Unconventional wisdom: Are investors too worried about the best companies in history?
All this bubble talk needs some context.
Mentioned: Microsoft Corp (MSFT), NVIDIA Corp (NVDA), Apple Inc (AAPL), Alphabet Inc Class A (GOOGL), Tesla Inc (TSLA), Amazon.com Inc (AMZN)
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Are investors too worried about the best companies in history?
“Everything has beauty, but not everyone sees it.”
- Confucius
In the first twenty days of October the word ‘bubble’ has appeared in the AFR forty-three times. If we are in a bubble none of us can say we weren’t warned.
As investors we all need to be cognisant of the ways our emotional reactions to external stimuli influence our investment decisions. Classically this is thought of as herd mentality.
However, that simplistic picture ignores our differences and how our personal experiences shape our individual view of the world.
I am Mark LaMonica…and I have bubble-phobia.
Part of this can be chalked up to my natural scepticism and contrarian streak. I see everyone get excited about an investment opportunity and can’t help but think it is either too late to take advantage of the opportunity, or the high expectations will lead to big losses.
Part of this is my interest in studying history where a familiar pattern repeats ad nauseum—lots of capital chases an opportunity and investors get burned.
And part is because my first experience picking shares came during the height of the dotcom bull market which was shortly followed by the crash.
Whatever the reason I’m a believer that slow and steady wins the race.
Everyone is talking about a bubble
Bubble talk is everywhere. Locally DroneShield is up 500% this year and trading at 468 times earnings. Lithium shares are skyrocketing. Even Zip is back.
Retail brokers are raking in record profits as the few Australians not in line to buy gold try to trade their way to prosperity.
In the US it is all about AI and the magnificent seven. I can watch the clearly speculative behaviour in some corners of the market with bemused detachment…but not the magnificent seven.
I directly own Microsoft and Apple as part of my dividend growth strategy and have a heavy dose of the top US shares through index funds.
As someone who is susceptible to bubble talk I need to make a conscious effort not to react in times like this. I often revisit my goals and strategy to remain long-term oriented. I work on emotionally detaching from day-to-day noise. And I try to rationally examine the case for and against shares that I hold in my portfolio.
Is the magnificent seven a bubble about to pop? Or are these some of the greatest companies in history who have bright futures even if valuations may be stretched?
I am going to explore the prospects for what I will call the magnificent five as Amazon and Tesla our outliers with different business models. As always, I am going to look to history to find out if these global leaders are truly magnificent.
Dutch ingenuity
The Dutch had a problem. They wanted a piece of the lucrative spice, textiles and porcelain trade with Asia. The problem was the Spanish and the Portuguese had a multi-century head start.
To catch-up to their rivals the Dutch had to get creative. What they came up with was a novel approach to combine a government granted monopoly for Dutch trade with Asia and private capital.
The Dutch East India Company was the first publicly traded company in the world. Many things would seem familiar to modern investors including a formalised corporate governance structure with a board, regular dividends and decentralised ownership.
Then there are things less familiar to all but the biggest critics of modern capitalism—the right to wage war, run courts, mint money, exploit foreigners and maintain a standing army.
It is hard to get things right the first time. Yet the first publicly traded company in the world was also the most valuable in history. According to the Motley Fool the Dutch East India company was worth a staggering $10 trillion US by 1637.
One of the reasons why the Dutch needed private capital to fund trade with Asia was the necessity of carrying high levels of inventory. Spices acquired in Indonesia had a long journey to market on Dutch East India Company ships traveling around the Cape of Good Hope.
The inventory levels tied up capital. This generally lowers returns on invested capital. According to Jan De Vries a Dutch economic historian the net profit margin for the Dutch East India Company was 18% during the golden age between 1630 and 1670. Half of this profit was paid in dividends and the other half reinvested. The return on invested capital (“ROIC”) was approximately 6%.
ROIC shows how effectively a company uses debt and equity capital to generate profits. Earning a return on invested capital that exceeds the cost of capital is an indication of a moat and turbo charges returns over the long-term.
The ROIC for the magnificent five is off the charts. There is no need to estimate the cost of capital as the ROIC is obviously higher with Alphabet at 31.01%, Apple at 59.18%, Microsoft at 27.48%, Meta at 31.90% and Nvidia at 95.04%.
Go straight to jail, do not pass go, do not collect $200
Lizzie Magie was a renaissance woman. She was a writer, stage actress, holder of a patent on a typewriter and a comedian. Lizzie also had her causes. She was an abolitionist, feminist and progressive activist.
Lizzie was a committed follower of Henry George who advocated for a progressive economic agenda. To spread his message Lizzie invented The Landlord’s Game which eventually was renamed after the target of George’s ire—the monopolists.
The goal of Monopoly is to control as much property as possible and drive your opponents into bankruptcy. Lizzie thought this would awaken players to the evils of the day.
Henry George and Lizzie Magie were products of their time. It was the age of the robber barons who built mammoth conglomerates that ruled the US economy—none more so than John Rockefeller and Standard Oil.
The secret to Standard Oil’s success was creating a cost advantage through scale. For all the histrionics about railroad rebates and Rockefeller’s maniacal pursuit of vertical and horizontal integration it was all about building a sustainable competitive advantage. Standard Oil introduced cross ownership and cooperation—collusion to the critics—that somewhat resembles the recent news about chip makers and AI purveyors getting in bed together.
Rockefeller was trying to tame the boom-and-bust business cycle in the oil industry. Most commodity producers are price takers. Rockefeller wanted to be a price maker. This could only occur if Standard Oil controlled production and all of the steps needed to take oil out of the ground and get it to consumers.
