A Little Tap On The Shoulder

Back in December 1999, in a piece modestly entitled AOL, RCA and The Shape of History, we published the following chart. It compared the performance of RCA (the pioneer of radio) in the 1920s to that of AOL (the pioneer of mass-market Internet) in the 1990s. The idea had come from an article in the New Yorker and we inferred that, regardless of a company’s technological merits or uniqueness, a speculative bubble is a bubble and it will burst. Here is the chart as presented then:

Zap forward to 2002. A reader who teaches a graduate seminar in interactive marketing at a prestigious university asked for an updated chart, together with some comments. The updated chart is easy:

As for comments, they are less visually obvious than the roughly 90-percent decline in the stock price in less than three years.

First, there is the seemingly paradoxical precept of one of my early mentors. “When a young, exciting company is not yet profitable”, he used to say somewhat tongue-in-cheek, “it is hard for its stock to go down, because it is driven by dreams. But when it becomes profitable, beware! The stock price must then confront the reality of the company’s computable earning power and it will often come down as dreams are replaced with more realistic expectations”.

During the period between the two charts, AOL’s operating losses first began to shrink and, more recently, became actual earnings. At the same time, however, it slowly became obvious that Internet advertising was falling short of early hopes – especially in the wake of the collapse of many early advertisers, themselves fledgling Internet companies. Concurrently, it became known that AOL was not the ideal internet provider for broadband access, which is the fastest growing segment of the market. Finally, the rationalization of the Time-Warner acquisition, which was supposed to ideally marry the premier content provider with the largest portal, began to look like an intellectual construction with many cultural and other obstacles. Dreams were being overtaken by reality.

More broadly at stake is the skepticism inherent in all contrarian investing. When the price of a stock has gone up exponentially, this skepticism can be summarized by the simplistic but age-tested adage: “trees don’t grow to the sky”. Great companies, like RCA, can keep growing for a long, long time. But stock prices, besides operating results, are moved to a significant degree by crowd psychology. As a result, they fluctuate widely around any definition of fundamental value, as the crowd’s mood oscillates between excess optimism and excess pessimism. This is true even when the company’s fundamental value keeps going up. When the mood is excessively optimistic, a company’s stock price discounts too many years of future growth if the company should continue to do well and provides no cushion for disappointments (even minor ones) should operations falter.

The contrarian approach also applies to other assets, as well as the outlooks for economies and financial markets – with a twist.

In a recent piece, Morgan Stanley’s Barton Biggs pointed to the fact that the few investors who have been consistently successful over the really long term (a few decades) tend to be pessimists. Actually, “skeptics” should be more accurate, since you need at least a modicum of optimism to make a long-term commitment to the stock market. Biggs also argues that pessimistic scenarios appeal to the intellect more than optimistic ones. The reason, he says is that failure represents a closure, and that the events leading to it can be thoroughly analyzed, whereas success is never definitive. Thus, analytical investors and strategists tend to demonstrate a bias in favor of pessimistic scenarios and arguments.

In spite of everything interesting I learned on my recent trip to China (more on this soon), these are the first reflections that came to my mind as I returned. Perhaps it was the fact that long trips are a propitious time to reflect on current events with the proper distance; perhaps it was the contrast I observed between the enthusiasm of young Chinese entrepreneurs and the resignation and fear of European businessmen and investors I met upon returning. Whatever it is, it convinced me that the skeptical and contrarian way to look at the world’s major economies and stock markets today is to adopt an optimistic bias.

It is true that dire global scenarios can be painted for the long term. But, as Lord Keynes said, “in the long term, we are all dead”, while Warren Buffet likes to point out that “fear is the foe of the faddist and the friend of the fundamentalist”. There are many problems -- economic, financial and political – for which it is hard, today, to imagine easy unwindings. And yet, long term, complex problems are usually solved by muddling through them rather than through single, immediate actions.

Most of the literate, thoughtful people I met since my return enunciated the challenges ahead quite clearly: they must be largely priced into the market. Without ignoring these challenges, therefore, my contrarian approach leads me to look at the positive “straws in the wind” amid today’s widespread skepticism. As expressed in mid-October in Looking Over the Valley, I remain a cyclical (global) bull while retaining the secular pessimism that qualifies me as an intellectual.

François Sicart
November 2, 2002

^© Tocqueville Asset Management L.P.