Recent investment headlines remind us of when the internet bubble popped almost 20 years ago as commentators shock their followers with statements like this one from Barron’s in late November: “Now the talk is about a trillion-dollar meltdown. The FAANGs — a basket of high-growth technology companies that includes Facebook, Amazon, Apple, Netflix and Alphabet (Google) — have lost $1.1 trillion since their peaks. This month alone, the loss comes to $400 billion.” Reaching into my firm’s newsletter vault for a classic penned after the internet stock bubble crashed, we find much of what was discussed then has relevance today.
From “Cash, Stock and 1965 Lincoln Continentals” (July 2001):
“The investment public has been treated to quite a lesson over the last fifteen months. By most estimates, U.S. stocks are down some $3.0 trillion since March of 2000. Many previously highflying companies have witnessed billion dollar drops in their market value. With all these billions and trillions bandied about, it is time to draw an important distinction between ‘cash’ and ‘stock.’
“While ‘cash’ is the legal tender that teller machines spew and that children accept as weekly allowance, ‘stock’ is a printed piece of paper representing partial ownership in a company. Let’s use an analogy to contrast the two and their relevance to investing.
“Suppose you are a collector of old cars or, like me, you inherit your grandfather’s 1965 Lincoln Continental. Curious as to its value, you flip through The Whitewall Street Journal and learn that 500 Lincolns still exist and that recent sales occurred at around $10,000 each. Treating the old car market like the stock market, the “market value” of the Lincoln 500 (i.e., S&P 500) would be $5.0 million (500 cars x $10,000 each).
“Now, pretend that Jack Nicholson stars in a new movie entitled ‘Honeywell Jack.’ The Hollywood set crew buys a 1965 Lincoln as Jack’s cool car in the movie, which is a success, and now everyone wants to own a Lincoln just like Jack’s. In fact, one Lincoln is sold to an exuberant investor during the movie’s first week for $20,000. Accordingly, the market value of the Lincoln 500 doubles to $10 million (500 Lincolns x $20,000 each). Lincoln owners see the transaction reported in The Whitewall Street Journal and conclude that their investment is up 100% in one week.
“Yes, that’s how it works on Wall Street. The market value of the Lincoln 500 went up $5.0 million while only $20,000 in cash traded hands with the sale of one car! Similarly, when the stock market lost $3.0 trillion in ‘stock’ value over the last 15 months, it is important to note that far less cash changed hands.”
Back to 2019…
While the combined market value of the FAANG stocks dropped by $500 billion or more in recent months, we remind readers that only 1-2 percent of the shares of these companies actually change hands each day.
There is, however, a big difference between values of tech stocks now and nearly 20 years ago — since some of today’s standard bearers make lots of money. Specifically, the three with solid historic profitability (Apple, Facebook and Google) currently trade at an average multiple of 18 times next year’s estimated earnings — a valuation that seems reasonable by most historic measures. The other two (Netflix and Amazon) are valued at roughly 65 times next year’s earnings estimates. Ironically, and perhaps why more correction is nigh in segments of the market, the latter two stocks have substantially outperformed the former group this year.
As we face what may be the later stages of a nearly 10-year bull market, we continue to believe that investors’ focus should be on the underlying relative free cash flow produced by companies rather than how markets might be pricing 1 percent slices of those enterprises trading on a daily basis. Like the family’s durable 1965 Lincoln, this philosophy of “following the cash” has been tested over time and we believe will help investors reach their goals over the next decade and beyond.
This commentary is for informational purposes only and the opinions expressed herein are those solely of Andrew Burns, an adviser and principal at Hamilton Point Investment Advisors, LLC, in Chapel Hill. This is not a recommendation to buy or sell any particular security or product and should not be considered financial advice. Past performance is not indicative of future results.