When even the winners can be losers

A reality check amid market of high-flyers

“(The automobile was) the most important invention, probably, of the first half of the 20th century. It had an enormous impact on people’s lives. If you had seen at the time of the first cars how this country would develop in connection with autos, you would have said, ‘This is the place I must be.’ But of the 2,000 companies, as of a few years ago, only three car companies survived. So autos had an enormous impact on America but the opposite direction on investors." —Warren Buffett, Allen & Co. Conference, 1999

We are on the verge of madness once again. During the past year, we have witnessed something we haven’t seen for some time: That is, prices of certain stocks doing moon shots that make little sense from a valuation point of view. Our question is, what will be the long-term returns of owning such companies?

Back in 1999, I was one of three portfolio managers who gave presentations at a conference on equities and the markets. One young PM got up and proudly proclaimed that she was thrilled to be buying companies, mainly dot-coms and other assorted newly public technology companies that had no earnings but were instead, “investing in the business for future earnings.”

The other well-known portfolio manager proclaimed that the Ben Graham-style of investing was no longer relevant, and that he was in up to his neck in the current and, as he saw it, future winners — once again, tech and dot-com stocks. I gave my standard presentation that most in the crowd ignored: It was about searching for companies that were actually making money, had some predictability of future growth and traded at discount prices.

After the seminar, people gathered around the famous PM, getting autographs from him (I’m serious!) No one talked to me afterwards. I thought to myself: You are either a dinosaur, soon to be extinct or this is a powerful indicator that insanity has overtaken the market and sooner or later, this will come apart. As history has shown, it turned out to be the latter. Shortly thereafter, the market declined about 50 per cent from the spring 2000 highs to the lows in September 2002.

Just to measure how extreme current valuations have become, we ran a search for companies that had the following characteristics: Their stock price that had appreciated at least 50 per cent since the beginning of the current calendar year (eight months); they had IPO’D on a major U.S. exchange; they were trading at at least 10 times trailing 12-month revenues; and they had negative EBITDA (earnings before interest, taxes and depreciation/amortization) again, using trailing 12 months’ numbers.

Fifty-eight companies met these criteria.

With few exceptions, the list is dominated by biotech pharmaceutical names, companies largely in the formative stages of developing various new medical products that will hopefully cure all human ailments.

To get some idea of what happened the last time we had this market phenomenon occur, we went back to the dot-com peak in 1999-2000.

We sought out companies meeting the same parameters as listed above. Instead of year-to-date, we measured price appreciation in the eight-month period beginning July 10, 1999 to March 10, 2000. The search yielded 57 firms composed of a mix of technology-based, dot-com and pharma companies. (By comparison, 15 companies met our criteria in 2005, 16 in 2007, and only two in 2011).

Since March 2000, the average return on these 57 companies has been an impressive 73.4 per cent. The S&P 500, by comparison, has outperformed over the same period, generating a return of 107.7 per cent. Importantly, however, the return of the selected stocks is strongly skewed by just two companies — Celgene and Vertex. The first has appreciated by more than 1,500 per cent since March 2000 and the latter almost 2,400 per cent.

But if these two are removed from the calculation, the average return drops to just five per cent over 18 years — not too impressive. Even including these two success stories, however, the median return for the 57 stocks proved to be -84 per cent; half the companies were gone within five years of the 2000 peak. So, unless you were smart or lucky enough to pick the two monster winners listed above, the net results of owning this group at the peak was to put it mildly, a disaster.

These dot-com stocks, as well as Buffett’s observation surrounding autos look a lot like modern day pharma stocks, including the 58 identified by our screen. There’s lots of excitement about these pharma companies and what incredible advances they will bring to society and the world as a whole in the coming decades. But you are more than paying for these possibilities. And if you are a long-term investor — and most, I would venture, are not — all you have to know is how to pick the tiny number of currently outrageously priced companies that will be the next Johnson & Johnson, Pfizer or Roche Holdings. Good luck.

Until the next market downturn, when the tide goes out and we find out who is swimming naked, it looks like investors will continue to party like its 1999.

STOCK PRICES WITH LITTLE SENSE FROM A VALUATION POINT OF VIEW.

HENNY RAY ABRAMS / NATIONAL POST FILES Two men observe stock quotes at the Nasdaq Markesite on Dec. 20, 2000, a market peak. The frenzy that drove dot-com and tech stocks then, looks a lot like the enthusiasm for some pharma stocks today, Larry Sarbit writes.