by Ryan Sailer, CFA, Vice President & Senior Portfolio Manager
The stock market is up single digits through the first half of 2011, a far cry from the exuberant returns seen in the market of the late 1990’s. However, a deeper dive into the market reveals some potentially disturbing similarities between the two time periods.
First, look at the IPO markets. During the original “tech bubble” of the late 90’s, it was a common occurrence to see internet startups with no profits, immaterial revenues, and questionable long-term profit potential take off after going public. In fact, simply adding a “.com” to your company name was usually good for a nice jump in the stock price. Fast forward through the 80% market collapse of the tech-laden Nasdaq from 2000 through 2002, and the financial crisis of 2008, and surely such speculation is unlikely to happen again, right?
Unfortunately, history may be repeating itself. Take a look at a couple of recent internet IPOs – LinkedIn (LNKD) and Zillow (Z). LinkedIn is a social networking company designed for professionals. The market has given the company a market capitalization of close to $10 billion at the end of July, despite LinkedIn’s lack of net income. For the current year, LinkedIn is expected to generate close to $500 million in revenues and come close to breaking even – forward earnings are expected to be closer to $0.50/share. Doing the math we get multiples of 20 times sales and 200 times forward earnings estimates. Zillow is a real estate website that provides “zestimates” of home prices. Zillow boasts growing revenue of approximately $30 million and is currently unprofitable. We’ll give Zillow some credit and assume they will continue growing and be able to turn a profit soon. Apply the price to sales ratio of a profitable, growing company like Apple, and you ring up a market value of approximately $100 million for Zillow. So what value did the market give to Zillow following its late July IPO? Try $1 billion, or 10 times the multiple of Apple.
On a broader level, we also see signs of perhaps too much of an appetite for risk. The basis for most investment decisions requires one to be compensated for taking risk. Put another way, the riskier the asset, the less expensive the cost should be. Right now, mega-cap stocks, which typically would carry adjectives such as safe, blue-chip, high-quality, diversified, etc. actually trade at a significant discount to the market. Small caps stocks, which generally speaking carry more risk than their larger counterparts, trade at nearly two times the multiple of mega-cap stocks. Investors are paying twice as much for riskier earnings than safer earnings. Of course, smaller stocks are seen as having more potential for growth, but most of the mega-cap stocks are currently growing revenues and earnings, and many have already established a presence in faster-growing emerging markets.
Fortunately, the market isn’t nearly as stretched on a valuation basis as it was during the tech bubble of the late 90’s. Trading at roughly 13 times estimated earnings in a low interest rate environment seems reasonable given the uncertain economic environment, and inexpensive if the economy were to rebound. It’s also not hard to find some very intriguing values, namely blue-chip companies which trade at a discount to the market and sport dividend yields above the 10-year Treasury.
Ironically, many of these inexpensive, high quality, dividend-paying stocks happen to be many of the very same companies that were culprits in the last bubble. Take Microsoft (MSFT) for example. In the past decade Microsoft has grown its revenues from approximately $25 billion to nearly $70 billion, but over that same time period its market cap has shrunk from almost $400 billion to just over $200 billion. Cisco Systems (CSCO) carried a triple-digit P/E ratio for much of the year 2000, but now sells for just 10x earnings. Both Microsoft and Cisco pay dividend yields greater than a 5-year Treasury bond.
Signs of frothiness or perhaps a downright bubble are apparent. We’ve seen how this story ends before, and there is no logical reason why it will end differently this time. The good news is that there seems to be a very good alternative that is being largely ignored by the market. In 1999, you could have bought a 10-year Treasury yielding 6% and trounced the stock market for the next 10 years. This time, it’s not the bond market that is being ignored; the unloved area of the market appears to be good old fashioned blue-chip stocks. Getting the opportunity to buy some great companies at below market prices (and a nice dividend yield) seems to be too good to ignore, even if the market isn’t paying attention for now.