement that makes centennial turns seem the natural apotheoses of exuberance). Just pause to consider the printing press, the agricultural and industrial revolutions, the assembly line, television and radio, and now computers and the Internet.
Even the sober Ben Graham felt constrained to report on the sense of his time, writing in the relatively recent period of the early 1970s that: "the rapid and pervasive growth of technology in recent years is not without major effect on the attitude and the labors of the security analyst. More so than in the past, the progress or retrogression of the typical company in the coming decade may depend on its relation to new products and new processes." 18 To repeat what Graham was fond of saying, flus qa change, flus qa la meme chose.
