Art of Value Investing - The Dot com Bubble
A Case study of the Dot com bubble, Warren Buffett and forecast earnings
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” — Benjamin Graham
What is value investing
Investing in value stocks often come with great challenges. The concept of intrinsic value is often used when investigating the discrepancies of value in the target stock. However, the estimation of intrinsic value is subjective to each individual investor. Two different investors can analyse the same data and still come up with different estimations of intrinsic value of a target stock. Thus, a common practice for value investors is to develop their own margin of safety according to their own risk tolerance and incorporate an uncertainty of their estimation when investing in stocks where they found deeply undervalued.
Due to the value investing process being relatively subjective compare to other forms of investing, there are also several different methods within value investing itself. Certain investors will only pay attention to current financials and discard potential future growth in their decision making process. Other investors like to analyse the cash flow for future growth and make decisions accordingly. Although there are several ways to value invest, the fundamental theory of value investing is the same for all; purchasing undervalue assets and sell them once they reached the intrinsic value predetermined by the investor.
A practical case
Motorcar Parts of America Inc 2019 Quarter 3 earnings report (MPAA)
MPAA released their “Quarter 3 earnings” yesterday on February 11th 2019. As you can see on Fig 1 that as the market opens on Monday (February 11th) a significant drop in stock prices can be found. This is a classic example of markets overreacting on stocks reporting an undesired earning figures in their quarter reports. By examine the “Motorcar Parts of America Inc (MPAA) Q3 2019 Earnings Conference Call Transcript” we can see an explanation for the decrease in their gross margin. However, investors are subjective and just after 4 hours after the market opened, the stock have recovered as investors recognises the intrinsic value of the business and the undervalued pricing of the stock. Although earnings have shown disappointments, but the operations of the business is growing; especially a newly founded distribution center in Mexico that could potential provide value in the future. Therefore, in value investing, one must look beyond the financial figures, and search for other factors such as the business model, the operations, or other competitive environments that could potentially influence the intrinsic value of a business.
Making money through a bubble burst
Capitalistic markets are dynamic and highly unpredictable, so it’s hard to forecast earnings without uncertainties, the best method is to look into past earnings and hope that the trends will hold for the future.
In the era of the Dot.com bubble in the late 90s; many tech companies appears on the market alongside the rapid growth of technology. Many risks are associated with tech companies that investors don’t know about. For example, it is uncertain whether an individual will invest in the Yahoo search engine or a better search engine that recently appeared on the market (Google slide in quick). Traditional businesses such as McDonalds or Coca Cola do not face the same risk that Yahoo faces. At that time, the strength of the two traditional businesses relies heavily on their brand that is unlikely to change in the short term. Yahoo and Google both possess similar technology and consumers could not perceive much of a brand difference between the two since it’s so new. However, many investors ignore the financials and risks associated with the technology industry and give crazy valuations that are clearly overvalued for the stock. The owner of Dallas Mavericks Mark Cuban made his billions by selling his Boardcast.com website to Yahoo for $5 billion. Shockingly, at the time Boardcast.com had a revenue less than $100 million and was not earning a profit. To put it into perspective, the valuation of $5 billion was the same as Apple’s valuation.
Lesson learned here is that investors should balance both future growth and current financials when making value investment decisions. The Dot.com bubble crashed due to investors being too hyped up about technology and the future society’s dependency on technology and regard any cash flow figures as insignificant to their valuations.
Warren Buffett is probably the most iconic value investors of our time. He was one of the very few that made a fortune with buying heavily discounted Amazon stocks after the crash. Just like any other high-tech companies, Amazon stocks fell short as the bubble bursts. However, there is a key difference between Amazon and other high-tech companies. Warren Buffett did not see Amazon as a tech business, but rather a retail business like Walmart. The dot-com bubble bursts, Amazon securities collapses, and Warren Buffett saw an opportunity to buy heavily discounted bonds that were once overpriced. The bonds rose back to par and Warren Buffett’s legacy continued.
“I’ve watched Amazon from the start. I think what Jeff Bezos has done is something close to a miracle … The problem is when I think something will be a miracle, I tend not to bet on it. It would have been far better obviously if I had some insights into certain businesses.” — Warren Buffett on not investing in Amazon early.
Forecasting Earnings
According to Benjamin Graham and David Dodd, there are two vital rules in forecasting future earnings.
- Companies with stable earnings are easier to forecast, thus preferable.
- A firm’s average earnings can provide a rough guide to the future; the earnings trend is far less reliable.
In the current society with rapid flow of information, the world around us becomes more changeable and sensitive towards information. The stability of a firm’s earnings indicates the firm’s ability to adapt to the environment or treating contingencies. Therefore, Graham and Dodd suggests that the more volatile the earnings, the more cautious the investor should be in reading and treating the data. Graham and Dodd suggests one should not look passed the 10 year period back into the past or into the future. Hence the first rule.
If you are into basketball, you should be familiar with Linsanity . He is an Asian American player who, in a blink of an eye, enjoyed a short-lived spotlight of the Madison Square Garden. In his first five starts, he scored 136 Points averaging 26.8 points per game, the most in history since the merger of NBA and ABA. Many veterans in NBA media did ridiculously comparisons, Many comparisons, I believed were for publicity, but some ridicolously compared Lin with the great Michael Jordan or Isaiah Thomas. There was no doubt that everyone was hyped with Linsainty, but most rational people would assume that a player like Lin, who before Linsainty had almost produced nothing, would be able to produce such stats next year. Even if he does, the odds of him scoring such numbers will be revert back to normal, as the trend declines.
As Graham and Dodd put it,
Investors get seduced by the trend; perhaps they want to be seduced, “Trends carried far enough into the future will yield any desired result.” — Graham and Dodd, Security Analysis
To distinguish the difference between trend and average, we can take a look at the historical Earnings Per Share of Apple (2008–2013)
Looking at the historical EPS values for APPL from 2008 to 2012, one can observe a a slight upward trend. An analyst can casually follow the trend and come up with an EPS forecast for the next few years: $7.21 for 2013, $7.93 for 2014, and so on. However, the true EPS of 2013 was $5.68, it did not follow the trend. In fact the unaccounted factor of a compressed EPS was not related to the operations. Apple stocks were trading on a pattern by late 2012, so when earnings increase and price remains stock, by definition the P/E ratio decreases, and the earning ability of a share act accordingly.
Therefore,
Investors should spend a significant amount of time studying their target companies and its competitors. One should know the number and understand the number of certain financial figures in the reports. The advice given in the book Security Analysis suggests investors to work in teams to balance out the subjective views in valuing a investment decision. Or you could be like Warren Buffett work in solitary in majority of the time with his business partner Charlie Munger living 1,500 miles away.
Sources: Security Analysis: Sixth Edition, Foreword by Warren Buffett
