Ivanna Hampton: Welcome to Investing Insights. I’m your host Ivanna Hampton. The tech bubble appeared to resemble another era. However, many managers declared then that “this time it is different,” until it wasn’t. Morningstar Research Services’ senior manager research analyst Jack Shannon is joining Investing Insights. Jack has written about how 2020 and 2021 were a virtual repeat of the dot-com bubble.
Hampton: So, Jack, why did you decide to compare these two investing periods?
Jack Shannon: In my everyday role here at Morningstar, I talk with fund managers, get annual updates from them, just to see what they’re doing with their portfolio and explaining maybe the past year’s moves within their portfolio. And so what I had begun to hear through 2020 and then really into 2021 was, especially among growth managers, you’d see them start buying stocks, and maybe they usually didn’t buy. You’d see them buying these younger, unprofitable companies where typically they’ll tell you like “I only want to buy entrenched businesses with entrenched competitive advantages, yadda, yadda, yadda.” And so you’d ask them about like, “Why are you repositioning a little bit?” and I would always frame it as like, “The skeptic could say this is sort of a repeat of the tech bubble where things are starting to get a little inflated.” And they’d always tell me “Well, this is very different than the tech bubble. This time, these tech companies are producing a lot of cash flow. They’re profitable. This is not like the dot-com bubble, where any company with a dot-com in their name would then, see this big valuation jump.”
And so I’d always hear this from managers, and I sort of took it at the trust-but-verify stance, where it’s like, “OK, interesting, but at some point, I’m going to get around to like actually verifying this.” And so then after the 2022 market decline where especially that basket of stocks did really, really poorly, I decided to systematically look at it to see just how similar the two periods were, and it turns out they were strikingly similar.
Hampton: All right, so you’ve written that it’s dangerous “when the market chases companies pursuing growth at any cost.” Can you share a couple of examples from the recent mania?
Shannon: The most obvious examples are the COVID beneficiary stocks. These are the companies that during the COVID policies benefited greatly. So think of Carvana, which is an online website where you can buy and sell used cars. That’s one where you saw the revenue go from, I don’t know, what the exact numbers are, but revenue grew about 3 times between the end of 2019 and the end of 2021. Stock price went up like 5x. And plenty of managers I covered, I talked to them about that, and they’d say, “Well, this is fundamentally changing the car-buying industry where it’s, like, yes, it pulled forward some demand. But we think going forward, people are not going to be going onto the showroom floors, not going to be walking on the parking lots to buy new cars. They’re going to go online.” And that was always the defense. And when you’d ask them about the valuation and say, “Hey, this seems like mostly just some sort of, I guess, unique circumstances around the period.” They say, “No, we think this is a new phenomenon it will persist going forward.” So, like Carvana was one where you saw a lot of managers come in after the stock had hit its peak. So I think like T. Rowe Price Blue Chip Growth is one, where they owned like 1.2% of their portfolio in Carvana, and then subsequently, Carvana dropped 90%. So you see some managers who we really respect and actually have very high ratings on still get sucked into that narrative of the day, and it’s hard, I think, for most people to filter through that noise. There are other, examples like that, like DoorDash is another one where we didn’t get to eat in restaurants for like a year, so people were ordering in. DoorDash’s revenues looked great for a while because people are obviously not going to restaurants. And so you saw a bunch of, again, managers that we have high ratings on build up pretty significant stakes in that company and again subsequently felt the burn when that growth didn’t continue.
Hampton: Why do you think active fund managers snapped up these growth stocks while their valuations were skyrocketing?
Shannon: I think they’re like everybody else. They’re prone to the same biases me and you are where it’s like, “Hey, this seems to be working. You know this basket of stocks is doing well.” You listen to the narrative that’s out there and you say to yourself, “Well, this makes sense. Maybe I should buy it.” And there’s also I think, no one will ever admit to it, but I do think there is some looking over the shoulder-ism about it, where if you’re an active manager, you’re being paid to generate relative performance. You want to beat your peers, and you want to beat the index. So if your peers are buying this basket of stocks that’s doing well and because of that the index then starts to take on more exposure to that same basket of stocks, you’re sort of incentivized to do so as well, because if you don’t do it and the trend continues, you look like you’re lagging everybody. You get questions from clients saying like, “How did you miss this big market move? I thought you were supposed to be the person with foresight here.” And then if you do do it, there’s not too much downside. I mean, there is a downside in that you’ll maybe lose capital, but at the same time, the index is going to go down, too, and so are your peers. So there is an asymmetric incentive structure there that, again, no one really ever admit to it, but I do think that does come into play.
How to Spot a Bubble in Funds
Hampton: I think that it’s interesting that you brought that up, and I hope the listeners are taking note of that. How can an individual investors spot a bubble in the funds either that they own or they’re thinking about buying?
Shannon: Certainly easier to do in hindsight than it is at the moment. I mean, I’m obviously sitting here being the hindsight genius, but yeah, it’s very hard at the time. I think what this paper showed was there are some things that are just unsustainable. What I focused on was never-profitable companies, so not only companies that are unprofitable at the time, but they had never turned to profit, and then of that basket, the ones that were trading at very high multiples. Something I do in my everyday due diligence when I’m monitoring my coverage list is I run an analysis that just tracks how much of the portfolio is in these never-profitable businesses and it varies depending on what category of investment it is, like small-growth funds are going to naturally have more than large-growth funds. But one thing you can do there is—probably talked about it in the performance section—the more exposure you have to that basket of never-profitable companies, certainly the more risky that that fund is going to be, and especially in the times where valuations start to get high, the more and more risky they get. Yeah, that’s really where you can get burned. It’s an easy screen to run, I guess. Just look at a portfolio and see which ones are profitable or not, and that could hopefully help avoid some future pain.
