At the end of last year, we posted a piece reviewing our research from 2021. We explained that after a brutal 2020 where we were bombarded by skeptics, ‘21 had been a terrific year for KCR and we expected more in ‘22 based on the data. Thankfully, fortune favors the patient, disciplined, and empirically inclined.
2022 has been another wonderful year for KCR. We are deeply grateful for the kindness and support of our subscribers. This year we chose to break our 2022 Year in Review into two parts.
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Get our insights direct to your inbox: SUBSCRIBEThis first section will revisit the most popular charts from 2022 that provided stunning evidence of the inevitable collapse of sundry speculative excesses. In next Friday’s piece we will hit on the punchiest charts from our bullish calls in 2022.
The chart below is from our January post, Stocks Most Like Enron. We built a custom index of stocks that had earnings manipulation, valuation, and ranking scores worse than when Enron peaked.
As always in finance: the past proved to be a prologue. Sitting at preposterous valuations with dubious earnings, these speculative investments went on to experience cataclysmic price movements. The declines were brutal and day traders, engaged in speculation, took a fearsome beating.
On to other types of high-risk speculative malfeasance and their consequences!
The ABCs of Stock Speculation Involved a Lot of SBC
Since our 2019 piece on Amazon’s statement of cash flows, KCR has been relentlessly hammering home the folly of stock-based compensation (SBC). Our team’s work spilled across our website’s pages and into the realm of peer-reviewed academia. Nobody was listening.
Our motto became: “it won’t matter until it is all that matters.”
2022 was the year the roof caved in. Stock-based compensation is a very real expense. The rampant, but GAAP-compliant, use of SBC created the temporary illusion of cash profits.
The fallout has been enormous. Our team fears there is more pain ahead. The chart below reminded readers just how out-of-control this accounting gimmick had become.
At the height of the bubble, a collection of firms valued at ~$1 trillion dollars were using so much stock to pay employees that it amounted to 33% of total sales.
If we sound a little crusty on stock comp its because we were routinely derided for being pessimists. Some claimed we were unaware of the enormous benefits of increasing management and shareholder alignment. These arguments were neither new nor honest, and we feared the ebullient promoters making such claims would decimate many inexperienced market participants.
KCR takes no pleasure in watching promotional shills, often masquerading as “the good guys,” turn financial markets into a predatory game rigged against retail investors. We wrote with dismay as Robinhood pilloried its clients in its initial public offering. Then we went on to explain the lack of merit in Robinhood’s attack on Buffett and Munger and leaned on work from Terrance Odean & Brad Barber to explain how these types of speculative endeavors have always crushed small investors.
An unfortunate but all-too-familiar chapter in financial history.
On to the next optically stimulating tome of financial malfeasance.
Speculation and Risk Sharing with New Financial Assets!
Some of 2022’s most-loved stocks were software stocks. Touted as a “new financial asset” with infinite scale, they became the affection of specialty mutual funds that invested in innovation. In reality, many of these stocks merged the worst features of this bubble: indefensible valuations and immense stock-based compensation.
In January we built the below chart at Herb Greenberg’s suggestion. The work showed that software companies valued at over 10x price to sales summed to a staggering $7 trillion dollars. Stocks sitting at these obscene valuations have been another area where KCR has been relentlessly sounding the klaxons of financial (in)sanity.
As we explained in Tesla Price to Sales Ratio & the Coming Tax on Index Fund Owners, the weight of obscenely priced stocks in the S&P Index had hit the same level seen at the peak of the dot.com bubble.
Our work asked why anyone would buy an index where 17% of their money was being shoveled into a group of stocks with no empirical precedent for generating solid risk-adjusted returns.
Speculative Traders Prefer Index Funds
To pound the point home, we published a piece showing the valuation distortions that had come to afflict the Russell 1000 Large Cap Core Index. The chart below showed what percent of the index was in each valuation bucket over all of history (navy blue bars). The light blue bars showed what the distribution looked like when we published. You can see that stocks > 10x price to sales made up 16% of the benchmark, an incredible 4x its historical average (last two bars on the right).
We followed that up with our piece, Large Cap Growth Index Funds & the Path to Poverty. In the chart below we showed that the top 30 stocks in the Russell 1000 growth index made up a staggering 65% of investors’ exposure. A level not seen since the peak of the dot.com bubble. We once again asked, WHY would anyone invest like this? If it wasn’t deemed an “index fund” but was viewed as an “actively managed” fund, this portfolio would fail the SEC’s diversification rules. Again. Why?
We continued to pound on the needless risks taken by index fund investors in our piece Vanguard Small Cap Index Fund: the Myth of Low-Cost Indexing. Like our withering criticisms of those that blindly embrace Large-Cap Core and Growth Index Funds, our gripe with small-cap index funds is not the explicit cost charged by the manager. Rather, as shown in the chart below, the number of companies in the index that can’t turn a profit is hitting all-time highs.
This is needless and reckless in our view. Why would you buy all those loss-making firms? The same piece put out the below chart. The red line is the compound returns of the money losers in the index. The light blue line is the compound return if you just bought the profitable small-cap stocks. Not. Complicated.
Price Fluctuations & Long-Term Technical Analysis
KCR does not use line charts or ad hoc technical analysis in our investment process. But we do believe in the power of an image to help us understand where we are relative to history. Built for one of KCR’s original and longest-running clients and friends, the chart below is a testament to just how extreme this cycle became.
What’s the very simple message across this and many of the charts above? Growth may have a long way to decline relative to value.
We would like to close on a cautionary note. We published Anatomy of a Bear Market: Violent Volatility early in 2022. The top chart below shows the 10-day rolling returns of Growth minus Value since 1991. Looking back at the period following the peak of the stock market’s bubble in 1999, volatility explodes.
Said differently: investors cling to the Pavlovian get-rich-quick tropes that characterize bubbles in growth stocks, and the style does not go “down” without a fight.
In the bottom chart we expanded the more recent experience for the sake of clarity. Once again you can see the same dynamic is playing out: growth and value are trading violent blows today just as they did post the dot.com bubble. For disciplined investors, the message is clear: be ready to feel uncomfortable.
Next week we will shift gears and walk through what we have highlighted and where we see terrific prospects for patient and historically informed investors willing to step out of the index-fund bubble!