Market bubbles are always a surprise and always expected. They build in plain view, and ignoring them requires greater and greater effort as they inflate. Onlookers are shocked when they eventually burst, and the weird thing about these unnoticed air pockets is the way they sneak up on you from new and unanticipated areas. The dot-com bubble grew in a nascent area of technology that was exciting and magical. It reminded me of the rules from the show “Whose Line Is It Anyway?: Where everything is made up and the points don’t matter!”
During the late 1990s, as share prices soared for companies that hadn’t existed even three years before and had silly names like Yahoo and Google, experienced investors and Graham and Dodd disciples like Warren Buffett scratched their collective heads as they were told to ignore more traditional valuation metrics, such as price-to-earnings and price-to-book ratios. This was a new world where value was determined by the number of clicks and the number of eyeballs a website received.
When old-school, disciplined investors questioned the soaring valuations (as measured by traditional metrics), they were dismissed as “not getting it.” Warren Buffett was said to be getting old and clearly losing a step. But the soaring prices ultimately demand a rationalization, and in the late 90s it was a “paradigm shift” or “new paradigm.” The answer for non-sensical prices was a new non-sensical term uttered with gravitas. It’s a new paradigm. And we were all supposed to nod at the new emperor’s beautiful clothes.
Two new arrivals, or perhaps more accurately, old arrivals given a seeming resurrection as part of another “new paradigm” on today’s investment scene are making my warning system tingle. Though it could be lumbago at my age, I’m beginning to worry about the proliferation of Special Purpose Acquisition Companies, or SPACs, and a metric called the Total Addressable Market, or TAM.
According to Investopedia, a SPAC is “a company with no commercial operations that is formed strictly to raise capital through an initial public offering (IPO) for the purpose of acquiring an existing company.” Also known as “blank check companies,” SPACs have been around for decades. In recent years, they’ve gone mainstream, attracting big-name underwriters and investors and raising record amounts of IPO money. In 2020, more than 50 SPACs have been formed in the U.S., raising some $21.5 billion as of the beginning of August. These funds will be invested by the SPAC on a company or companies to be named later by the expert investment team.
SPACs are dangerous investment vehicles. Effectively they are a publicly accessible hedge fund. Investors (and I use the term loosely) are investing in the acumen of the company directors who are operating without a business plan but looking to invest/merge with those companies that do. And they are doing so with stock valuations at historically high valuations (especially for those companies most likely to be target acquisitions for SPACs)!
Total Addressable Market, or TAM, is a term that investment analysts use to frame the maximum potential sales universe for a given product or industry sector. For example, when evaluating a new company that manufactures an innovative new needleless, pain-free injection system, the TAM would include the entire market for flu shots, insulin, tetanus, etc., along with the potential demand for syringes that will be required for the COVID 19 vaccines. An especially creative analyst might even add the potential market demand from illegal heroin use.
An analyst relying on TAM is eager to point out that a growing company in a growing industry has more to recommend than a growing company in a shrinking industry. And that makes sense up to a point. It is rational to identify sources of potential upside for any company; indeed identifying potential avenues of growth is essential for diligent management. Finance professionals call these kinds of potential but uncertain sources of upside “real options.” It is perfectly reasonable to be aware of these real options when making investment decisions, but it doesn’t make sense when it is relied upon to the exclusion of the more traditional valuation metrics.
When valuations become bubbly, investors clamor for a new-paradigm explanation to justify sky-high prices that don’t make sense. And what we’ve consistently seen over the years is that when pressed for the need to justify the unjustifiable, analysts and investors can be very creative in coming up with new ways to follow the herd.
I was criticized recently as being one of those stodgy guys who didn’t understand the importance of TAM. It was posited that I never would have bought Amazon and other tech stocks 25 years ago because I would have been looking for earnings when there were none. By ignoring the TAM for Amazon, for example, I wouldn’t have bought it. But that same discipline that relies on sound fundamentals also kept me from buying dozens and dozens of other companies that are no longer in business (remember TheGlobe.com, JDS Uniphase and Pets.com?). Lots of people made a lot of money on JDS Uniphase. But there were buyers of the stock at $153 a share. And a few months later it was at $2. I couldn’t look at myself in the mirror if I made an investment that lost over 98% of its value based on the sole metric that it might sell billions if it were a monopoly. And I certainly couldn’t tell a client I made that investment on their behalf.
In 2016, Hollywood stuntman Eddie Braun decided he wanted to jump over the Grand Canyon on a motorcycle. He succeeded, but that doesn’t mean it was a good idea to try it in the first place! In the same vein, many people have made good money (and will continue to do so) flipping speculative stocks that are short on sound fundamentals. But that doesn’t mean that those were sound investment decisions. If you want to gamble, go to Vegas!
Watching the funds that are flowing into SPACs along with the rise of TAM as a way of getting around fundamental valuations is making me remember market bubbles past. There were different explanations for the Nifty Fifty in the 1970’s and the housing speculation that was fueled by no-doc and sub-prime mortgages and off-balance sheet SIVs in the mid 2000s. I’ve seen it before. It ends painfully.
During the housing and banking bubbles of 2007, I wrote my second book, The Arrogance Cycle: If you think you can’t lose, think again. It’s worth dusting it off. One of the things I wrote about was the haughty, meanness of arrogance. “Arrogance was epitomized by that know-it-all kid in your class who was always waving his hand with or without the correct answer. Arrogance was the supremely confident athlete of modest ability who sneered at lesser players and wouldn’t let them on his team.” Arrogant know-it-alls don’t brook questions or fact-finding. They want to bully you back into line.
The strains of SPACs and TAM are striking chords of warning for me. And while it’s clearly a different tune, it rhymes.
Our clearly articulated investment discipline demands earnings growth, strong returns on equity, reasonable amounts of debt, and strong balance sheets. These touchstones of healthy companies have seen us through decades of sunny and stormy market days. Total Addressable Market is not irrelevant, but it is a small part of evaluating growth and the justification of debt. It is not, by any stretch of the imagination, the central metric for investment suitability. We are very comfortable with our current holdings, and our research never stops: searching for new opportunities, but also always questioning if our current holdings still justify our investment thesis. When folks begin to argue that it’s different this time, be scared. Be very scared. Stick to your discipline and stay focused on your long-term goals.