Buffett on Dotcom crash
Updated: Dec 23, 2020
Early on in the biography of Warren Buffett, The Snowball, the author - Alice Schroeder - details the story of the billionaire investor's key note speech at the end of the Sun Valley conference in July 1999. In this speech, Warren set out reasons to be cautious about the tech market. For those that are not well acquainted, this was on the eve of the "dotcom" crash of the early two-thousands. Having read this part of the book, I could not help but notice that there are some parts which seem to bear some resemblance to current market occurrences in the present day. This is what draws me to write this blog post. History may or may not repeat itself, but - as Mark Twain said - perhaps it often rhymes.
Before giving an overview of Warren's conference closing speech, it is best to set the scene.
The Sun Valley conference was an invite only affair, ran by a boutique investment bank Allen & Co. Here, they invited the powerful and influential from various walks to life to enjoy a week of relaxing, socialising and learning - with speeches given throughout the week from various conference attendees. At this conference, due to the then-recent massive rise in technology companies, many of the first-time attendees were bosses and CEOs from this field.
At the time, the market was approaching the zenith of the dotcom bubble, where at its peak the average PE ratio was in the 200 region, companies would often trade for high multiples of sales, and it was not unheard of for stocks to only take a few days after an going public to double from its IPO price. Needless to say, Warren Buffett, being a value investor, did not get involved in that market, missing out on the massive upswing of that bubble. As such, when Warren said what he said at this conference in 1999, it was taken by many as the comments of a sour man who had missed the train.
He stated a couple of things that I feel ring true today (but the implications, of course may be very different in an economy now 20 years down the road). He made a couple of salient points, that are worth unpacking.
First, that he stock market is not destined to forever increase every year, year over year. There may be periods of stagnation. As evidence for this, Warren gave the example of the Dow Jones having returned no net returns over a seventeen year period from 1964 to 1981, beginning and ending the period within a point of 875.
Second, that the main drivers of the stock market over the longer term are interest rates and corporate profitability. We shall take each in turn.
Interest rates, Buffett says, work like the financial equivalent of gravity - the higher they are, the more they pull prices down. Returning to the above cited period of 1964 to 1981, interest rates were increasing - culminating in the yield on long term government bonds increasing from 4% to over 15%. This means that as returns on government bonds rose, the relative value of the return on the stock market fell, so stock prices fell. This, Buffett states, is clearly a major force throughout this seventeen year period as this interest rate effect dominated other effects - this was also during the same period that GDP rose by 370%. Equally, taking the following 17 year period bull market to 1998, thanks to the efforts of the Federal Reserve, the yield on long term government debt fell back to around 5%, meaning stock market returns looked increasingly attractive, reducing the gravitational pull and allowing the Dow to rocket from 875 to 9,181 - a tenfold increase.
Corporate profitability is another key determining factor. A companies profits dictates how much a company can pay out to its shareholders and over the long run determines how much the company is worth, and therefore, at the end of the day, is one of the key determinants of the stock price. Buffett points out that corporate profits tend to fluctuate around a constant share of GDP. As below, you can see that over the long term, thats is probably a fair approximation.
Therefore, you can make the argument, since corporate profits are a proportion of GDP, that the terminal value of stock prices, reflecting corporate profits, is determined by GDP, ignoring the aforementioned changes in interest rates.
Taking the two in hand, Buffett said this gives you an understanding of the fundamental drivers of the stock market.
Now, with regards to the market realities of the time - where dotcom stocks were disrupting business - Buffett gave the example of two industries which changed the landscape of American life significantly: automobiles and aviation. Undoubtedly, these two inventions drove much of the change in American life throughout the 20th century and so given its conceptual importance, he looked at the effects this had on feeding through to investor returns. To put it briefly, not a lot. He said that by the end of the 1990s, for all the over 2000 car makes over the century, only three still existed that were American owned, which were still "themselves no lollapaloozas for investors" - as Buffett put it in a speech later in 1999. The tale for the aviation industry is a similar one.
Taking a more modern example, when it comes to mobile phones - another technological revolution that has undoubtedly changed the way we live our lives over the past 30 years - who ever talks about Eriksson, Motorola or Nokia or even Blackberry anymore? It seems that being in an industry that will be important in driving change in the world does not always feed through to investor returns.
So, given that being an industry for the future is not a guarantee of returns, we return to the above mentioned long term drivers of the stock market. Buffett stated that: in order to justify a PE ratio of 200 for the Nasdaq, either corporate profitability or interest rates (which were both within the bounds of normal for their long run averages) would have to move significantly to accommodate this. He stated that at the time, he had no reason to believe that profitability would increase, and equally that interest rates were more likely to move in direction of harming stock prices (rise).
This leads one to the inevitable conclusion that stock prices could not sustainably exist at the price point they were at that time.
The Nasdaq peaked at 5,048.62 on the 10th March 2000. Two and a half years later on October 9, 2002, the market bottomed out at 1,114, down 78% from its peak. It would not surpass the previous peak for nearly 15 years to the day - 2nd March 2015 - where it closed at 5,008.10.
For the next post, we want to look into how fair a comparison - if at all - it is to contrast the dotcom era with today - on both the individual company level and market general levels.
SCHROEDER, A. (2008). The snowball: Warren Buffett and the business of life. New York, Bantam Books.
Federal Reserve Bank of St Louis, https://www.stlouisfed.org/