Getting older has some disadvantages. My back hurts more than I'd like, and I quit playing competitive volleyball when I turned 50 because I was tired of feeling like a bag of broken glass the next morning.
But as an investor, getting older isn't all bad. You've seen some stuff. And that can help you avoid problems because most investing problems come back around over and over, given that they're usually driven by human psychology.
I was reminded of this recently while listening to a podcast featuring the legendary Jim Grant of Grant's Interest Rate Observer. He mentioned one of my favorite stories from the dot-com era, that of Sun Microsystem's CEO (Scott McNealy) being interviewed toward the end of the 2000-2002 bear market.
Now for those who either weren't around or weren't paying attention in 2000, Sun Microsystems was one of the hottest stocks of the dot-com Internet bubble. "We put the dot in dot com" was its slogan and its market capitalization soared to ~$200 billion. Back then, that was real money, landing the company just outside the top 10 largest public companies globally. At its peak, the company was valued at 10x revenues, a key detail as we'll see in a moment.
Of course, everyone knows what happened next. The bubble popped and all these Internet stocks got crushed. What's unique about Sun's story is that toward the end of the 2000-2002 bear market, McNealy gave a classic interview that has become one of the defining moments of the whole dot-com era. It appeared in BusinessWeek in March 2002, but unfortunately requires a subscription to see that original article. Not to worry though, as this legendary passage can be found all over the Internet:
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends.
That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate.
Now, having done that, would any of you like to buy my stock at $64?
Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
Translation, straight from the lips of this mega-tech CEO: You'd have to be crazy to pay 10x revenues for a stock, even one growing as fast and with prospects as bright as the premier Internet company at the height of the dot-com bubble.
Fast forward
Another weird thing about getting older is how the excesses of the past almost look quaint compared to the lunacy of the present. (This is true in many areas, but we'll limit this discussion to investing!)
Exhibit A: Nvidia
If you've been living under a rock in 2023, you may not realize there's quite a bit of excitement at present about AI — artificial intelligence. It's going to be amazing, and/or destroy the whole world, depending on who you talk to. But one thing that no one is debating is it will take an incredible amount of computer processing power to get to this imagined future, whatever it ends up being.
Enter Nvidia, the semiconductor giant. In many respects, Nvidia sits at the center of the AI zeitgeist in a similar way that Sun Microsystems sat at the center of the Internet bubble, at least in investing terms.
In the interest of time, I'll jump right to the punchline. Remember how ridiculous CEO Scott McNealy thought his company's valuation was at 10x revenues? According to YCharts, Nvidia currently trades at an absolutely eye-watering 37.28x revenues.
10x — how quaint.
In fact, while Nvidia leads this statistic by a country mile, a whopping 35 of the S&P 500's companies currently trade for 10x revenues or more. And this is after last year's market decline!
GMO's analysis
We've quoted from another investment legend, Jeremy Grantham, a number of times in the past. His shop, GMO, analyzed these Price/Sales (the same metric as Price/Revenues) outliers a couple of years ago in one of their quarterly reports.
Remember, to get this type of extreme valuation, investors have to be really excited about your stock. Typically the growth prospects of the company are amazing, etc. No one accidentally gets slapped with a 10x price/sales ratio.
But as the GMO chart below shows, the price you pay for a stock clearly matters, even when the company is amazing. Here's how companies whose stock is trading at 10x Price/Sales have performed in recent decades.
As a group, these 10x stocks underperformed the broad market by roughly half!
Their conclusion:
While it is not impossible to prove worthy of such a high valuation, it takes extraordinary results to do so. And investing where it will take something extraordinary to earn a good return has generally been a bad idea despite the existence of a handful of exceptions to the rule.
Bottom line: Even if everything goes well for many of these high-valuation companies, it's still hard to grow into valuations like these. And if things don't go well and events are interrupted by, let's say, a recession, well...
