What Were You Thinking?

May 19, 2023

2:59 PM PDT

Olympia, WA

The Internet was revolutionary. It completely changed our world, how we operate and interact with everyone. Even some of the most optimistic thinkers of the late 90s likely didn’t expect many of the impacts the Internet has had on our world. This line of thinking was big in the investment world in the late 90s. Many companies made the effort to turn their business into the next “internet play,” and they were rewarded by the stock market for doing this. From 1995 to its peak in March of 2000, the Nasdaq rose over 500%.

Then, overnight, economic reality set in, and the Nasdaq proceeded to fall over 70% from its peak.

Scott McNealy, CEO of Sun Microsystems, one of the stock market darlings of the time, had this to say in an interview after the bubble had popped:

“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?”

Nvidia is a company I follow somewhat closely. So far this year, it’s the best performing stock in the S&P 500, up over 100%. The story is one that makes a lot of sense: Artificial intelligence is here, ChatGPT showed everyone how radical AI will be, and Nvidia fits into the AI story quite well. You could put Nvidia into the “picks and shovels” category of the AI story as they produce the chips that many AI applications use for their processing. Everyone believes AI is the next thing that will be as big as the Internet was. AI has the potential to alter many aspects of our society just as the Internet did. I don’t necessarily disagree with this narrative. However, when you dig under the hood of Nvidia, you will find that it is valued at more than 26 times revenue. Scott McNealy’s quote above already makes Sun Microsystems’ stock sound ridiculous for trading at 10 times revenue. Now, replace every 10 in that quote with a 26 and you have Nvidia.

Another highflyer to start the year is Microsoft, up over 32%. You could put Microsoft into the same boat as Nvidia. Microsoft has partial ownership of OpenAI, the company that produced ChatGPT. They also operate Microsoft Azure, one of the newer entrants, but now a major player, in cloud computing platforms. All of the AI processes will be done on the cloud, so Microsoft could fit into both the “picks and shovels” category of the AI theme as well as being one of the AI producers. However, under the hood Microsoft has the same problem as Nvidia. Microsoft’s stock performance has been so strong this year that it is now valued at over 11 times revenue, just a tad more expensive than Sun Microsystems was at its peak.

The result is that this has all morphed into another bubble that we could call the AI bubble. The last few bubbles we saw (meme stocks, blockchain, ARKK, etc.) were in smaller names that didn’t have much of an impact on the overall market, but this AI bubble is happening in the biggest names in the market. The top-heavy nature of this bubble rally has caused the S&P 500 to rally nicely to start the year. However, if we compare the market cap-weighted S&P 500 index to the equal weighted S&P 500 index, we see how much of an impact these mega-cap tech stocks have had on the index. The market cap-weighted index has produced a year's worth of returns already while the equal weight index is just barely positive.

Will this divergence continue? It’s definitely possible. Bob Farrell’s market rule #4 states, “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.” It would be a good idea to tread cautiously.

We have had some slight underperformance the last few months as our positioning was not allocated to the majority of these high-flying names at the start of the year. Our sector rotation strategy did add communication services in February, which is the sector that Google, Meta, and Netflix are a part of, but even with this add we have still been underweight the big tech names. Thinking through our positioning now, we have two options: 1) we could abandon our process and chase momentum stocks, or 2) we can stay disciplined and stick with the process that has done well up until the last few months. We are choosing to go with option #2. If our process leads us into these names due to valuation adjustments, fundamental changes, or changes in positioning or technicals, we will make the necessary changes. The signals we are getting now suggest that there are better opportunities elsewhere, so that’s how we will continue to be positioned. These signals could change next month, or they could change two years from now. We will continue to be diligent as ever and make changes when we believe they are necessary. If instead we went with option #1, you would be right to ask us, “what were you thinking?”

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