Damage From the Tech Bubble
Hampton: All right, so talk about the damage from the tech bubble bursting. What did you see?
Shannon: Yeah, so very similar story between the tech bubble and then what we could just call the COVID bubble, I guess. What we saw was the more never-profitable businesses owned by a portfolio, the worse the fund did in the subsequent crash. I think the period for the tech bubble’s like maybe March 2000 to March 2001. The Russell 1000 Growth—so I was looking at growth funds, large-growth funds—Russell 1000 Growth fell 42%. And if every fund in the category that did not own any never-profitable companies beat the index, every single one of them did, and the ones that did the worst is Baron Opportunity, a few others that lost more than 50%. But they had more than 50% of their portfolio in these companies. And then again we saw the same thing with the COVID era. It’s not a pure linear trend, but it’s a pretty strong correlation between how much of these junkier, high-valuation companies you own and the worst performance you saw.
Tech Bubble Vs. Dot-Com Bubble
Hampton: So you did all this research, were there any surprises when you compared the tech bubble to the dot-com bubble?
Shannon: I was surprised at how similar they were. Obviously, I went in with a hunch like they were going to be fairly similar because, maybe the natural skeptic in me, but I was surprised that like, I guess I went into it thinking markets are efficient. There’s market memory. People learn from past mistakes, and there should be, I guess, some sort of memory that sticks in you where there’s senior people at your firm or someone who would say, “This reminds me of this scenario” or “this reminds me of this era.” So I expected it to be similar phenomena but a little more muted, but it ended up being like very, very similar and so that’s—I mean to me it said that maybe markets aren’t as efficient as we like to popularly think they are, and maybe every new generation of market participants, whether it’s traders, portfolio managers, analysts, mnaybe they are doomed to have to learn the same lessons over and over again that their predecessors had to learn. That’s the, I guess, the maybe pessimistic view of it, but I think there is some truth to it.
Hampton: Let’s hope that the next generation learns from this generation.
Shannon: I hope so, but I mean, yeah. You see it repeat through history, so it … Some people are better at it than others, and I’ve actually talked to different asset-management firms about how they try to … because they’ll acknowledge that that is a problem. You know, when you bring new people in, especially younger analysts today who maybe, they graduated college after the financial crisis. And so they’ve only known really one market environment. Firms are actually tackling like, “How do we inform younger analysts about history and how do we ingrain in them that like today is not the only world, and that things have happened in the past and could happen again?”
Hampton: History lessons.
Shannon: Yes, I think they’re good.
Rising Interest Rates
Hampton: Right now, we’re in a rising-interest-rate environment. How did the interest-rate environment during the tech bubble and the dot-com bubble play a role in those?
Shannon: That’s an interesting angle because back in the tech bubble/dot-com bubble era, rates were normal. The ... 10-year Treasury is about 5% to 6% yield, whereas during the sort of COVID bubble, rates were below 1%, 10-year rate was below 1%. And so why that matters is because the way interest rates affect valuations is through a discount rate. So, long story short, you think about a company you project its earnings out into the future—the higher the discount rate is, the less value those future earnings are, and so the less valuable that company is today. So there is an argument to be made that maybe the COVID-bubble participants weren’t as bad as the tech bubble, because the tech-bubble people were having these huge valuations with high interest rates, which makes it even maybe a bit crazier than when it’s super low interest rates, you can mentally talk yourself into the valuation-making sense, but that gets into like the idea of interest rates don’t stay the same forever. Interest rates are always changing. So if you’re buying a stock based on a valuation that’s based on just the current interest rate, and that valuation could change steeply if interest rates go up, maybe you’re not holding the right company to begin with and maybe ... everyone does sensitivity analysis, which is just like, “Hey, if we change this input, how much does our valuation change?” And I wonder how much of that was actually done with interest rates for this latest round of stocks, because you talked to managers who got burned by it, and a lot of them say “Well, I got burned because rates went up. I didn’t get burned because my thesis was wrong. I still think this is a great company. I still think it’s got potential to grow and become an industry leader in five to 10 years, but the market sold it off because of the rates and because of the valuation hit, but I still think I might be right,” which is a fun conversation. And they will be right about some of them, they will.
Hampton: All right. You just have to keep a record and come back in five to 10 years.
Shannon: I have records.
Hampton: Do you have anything else to add from your research?
Shannon: No, like I said, there’s a pessimistic takeaway, which would be that we’re doomed to repeat things, or there is an optimistic way, which is just, if you know that this sort of thing is a cycle and you might have some leading indicators, and I think one of the leading indicators could be how much activity there is by fund managers in buying these junkier, high-valuation companies, I think if you can see that ahead of time, you can maybe prepare yourself and at least avoid some funds that have the potential to really blow up, which we saw in both periods.
Hampton: Thank you, Jack, for explaining why this time it was not different.
Shannon: Yes, thank you for having me.
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