The Importance of Prudence in a Time of Rampant Speculative Trading

  • We believe the $4.5 trillion market cap of stocks trading over 20x sales likely understates the market cap sitting at these obscene multiples due to the massive amount of firms that are still held by private market
  • Our prior chart of firms trading at over 10x price to sales featured the legendary Sun Microsystems quote by Scott McNealy who said the 95% decline in stock price was inevitable
  • At the prior peak in 2000, speculative assets at these valuations collapsed and wiped out those engaged in speculative trading strategies
  • Our piece explaining what high volume in stocks means provides more evidence that today’s speculative trading is peaking as it did in 2000
  • Avoiding speculative investments and insisting on solid fundamentals at reasonable prices, KCR is comfortably out-of-fashion today

This chart is another example of the reckless speculative market underway today. Please read on to see how these speculative 20x price-to-sales firms did post the dot.com bubble and how they look today.

Total Market Cap Stocks with P to S greater than 20x

What is Speculation?

Stock speculation is an unfortunately common phenomenon in periods like today, i.e clean tech shares. Financial historians have suggested that societies stumble into periods where people simply suffer a case of collective financial amnesia. Humanity reliably forgoes the readily available and time-tested lessons of history. Due to a combination of greed and “FOMO”, many people suddenly begin chasing baubles of little to no financial merit.

To simplify: in our view, stock speculation is the act of buying an asset you do not fully understand based almost entirely on price performance.

Types of Speculative Investors:

As explained in our Market Cap vs. Revenue post, history indicates that paying over 20x price to sales is little more than the tacit admission that you are effectively putting on a speculative trade. Any premise of buying and holding has been tossed aside and the typical speculator expects a greater fool to take them out of the position at a higher price.

The human tendency to believe we can predict the future is an unfortunate one. We encourage readers to revisit what we learned from Chapter 7 of Seth Klarman’s Margin of Safety book, quickly revisit the pain of investing in bear markets, or read a quick summary of the Enron disaster. Keep history close!

Speculative Investments Come with DIRE Risks:

The chart below shows the return on stocks at 20x price to sales as the market crashed from the dot.com peak. You did not lose “some” money. You lost nearly 90% of your money. Price movements in stocks at these valuations can be violent and swift. . KCR would like to make the following observation about a 90% drawdown:

  • One dollar turns into ten cents ($0.10)
  • It is easy to forget that if your investment falls to 10 cents you now need a 900% return just to get to the break even point
  • Short term trading in high volume stocks at high valuations = high risk and often disaster

20x P to S Return on 1 Invested at the Peak of the Dot Com Bubble

The internet bubble took the United States past the historic valuation highs of 1929 that preceded the Great Depression. This newsletter has been tireless in advocating investors avoid mutual funds and other financial instruments whose share prices seem to rely entirely on technical analysis rather than fundamental merits.

The class of stock promoters endorsing “HODLers” and other acronym rich terms sweeping speculators today might be careful. As our QTFC on Galbraith’s book about market euphoria reminds us: stock promoters who held themselves out as geniuses became the target of great acrimony after each crash.

The table below compares the companies trading at 20x price to sales today with the crop of companies that were at 20x price to sales at the peak of the Dot.com bubble. Notice how similar the two groups are.

Fundamentals of the stocks trading at 20x sales

Today as in 2000 both groups traded at huge multiples of sales, had negative PE ratios, margins and ROAs. Investors are suffering from a -10% total yield and being diluted by share issuance.

Stock Market Speculation: The Ruinous Rhyme of History

Ask yourself the following: why is today any different this time than 2000?

In 1994 C-Span recorded a presentation by Fidelity legend Peter Lynch. He emphasized the need to understand the companies you own. He talks about how he has made lots of money in firms like Dunkin Donuts and Coca Cola.

A fierce advocate for common sense, Mr. Lynch’s point is to buy what you understand and not treat stocks like “lottery tickets” because you must understand the actual business behind the shares you buy. If you do not you are engaged in rank stock speculation of the worst kind.

