Is it time to prepare for another tech crash?
Seth Klarman is considered to be one of the best value investors alive today. Even though it’s impossible for most investors to benefit from his success as his hedge fund, Baupost has been closed to new funds for many years, during the nearly three decades that Baupost has been operating, Klarman has dished out hundreds of pages of wisdom via his yearly investment letters.
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Not only are these letters full of nuggets of advice for value investors, but they also offer some insight into various market conditions. Indeed, when Klarman first started managing investors’ money, it was in the run-up to the dot-com bubble, and he had to sit still and watch while the market lifted the most speculative stocks and left value trailing in the dust. When the bubble eventually burst Klarman reaped the benefits but then, heading into the next bubble, he suffered again. 2008/2009 and the following years proved to be lucrative for value investors, and as history repeated itself once again, Klarman profited.
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Time for another tech crash?
Today, we once again find ourselves in a position where growth is outperforming everything and value stocks are being left behind. The similarities to today’s environment and that of the late 1990s are staggering. Klarman’s letters to investors at the time provide a great insight into this environment. In June 1999 he wrote:
“Students of financial history can point to historic levels of valuation to suggest that we are in a bubble. But students of psychology may be needed to complete the picture. For one thing, the financial markets have been so strong for so long that fear of market risk has mostly evaporated. People who used to hold bank certificates of deposit now maintain a portfolio of growth stocks.”
In the same letter, he also cautioned on the valuation of tech stocks considering the lack of barriers to entry their individual markets and warning of a tech crash:
“Many of today's leading technology and telecommunications companies trade at 50 to 100 times earnings, or higher. While most of these companies are growing rapidly and possess extraordinary technology, these businesses remain highly competitive. Very low costs of capital and high returns attract enormous competition, and companies have to innovate faster and faster to stay ahead of the pack. Product life cycles are shorter and shorter, and unit prices continue to decline. We understand that the technology content of these companies is fabulous. Whether they are good businesses, deserving of astronomical multiples of current earnings, is an entirely different matter.”
And Klarman expressed concern at the high valuation of the current stock of the moment; AOL:
“A recent Wall Street Journal article was headlined: For Some Stocks, Price Doesn't Matter. Within the article, the co-manager of the billion dollar Stein Roe Young Investor Fund described how he had revised his investment strategy to cope with today's environment: “To own a company like AOL (America Online), you had to throw out traditional measures of valuing companies. We had to say we have to own what we think is the dominant franchise in the Internet. It was a space that as a money manager you simply have to be in.” Another manager similarly said, “It's almost like you have to own it.” AOL recently sold for 388 times 1998 earnings and 238 times projected 1999 earnings.”
If you take these quotes and put them in an opinion piece with today’s date (and replace the reference to AOL with Amazon), it’s unlikely any investor would notice the difference.
How is Klarman reacting to this environment? Well, according to the June 1999 letter, around 40% of Baupost’s assets were in cash and US government securities, Klarman’s favorite hedge. 25% of the fund’s portfolio was devoted to investments “with catalysts for the partial or complete realization of underlying value. This includes corporate bankruptcies, restructurings and workouts, liquidations, breakups, asset sales and the like.” The remainder of the portfolio was split, 32% in “deeply undervalued securities with no strong catalyst for value realization” and the remainder in market hedges as well as various other option exposures.
So will 2017 be tech crash 2.0? Wait, to find out that answer.
