Markets are efficient, or so we’ve been told. I am not here to rebut this academic nonsense. But let me give you one of the core reasons markets are — and will remain — inefficient: because human beings are efficient.
To function in everyday life, we use our brains to simplify complex problems through heuristics like pattern recognition. We become accustomed to drawing straight lines when we see two points, and if we get a third or fourth point that fits the line, our confidence about the continuity of that line increases exponentially. When we invest in a company, we become excited, even certain, about its prospects after its stock price has gone up for a long period, while we often dismiss stocks that have declined or flat lined, especially if that has happened for a considerable time.
Imagine an analyst bringing a “fresh” stock idea to a portfolio manager at a large mutual fund firm. He’d say something along these lines: “Cisco Systems is a buy. It has a bulletproof balance sheet with $25 billion of net cash [cash less debt]; its stock is cheap, trading at 9 times earnings [excluding net cash]; it’s providing double-digit returns on capital; and it is a dominant player in the networking equipment industry, which is poised to grow faster than the economy thanks to iPads, Androids, Kindles, Hulu and Netflix.”
I can see the portfolio manager’s smile, followed by a laugh and the inevitable reply, “This stock is a value trap; it has gone nowhere in more than a decade.” I’m glad I’m not that analyst, who is going to have a heck of a time convincing the portfolio manager to buy into his argument. After all, Cisco shattered the dot-com dreams of many investors in the years following March 2000, when it hit $80 a share and, for a brief moment, was one of the most valuable companies in the world, sporting a modest price-earnings ratio of 100-plus.
Since then, gravity has caught up with Cisco’s shares (it always does), which have declined almost 80 percent from their high, to $17. Most investors who bought the stock during the past decade have either lost or made no money. Draw a straight line through its stock price chart and you might conclude that Cisco will either decline to zero or, at best, go nowhere. Add a few recent quarters of disappointing Wall Street guidance and you have an untouchable, unrecommendable stock.
However, the fundamentals tell a very different story. Cisco’s revenues, earnings and cash flows have all at least tripled since 1999. Through no fault of its own, Cisco’s stock was too expensive during the dot-com bubble, and it needed time to catch up to its fundamentals. Of course, as usually happens, investors got overexcited on both the way up and the way down. The same investors who could not get enough of Cisco when it was trading at more than 100 times earnings won’t touch it at 9 times earnings.
With more than $40 billion in sales, Cisco is no spring chicken. It will likely see some margin compression as parts of its operation continue to mature. Revenue and earnings will grow at a slower rate than they did over the past decade. But at its current price, Cisco doesn’t have to do anything heroic to justify its valuation; it just needs to show it has a pulse.
Of course, it is very difficult to get a unique insight into Cisco’s business — or into the business of any large-cap company, which is typically followed by a small army of analysts (nearly 40 cover Cisco). Some sell-side analysts undoubtedly know what CEO John Chambers’s favorite cereal is and can recite the model number of every Cisco router. Most of us cannot compete with that, nor do we need to.
To succeed, investors need to have a longer time horizon than Wall Street’s, which shouldn’t be difficult. Sell-side analysts exist to serve their buy-side masters — money managers who are judged and compensated on monthly and quarterly performance — and thus expend their energy analyzing the next quarter, not the next five years. Having a longtime horizon is a huge competitive advantage when analyzing companies like Cisco, whose earnings should be significantly higher in three to five years than they are today. (That’s why we recently bought Cisco shares.)
It is also important to understand that even a much followed stock like Cisco will suffer from inefficiency as investors confuse lousy stock performance with fundamental performance. That is how to find high-quality companies at bargain-basement prices.
Understanding what happened in the past is important, not because it is a precursor to the future but because it helps build an analytical bridge from today into the future. Be inefficient — don’t draw straight lines.
Vitaliy Katsenelson (vk@imausa.com) is CIO at Investment Management Associates in Denver and author of The Little Book of Sideways Markets.
