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Howard Marks is a billionaire investor and the founder of Oaktree Capital Management, which oversees $205 billion in assets. Widely regarded as a legendary investor, Marks is known for his insightful and influential memos on market trends and broader economic issues. Recently, he released a new memo titled On Bubble Watch, where he explores the state of the stock market, examines whether we're in a bubble, and shares his expectations for future returns. This memo is quite detailed and in-depth, and I've been asked to analyze it for my channel. In today's articles, I’ll highlight the key points and insights from his latest memo. Let’s dive in.

Magnificent 7 Concentration Not Bubble?

To begin, Marks reflects on the market dynamics of this century’s first decade, noting how investors experienced two spectacular bubbles. This has made many people more vigilant about spotting potential bubbles today. Marks specifically addresses concerns about the S&P 500 and its top-performing stocks, dubbed the "Magnificent 7." At the end of October, these seven companies represented 33% of the S&P 500’s total market capitalization, a dramatic increase from around 20% during the 2000 tech bubble.

The central question he poses is: Does this concentration indicate a bubble? For Marks, bubbles are less about numerical metrics and more about investor psychology. He defines a bubble as a period of temporary mania fueled by irrational exuberance, blind adoration of certain assets, and a fear of missing out, which leads to a belief that no price is too high. The phrase "no price too high" resonates with Marks as a hallmark of bubble behavior. He argues that such mindsets, more than valuation parameters, are the true indicators of a bubble.

Emotional Trading

Marks highlights the emotional factors that create bubbles, emphasizing the influence of “newness.” When an industry or sector is perceived as novel, historical valuation benchmarks are often disregarded. This allows enthusiasm to grow unchecked. He points out that in established industries, historical price-to-earnings ratios or similar metrics can anchor valuations, but in new industries without precedent, these tethers are absent. This can lead to speculation and inflated valuations, as seen recently with quantum computing stocks. For example, some companies were trading at astronomical multiples, such as 300 times sales, despite being unprofitable—clearly disconnected from fundamentals.

While Marks does not explicitly call the S&P 500’s current situation a bubble, he warns of concentrated enthusiasm and cautions against ignoring fundamentals. Personally, I agree with his observations about pockets of irrationality in the market, though I don’t think we’re seeing widespread bubble behavior in major stocks like Microsoft, Google, or Amazon. That said, some companies, like Apple, may have stretched valuations relative to their growth.

In summary, Marks’ memo offers a thoughtful perspective on what constitutes a bubble, highlighting the psychological and emotional factors that drive them. His emphasis on the importance of fundamentals, even in periods of speculation, serves as a valuable reminder for investors. Let me know your thoughts on this memo and if there are specific areas you’d like me to dive deeper into!

Nifty Fifty Bubble

Howard Marks recounts the "Nifty Fifty" bubble, where the stocks of America’s fastest-growing and most admired companies were considered so exceptional that many believed nothing could go wrong with them. As a result, investors assumed there was no price too high for these stocks. Marks notes that from the time he started working in finance, anyone who invested in these stocks and held them for five years lost over 90% of their money—even though they were considered the best companies in the country. This decline was driven by the broader market downturn of 1973–1974 and the realization that these companies were trading at unsustainably high valuations, with price-to-earnings (P/E) ratios falling from 60–90 to just 6–9.

The key lesson here is the separation between the stock and the business. Marks emphasizes that even the strongest companies with stellar fundamentals and rapid growth can experience severe losses if their stocks become overvalued. The Nifty Fifty serves as a reminder that paying an excessive price for even the best businesses can lead to disastrous investment outcomes.

Cisco Tech Bubble

This concept extends to other historical examples, such as Cisco during the tech bubble. In the 1990s, Cisco’s stock price skyrocketed by over 100,000%, driven by its extraordinary growth, increasing revenue from $58 million in 1990 to $19 billion by 2000. However, from its peak in 2000 to its low in 2002, Cisco’s stock price plummeted by 87%. Even decades later, the stock remains below its 2000 highs, despite the business itself continuing to grow.

Marks highlights that the issue wasn't Cisco’s business performance but the extreme valuations investors were willing to pay. By 2000, investors had priced in decades of future growth, making it nearly impossible for the stock to generate adequate returns, even as the company grew. This reinforces the importance of the price you pay for a stock. As Marks succinctly states, “It’s not what you buy; it’s what you pay that counts.”

He adds that no asset is so good that it can’t become overpriced and dangerous, and few assets are so bad that they can’t become bargains if they get cheap enough. The principle applies even to the highest-quality businesses—investors must always focus on valuations.

Risk And Challenges

Finally, Marks discusses the risks of investing in new industries. When an industry is new, there are often no historical valuation benchmarks, earnings, or revenues to rely on, which leads investors to use speculative metrics like clicks or eyeballs, as seen during the tech bubble. This speculative mindset creates a “lottery ticket” mentality, where investors justify high valuations on the slim chance of extraordinary returns. However, this often results in significant losses as only a small fraction of companies in emerging fields succeed.

The overarching takeaway from Marks’ analysis is that while the quality of a business is important, the price you pay for its stock ultimately determines your investment outcome. By understanding this principle, investors can avoid the traps of overvaluation and speculative bubbles.

Anyone Remember 2018 Cannabis bubble

The cannabis bubble of 2018 offers a clear example of speculative frenzy in a new industry. Canopy Growth, a prominent cannabis company, saw its stock skyrocket 25x between 2016 and 2018, reaching a peak market capitalization of approximately $30 billion. This surge was fueled by Canada's legalization of recreational cannabis, which created excitement around the potential of a new market. Investors poured money into cannabis stocks, valuing companies based on their production capacity rather than critical factors like profitability, competitive dynamics, or actual market demand.

To capitalize on this hype, cannabis companies like Canopy Growth aggressively expanded their production capabilities, spending hundreds of millions on facilities. However, this led to a massive oversupply of cannabis in the Canadian market, turning it into a commodity with declining prices. As competition intensified, companies resorted to slashing prices, often below profitability, to sell their products. Many were forced to sell production facilities at significant losses, resulting in financial disaster. Canopy Growth's stock eventually plummeted 99% from its peak, reflecting the market’s collapse.

Even as Canopy Growth's revenue initially grew post-legalization, the company struggled to maintain this momentum, and its revenues have since declined. Importantly, Canopy Growth has never achieved profitability. Despite high investor expectations, the company continues to incur substantial losses, such as the $160 million loss recorded in the past year. This starkly contrasts with the inflated valuations and optimism that defined the cannabis bubble.

This serves as a cautionary tale of the risks inherent in speculative investing in new industries. Howard Marks’ analysis highlights the dangers of relying on unconventional metrics, such as "price to production," and pricing stocks based on an idealized vision of the future. Investors in new and unproven industries often fail to consider long-term profitability and the challenges of achieving sustainable growth.

The cannabis bubble parallels other speculative periods, such as the dot-com bubble, where investors paid extreme premiums for potential rather than fundamentals. As Marks emphasizes, investing requires focusing on the fundamentals and avoiding excessive valuations, especially in unproven industries. New industries, while exciting, are often fraught with uncertainty, making it essential to exercise caution and base decisions on sound financial analysis.

Marks concludes by discussing how high valuations can lead to lower future returns, as seen in historical trends. He observes that when the S&P 500’s price-to-earnings (P/E) ratio reaches elevated levels, subsequent 10-year returns are minimal or even negative. While current P/E ratios suggest expensive markets, Marks doesn’t sense an imminent bubble. Instead, he advises investors to temper their expectations for future returns, emphasizing the importance of buying at reasonable prices to maximize long-term gains.

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