Throughout our decades in the investment business, there have been several occasions when equity markets have become focused more on concepts than fundamentals. During these phases, many investors become enthralled with the potential of specific themes rather than intrinsic valuations of equity markets and their underlying companies. The dot-com era from 1995 to 2000 and the “Peak Oil” mania of 2008 are two prime examples.
The dot-com bubble was fueled by the idea that the internet would change the world, with investors driving up share prices of many companies on the prospect of unlimited growth potential. Investors speculated that a dot-com’s traffic growth would translate into earnings and cash flow growth. This resulted in what the late Alan Abelson, a long-time market commentator at Barron’s, dubbed the “Price to Fantasy Ratio”, whereby investors eschewed standard fundamental valuation metrics for the prospects of future growth. While the internet has indeed changed the world, this growth did not materialize for most of these companies. For every Amazon or Facebook, there were dozens of eToys and Pets.com that never survived. Even Nortel, which at one point represented over a third of the total market capitalization of the TSX and traded at 120 times earnings, went bankrupt. The result was that the NASDAQ Composite Index, where most of these companies traded, fell by 75 percent from March 2000 to October 2002.
The 2008 “Peak Oil” mania created similar heartache. Lax monetary policy and surging real estate prices due to unprecedented growth in sub-prime mortgage lending and credit default swaps, powered economic growth from 2002 to 2007. This, in turn, drove oil prices to a record $147 per barrel in 2008. Prognosticators predicted that economic growth would continue and that oil prices, given the scarcity of new supply, would trade at new peak oil prices for the foreseeable future. Some called for a “new normal” of oil prices trading at $240 per barrel. Oil stocks, as a result, catapulted in value. Unfortunately, the collapse of sub-prime lending and the resultant implosion of the credit default swap market put an end to this myth. Global economies entered the Great Recession and oil prices plummeted to $35 per barrel. As a result, the TSX energy sector declined 35% in 2008.
Why are these examples relevant? Over the past year, investors have focused on a singular theme – artificial intelligence (AI). As a result, 2023 was the year of the Magnificent Seven. These stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) gained on average, 71% during 2023, compared to a 6% gain for the remaining 493 stocks in the S&P 500 Index. The significant outperformance of these seven stocks propelled the overall S&P 500 gains to over 23% in Canadian dollar terms. In contrast, the TSX gained just under 12% for the year, with much of its performance coming in the last two months of 2023.
While AI will likely change the world going forward, we are still in the early days of its adoption and utilization. As such, we believe it is too early to determine the winners and losers of today’s AI landscape. Further development of AI will bring many more competitors into the space, create new models for growth and allow many traditional companies to enhance their revenue and profitability through the implementation of AI processes. Nonetheless, we remain convinced that companies should trade on their basic fundamental values – revenue, earnings and cash flow growth – rather than the speculative promise of future growth. As such, we will continue to focus on building high quality, diversified portfolios of companies with solid long-term growth prospects.
Fourth Quarter 2023
Throughout our decades in the investment business, there have been several occasions when equity markets have become focused more on concepts than fundamentals. During these phases, many investors become enthralled with the potential of specific themes rather than intrinsic valuations of equity markets and their underlying companies. The dot-com era from 1995 to 2000 and the “Peak Oil” mania of 2008 are two prime examples.
The dot-com bubble was fueled by the idea that the internet would change the world, with investors driving up share prices of many companies on the prospect of unlimited growth potential. Investors speculated that a dot-com’s traffic growth would translate into earnings and cash flow growth. This resulted in what the late Alan Abelson, a long-time market commentator at Barron’s, dubbed the “Price to Fantasy Ratio”, whereby investors eschewed standard fundamental valuation metrics for the prospects of future growth. While the internet has indeed changed the world, this growth did not materialize for most of these companies. For every Amazon or Facebook, there were dozens of eToys and Pets.com that never survived. Even Nortel, which at one point represented over a third of the total market capitalization of the TSX and traded at 120 times earnings, went bankrupt. The result was that the NASDAQ Composite Index, where most of these companies traded, fell by 75 percent from March 2000 to October 2002.
The 2008 “Peak Oil” mania created similar heartache. Lax monetary policy and surging real estate prices due to unprecedented growth in sub-prime mortgage lending and credit default swaps, powered economic growth from 2002 to 2007. This, in turn, drove oil prices to a record $147 per barrel in 2008. Prognosticators predicted that economic growth would continue and that oil prices, given the scarcity of new supply, would trade at new peak oil prices for the foreseeable future. Some called for a “new normal” of oil prices trading at $240 per barrel. Oil stocks, as a result, catapulted in value. Unfortunately, the collapse of sub-prime lending and the resultant implosion of the credit default swap market put an end to this myth. Global economies entered the Great Recession and oil prices plummeted to $35 per barrel. As a result, the TSX energy sector declined 35% in 2008.
Why are these examples relevant? Over the past year, investors have focused on a singular theme – artificial intelligence (AI). As a result, 2023 was the year of the Magnificent Seven. These stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) gained on average, 71% during 2023, compared to a 6% gain for the remaining 493 stocks in the S&P 500 Index. The significant outperformance of these seven stocks propelled the overall S&P 500 gains to over 23% in Canadian dollar terms. In contrast, the TSX gained just under 12% for the year, with much of its performance coming in the last two months of 2023.
While AI will likely change the world going forward, we are still in the early days of its adoption and utilization. As such, we believe it is too early to determine the winners and losers of today’s AI landscape. Further development of AI will bring many more competitors into the space, create new models for growth and allow many traditional companies to enhance their revenue and profitability through the implementation of AI processes. Nonetheless, we remain convinced that companies should trade on their basic fundamental values – revenue, earnings and cash flow growth – rather than the speculative promise of future growth. As such, we will continue to focus on building high quality, diversified portfolios of companies with solid long-term growth prospects.