Mr. Lynch contrasts the simplicity and common sense required to make money in the stock market with the type of companies a typical retail investor engaged in stock speculation tends to pursue:

The single most important thing to me in the stock market is to know what you own. I’m amazed at how many people own stocks they wouldn’t be able to tell you why they own it. … If you can’t explain to a 10 year old in two minutes or less why you own a stock you shouldn’t own it. ….

And this is the type of stock people like to own. This is the kind of company people adore owning. This is a relatively simple company. They make a very narrow, easy to understand product:

They make a 1 MB SRAM CMOS bipolar risk floating point data I/O array processor with an optimizing compiler a 16 dual port memory a double diffused metal oxide semiconductor monolithic logic chip with a plasma matrix vacuum fluorescent display that has a 16 bit dual memory that has a Unix operating system four whetstone megaflops polysilicone emitter a high bandwidth, that’s very important[LAUGHTER], six gigahertz double metallization communication protocol an asynchronous backward compatibility peripheral BUS architecture four way interleaf memory a token ring interchanging backplane and it does it in 15 nanoseconds of capability.

If you own a piece of crap like that you will never make money. Somebody will come along with more whetstones or less whetstones, a bigger megaflop or a smaller megaflop.

I made money in Dunkin Donuts. I could understand it. When there was recessions I didn’t have to worry about what was happening, I could go there and people were still there. I didn’t have to worry about Korean imports.

Mr. Lynch continues:

If you don’t understand it, it doesn’t work. This is the single biggest thing. It bothers me that people are very careful with their money.

The public when they buy a refrigerator they go to Consumer Reports, they buy a microwave oven they do that. … They do research. They go on a trip to Wyoming they get a Mobil travel guide. … People hear a tip on a bus on some stock and they’ll put half their life savings in it before sunset and they wonder why they lose money in the stock market. …

I’ll switch my thoughts to my long-shots. Avoid long-shots. I bought about 30 long shots in my life. I’ve never broken even on one of them.

History is clear: Buying stocks at 20x sales is the act of buying long-shots. Below is the compound return of investing in stocks over 20x price to sales vs. the broad market.

Return on 1 in 20x P to S and 1 in Broad Market

To the degree you believe the financial history that goes back many centuries will somehow be revoked this time we wish you luck.

Speculative Investments in a Single Table: Ben Graham Would Not Believe These Stock Existed

In the panel below we compare fundamentals of the stocks trading at 20x sales today to the top 25 ranked stocks in our Large Cap and Small & Midcap Model today. KCR’s research team is convinced that fundamentals will matter again as they always have.

Fundamentals of the stocks trading at 20x sales vs top 25 ranked stocks

How Stock Speculators are Different from Stock Investors In Two Simple Lists

Hopefully this post has helped some readers avoid the temptation of engaging in day trading by offering a very specific variant of the dire risks that arise when market sentiment rapidly shifts to bear trading as we believe it is about to. Investors engage in a process of rigorous research, preferably employing a margin of safety and purchase high quality assets at a discount to intrinsic value. Stock speculation involves the purchase of companies because they are going up agnostic of their fundamental merit.

We believe the lists provided below offer a lesson in high-contrast between speculative investments that we believe are ripe for disaster and actual stocks that are candidates for further investment research.

The list of stocks over 20x sales today runs into the hundreds. For the sake of simplicity we only list the firms that are burning cash and issuing stock to fund operations. Can you explain what these firms do to a 10 year old in two minutes?

Below that list of “value offenders” we published our top 25 ranked stocks in our Large Cap and Small & Mid Cap models. Aside from having features associated with quality these companies trade at reasonable valuations. In today’s environment these groups appear to be a lesson in contrast. Stock speculation vs. margin of safety long term investing.

Login or subscribe below to see the list of “value offenders” and top ranked Kailash stocks. If you are interested in learning how others explain and view stock speculation vs. investing globally, we suggest a review of Investopedia’s post, this work from the Journal of Finance or these articles from Business Insider, Morningstar, and Forbes to be excellent resources.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

[1] Couple thoughts in this footnote.  First, it took about 50 minutes to transcribe that text as we had to listen to it again and again.  We are sure there are errors in our transcript and for that we are sorry.  Second, in the unlikely event you are reading this Peter, one of the authors on the KCR research team would like to thank you for your patience in his earliest years.  You taught much, asked little and politely tolerated great stupidity.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

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