If prices were more predictable it would be easier to justify the enormous capital expenditures needed to build out a new industry. His plan worked to perfection. In 1904 Standard Oil controlled 85% of the global oil industry. Initial anti-trust measures took their toll and market share dropped to 64% in 1911 when the company was finally broken up.
When I was younger and studied Standard Oil it was presented as a bygone era of capitalism. It was unimaginable a company could ever again amass so much power. Yet over the last year 90% of global searches were on Google. According to the US Justice Department Google controls 91% of the digital ad market.
The famously secretive Rockefeller never published the revenue for Standard Oil so the profit margin is unknown. However, we can see the impact as the Standard Oil monopoly took hold in the return on assets figures published in The Trust Problem in the United States by Eliot Jones. Between 1882 and 1894 Standard Oil had a respectable 14.70% average return on assets. This figure jumped to 23.90% between 1895 and 1906.
Return on assets measures how efficiently a company uses their assets to generate profits. When Standard Oil controlled most of the market and the entire oil value chain they could ensure that they maximised profitability. When they didn’t have control it was harder.
The Google parent Alphabet has averaged a 21.37% return on assets over the last five years while Apple has clocked in at 28%, Microsoft 18.90% and Meta at 21.62%. Nvidia achieved a shocking 50.30%.
Neutron Jack
General Electric (“GE”) was the bluest of blue chips. The company joined the Dow Jones Industrial Average in 1896 and began a 122-year run as one of America’s most influential companies.
Never was GE so admired as the turn of the millennium. In 2000 GE was the most valuable company in the US under the leadership of their star CEO Jack Welch. Earning the nickname ‘neutron’ for ruthlessly trimming GE’s fat, Welch was the face of the renaissance of American capitalism after the doldrums of the 1970s.
The Welch playbook was simple—exceed Wall Street expectations and watch the share price skyrocket. GE shares increased 23% annually between 1980 and 2000. Much of that growth was based on constant acquisitions which totalled more than 100 annually for the last four years of Welch’s tenure.
The problem was GE just wasn’t that profitable. A net margin of under 10% for a capital-intensive company like GE meant vulnerability to economic downturns. After muddling along and paying multiple fines for improper accounting the global financial crisis almost sunk the company.
A high margin is a buffer that helps with any issues that may arise. If marketing or research and development needs additional funding a high margin can absorb that. Apple has the lowest net margin of the magnificent five at 24.30% with Alphabet at 31.12%, Microsoft at 36.15%, Meta at 29.99% and Nvidia at 52.41%.
Why so magnificent?
On the surface comparing some of today’s largest companies to the most celebrated of previous eras may not seem valuable. The legal and regulatory environment is different and technological advancements have dramatically changed business models.
The point of the comparison is to illustrate the dominance of our current market leaders. There are several reasons for this. One of the best summaries I’ve seen come from John Huber the founder of hedge fund Saber Capital Management. Huber’s thoughts include:
- Today’s tech giants carry very little—if any—inventory. This means there is no need to finance inventory in advance of sales. This is why the return on invested capital is so high for these businesses.
- The asset light business model means many of these tech giants have almost zero marginal costs on each additional sale. Each new ad served on Google and each new video game or Office 365 sale by Microsoft flows right to the bottom line. This is why the gross profit margins are so high.
- There has been a lot of focus on the enormous outlays on AI infrastructure. This is concerning if demand is overestimated. But many of these companies have taken advantage of capital expenditures by others. Think of how Microsoft got started. Companies around the world invested huge sums to build computer factories and manufacture the hardware to fulfill Bill Gates once derided declaration that a computer would be in every home. Microsoft profited off each of these sales with their software. Today Alphabet, Meta and Microsoft all profit off internet infrastructure built and maintained by others. Nvidia and Apple outsource manufacturing and instead focus on designing technology.
Final thoughts
I’ve owned Apple and Microsoft for more than a decade and I’m happy to continue holding. My goal is to grow my passive income and they are both delivering. The other members of the magnificent five don’t meet my investment strategy but that doesn’t mean they aren’t great companies.
The point of this exercise is not to dispute we are in a bubble. I think certain parts of the market are in bubble territory. Yet blanket statements about relative valuation measures like price to earnings require perspective.
Members of the magnificent five are the best companies in history. That doesn’t mean you should buy them at any price. That doesn’t mean they won’t get knocked off their pedestal. That doesn’t mean they won’t go down meaningfully in price during a downturn. It just means that all this bubble talk needs some context.
If you are in Brisbane come hear Shani and I speak at the Queensland Investors Club on November 11th.
Email me at [email protected] with your thoughts.
Shani and I have a favour to ask
Our book Invest Your Way was released on the 8th of October. A big thank you to everyone who ordered a copy in presale.
Order now from Booktopia for a signed copy!
The book is also available on Kindle and audiobook.
Invest Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
Get Mark’s insights in your inbox
Read more of Mark’s articles
Read previous editions of Unconventional wisdom
What i’ve been eating
I’m a sucker for XO sauce. Invented in Hong Kong during the 1980s XO is a mix of dried seafood, onions, garlic and chillis. It is appropriately named after very old Cognac to signify the luxury of the sauce. I ate at Café Paci in the Sydney suburb Newtown on Saturday and when I saw ‘potato dumplings, XO trout’ on the menu I knew I had to have it. Bad gnocchi can be chewy or mushy. Great gnocchi are fluffy and light. This was great gnocchi.
