One of the hardest aspects of investing is dealing with the psychological challenges financial markets present. Mr. Market’s extreme pessimism or optimism can be contagious at exactly the wrong time, leading to big losses and permanent losses of capital, which are precisely what we are most focused on avoiding. The current market is being dominated by some large cap Tech companies offering differing values. We’ve benefitted from buying stock and selling puts on META, GOOG, and Amazon when they sold off hard over the last year. Optimism on Artificial Intelligence seems to be creating a bit of a bubble in the sector now, reminiscent of the bubbles that emerged in 2000 and 2021. This bubble can be seen in the valuation of the current most in vogue stock Nvidia, which is trading at a staggering 29x revenue. The CEO of Sun Microsystems wrote a great shareholder letter when the dot-com bubble busted in the early 2000’s, which really highlighted how ridiculous the valuation had gotten.
“At 10 times revenue, 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 assume 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?”
Now don’t get me wrong, Nvidia is a great company with a fantastic past and a bright future. They have a great opportunity to grow earnings and revenues, but at the current valuation, perfect execution is needed. At a recent price of $316.78, the stock is trading at an Enterprise Value of 29x sales, or 182.1x trailing earnings. The market capitalization is $783B, so this is a massive company, which requires major growth to move the needle. I’m not aware of a large cap company that has ever been a good stock buy at over 20x sales. For smaller companies, earlier in their growth cycle it is more manageable, but still hard statistically to find winners. In the large cap space, it is much more difficult. That doesn’t mean to short Nvidia, because as John Maynard Keynes said, “markets can stay irrational longer than you can stay solvent.” What it does mean is that now is a time for a bit of caution. We are in a very mixed economy with reasonably high recessionary probabilities, and interest rates that have gone dramatically higher. This is a dangerous environment for extremely high and likely unsustainable valuations.
The founder of value investing Benjamin Graham said, “in the short-term, the stock market is a popularity contest, but in the long-term it is a weighing machine.” Think of a high school popularity contest picking which student would be the most successful. Then think of your high school reunions and how inaccurate those superficial perceptions often turned out being. With investing, often it is the ugly ducklings trading at immensely cheap valuations that turn out to be the best investments, because they just require the worst scenarios not occurring to be successful. They don’t have to execute perfectly. This isn’t the case every year or even every decade, but over the long-term, the math is undeniable. When you can find a combination of a great business and a low valuation, it makes sense to invest big, which is what we did with Google and Meta. Now as they’ve rallied, we’ve been able to lighten up and lock-in profits, particularly on the sold puts. I think there are better buys in other areas of the market, but by being focused on fundamentals and valuations, we are prepared to strike on any meaningful selloffs, while also being willing to sell when stocks reach fair value.