RE: Extropian Investing Group
Tue, 14 Oct 1997 10:17:57 -0700 (PDT)

At 07:27 PM 10/13/97 -0700, Ramez Naam wrote:
>> From: Eliezer S. Yudkowsky []
>> Whoa!  Microsoft, there, is trading at 60 times earnings.  20 is
>> considered
>> rich.  And Microsoft officials keep warning everyone that next year's
>> earnings
>> will not rise as sharply.
>> In my opinion, this bull market is a bubble if I ever saw one.  People
>> are
>> buying a stock in expectation that it will rise, rather than in
>> expectation of
>> receiving dividends.  The only way to make money on this stock market
>> if
>> someone else pays an equal amount of money.  In short, it's a pyramid
>> scheme,
>> not an investment strategy.
>Eliezer, this is an interesting analysis, and there's some truth to it. 
>However, both Price/Earning ratios and the overall bull market are more
>complex issues than is often conceived.
>First, what level of P/E is healthy depends on the growth rate of the
>company in which you're investing.  "Growth" companies with 20% annual
>profit growth routinely have P/Es of 20-25, as you suggest (even in a
>much less bullish market than we have currently).  Microsoft has had
>profit growth rates ranging from 35-60% for the past 5 years. 

This is where most people screw up. The current P/E is extrapolating
stellar performance for more than a decade in the future. Unfortunately,
this extrapolation was based on data from a period that is known to be far
outside the norm growth-wise. Therefore, people who invest in companies
with such wishful P/Es will not be able to collect a reasonable value for
their investment for a very long time, if ever, especially if the market
reverts to its historical behavior.

Mutual funds are exhibiting the same problem. 3/4 of mutual funds today
are 5 years old or younger, giving them an average return of 20-something%
over the life of the fund. A lot of people are buying into these funds
thinking they will get bigger returns than if they invest in a fund that
has been producing 13% over 75 years, when the opposite is generally true.

>Yes, every year Microsoft (and Intel and other infotech companies)
>inform Wall Street that they cannot maintain this level of revenue
>growth indefinitely.  Then in the following year they maintain or even
>increase their level of growth.  Thus the Street has stopped listening.

Wall Street is stupid for not listening. The growth was induced by broader
market factors; the growth inherent in the companies themselves wasn't as
stellar as people think.

>Second, your point about making money off of stock price rather than
>dividends is an excellent one that few people realize the significance
>of.  What you may be missing is the potential of owning a stock to
>realize future dividends at a higher rate.  Ie, I may purchase Microsoft
>stock now in the interest of making dividends off of it 5 or 10 years
>hence.  In this sense a high P/E ratio (and more generally inflated
>stock prices as more money flows into the market) reflects longer-range
>investing on the part of the public as a whole.  It also reflects a high
>degree of confidence in future economic growth.  Which I'd expect you to

A high P/E stock is an inherently poor investment from the standpoint of
dividends (effective return is less). When you purchase a high P/E stock,
you are essentially saying that you expect the stock to maintain or exceed
its current level of growth some number of years in the future, usually a
decade or more. I strongly believe that it is insane to try and predict
the growth of a tech company a decade or more in advance. It is
effectively impossible. No rational investor would claim to be able to do
this, but most investors claim as much by their actions.

>An awful lot of money has moved into the stock market in the past few
>years as interest rates have stayed low and bonds have been shown to be
>a less effective long-term investment than stocks (they always were,
>even when interest rates were moderate).  Analysts expect an even larger
>influx over the next 10-20 years as the baby boomers begin to inherit
>and invest money from their parents generation.  The larger the amount
>of money invested in stocks, the higher prices will be overall.
>To be clear, let me add that I think the current market is overvalued. 
>Perhaps by as much as 50%.  A market correction may wipe out a year or
>more of gains.  Nevertheless, for the investor with a horizon of at
>least 5 years, and preferably 10 or more, infotech is a very savory

Try this idea on for size:

The market isn't overvalued. The economy may very well support the current
capitalization of the market. What most people refer to as the
overvaluation of the stock market is actually the *hyper-speculation* of
the market. People are making investments based on unsupportable
speculative hypotheses. A decade is a long time for a tech company. The
state of the stock market has less to do with the total value of the
stocks, than with how well people are placing their money. The myopic
investment that is currently taking place may cause a stock market
correction, but in no way will hinder the growth of companies or the economy.

The market will continue to grow. It just won't grow in the ways or in the
stocks that people expect it to.

-James Rogers