Walter Updegrave
October 16, 2001
Money.com
I ususally don't get caught up in the day-to-day--or for that matter month-to-month--ups and downs of the stock market. I know that puts me at odds with the vast army of pundits who babble endlessly about each market hiccup. I consider such running commentary to be, to quote Bill Shakespeare in Macbeth, "a tale told by an idiot, full of sound and fury, signifying nothing."
But given the state of Nasdaq--it's fallen almost 40% from its March high and can't get up--even I have felt compelled to ponder a few questions. Questions like: What in the name of Intel, Cisco and Yahoo is going on here? Is this a case of air being let out of a bubble that isn't likely to inflate again? And what lessons can individual investors learn from Nasdaq's decline and stall?
Well, an article in the July/August issue of the Financial Analysts Journal by finance professors Louis K.C. Chan, Jason Karceski, and Josef Lakonishok sheds some light. The paper--"A New Paradigm or The Same Old Hype: The Future of Value Versus Growth Investing"--doesn't deal specifically with any of the major stock indexes or exchanges. But in trying to explain the outrageous returns of large-cap growth issues, including tech shares, the paper is clearly relevant to the once almighty Nasdaq. Even more important is that it raises issues investors should think about every time they buy a stock. Especially now.
The profs look at three possible reasons why growth stocks--big-cap growth stocks in particular--so thoroughly dominated small and value-oriented shares in the 90s. First, they propose a "rational" explanation. Perhaps, they posit, a phenomenal surge in growth companies' performance explains ballooning share prices. But when the good professors examined evidence such as operating margins and net earnings, they found little to support that hypothesis. From 1996 through 1998, for example, large growth company shares gained an annualized 34%. But during the same time, these companies' operating earnings before depreciation grew at a 9.6% annualized rate, which is actually a tad below their 10.6% average from 1970 through 1998. Slower profit growth hardly seems a plausible trigger for a huge jump in share prices.
Next, the professors consider a "New Paradigm" theory; the idea here being that dramatic technological advances spur great leaps forward in profitability, rendering old notions of valuation obsolete. But if the world has changed so radically, it's unlikely that the change occurred overnight and there should be some evidence of this powerful new paradigm in performance figures over the past five years or so. "We just didn't find any evidence of a rocket ship of growth," says University of Florida professor Jason Karceski.
Finally, the profs considered a "behavioral" explanation. As millions of investors piled into the market convinced they had to own large-growth shares, the market's success began to feed on itself, drawing in ever more investors and pushing large-growth valuations to irrational heights. The word for this phenomenon is "bubble," a situation in which an asset's value loses touch with its fundamentals. There is no quantitative way to test this theory, and the paper doesn't come right out and say which of the three explanations the profs find most believable. But when pressed, Karceski allows that "we'd probably fall in the behavioral camp."
The truth, of course, is that no one--not even a non-pundit like myself--knows what propelled the high-flying Nasdaq. But the paper has an important lesson about investing: you must truly examine your motives before buying any stock. Are you making a "rational" evaluation of a company's prospects? Have you decided the share price makes sense on the basis of earnings the company has proven it can achieve, or at least pull off without too much of a stretch? Buying on that basis doesn't guarantee big gains--just ask value managers who've suffered through several barren years--but at least the decision has a sturdy foundation. (Besides, many of those value managers now are being vindicated.)
If you're counting on technological innovations, globalization or any other New Paradigm motion to ratchet up a company's earnings power, well, that can be rational too, provided it's based on actual analysis. It's not enough to say a company with a P/E of 60 is a buy because it's projected to grow its earnings 30% a year over the next 10 years, or nearly four times as fast as the long-term earnings growth rate for U.S. stocks. You've got to have specific reasons to know why it should be able to pull off this heroic feat. Otherwise, it's guesswork.
But if you're buying a stock for no other reason that it had a meteoric rise in the recent past or because it was chatted up on CNBC, well, then you're not investing at all. You're proving the Greater Fool theory, speculating that a greater fool than you will be around to take your shares off your hands at a higher price in the future. Of course, the problem with that approach is that at times like today, those greater fools are getting very hard to find.