Old Economy Versus New Economy, In A super-heavyweight bout between representatives of the two:
Henry Blodget Debates Jeremy Grantham
By James M. Clash Next
MUCH HAS BEEN MADE OF the differences between the sizzle of the New Economy, replete with Internet splendor, and the languishing of the Old Economy, with its bricks and mortar stodginess and boring value orientation.
Who better to debate the subject than New Economy Merrill Lynch analyst Henry Blodget, 34, famous for his outrageous--but surprisingly accurate--Amazon price predictions a few years ago, and value-oriented, Old Economy money manager Jeremy Grantham, 61, of Boston's Grantham, Mayo, Van Otterloo & Co.?
We put them together at FORBES in early May to duke it out. Following are edited excerpts.
FORBES: We've all heard about the new paradigm, where valuations don't seem to matter much. What do you guys think?
Blodget: I think valuations matter, but less in the big-bang stage of an industry where you have few metrics to get comfortable with. But as an industry starts to mature, as some of the early sectors of the Internet are now, it starts to matter more, and you need to get a better handle on, say, Yahoo and what it could earn in three years.
I think the mistake a lot of investors made--certainly I made it initially--was to be too conservative about how quickly this industry could grow, about how much commerce would move online. So early estimates for companies like Yahoo were, in retrospect, ludicrously conser-vative. Yahoo was actually cheap when it came public, selling at four times 1999 earnings. Now the question becomes: Can you still have that at current valuations, when Yahoo is a $70 billion company, where then it was just a $1 billion company?
We've come out of a big-bang period, where investors have been willing to fund anybody with a business plan. The recent pull-back in the market is probably going to temper that enthusiasm. At the same time, we've gone into a period where it's become much more competitive because there are so many companies. The combination is leading to a pretty brutal shakeout in which valuation is going to become a lot more important. I think you'll see probably 75% of these companies disappear. They're definitely overvalued, and they'll either be merged or fail.
You can look at the impact of the Internet on the economy in a couple of ways. You can go sector by sector and say okay, what is the Internet likely to do to each? In some sectors, it's disruptive--it totally changes the way business is done and creates a huge headache for the incumbents. In other sectors, it's more an extension of business, another channel. But we still think that for the really good companies with long-term franchises there is an upside in valuations. I think some of the big dot-coms will be fast-growing for the next ten years. They have a very good runway. I think Yahoo and AOL-Time Warner can. We still think Amazon has a long way to go.
Grantham: Of course valuations matter. It's a question of degree. Some [of the Internet companies] will turn out to be good, most will be useless. But focusing on individual companies encourages people to look at one or two Yahoos and conclude that the sum [of all Internet companies] can be equally impressive. The sum [at the end of February] was $1.2 trillion [combined market cap for the Net sector, defined to include Cisco and AOL] against a negative $2.5 billion in earnings. I believe 80% of these companies will cease to exist, and that the total value 15 years from now will be hard-pressed to be $1.2 trillion, and will probably be less.
The Internet is a destroyer of costs, which is beautiful. One of the costs it's destroying is profits. It's the biggest revealer of prices. Industries--from insurance to ball-bearings--that have made lots of money selling to people who pay a little more than they have to will be squeezed. People can now find all the information they need, including price disclosure. Insurance companies will have their profits squeezed. Ball-bearing manufacturers will have their profits squeezed. Individuals are the enormous beneficiaries.
[Bulls] need to find an excuse. Excuses in each of the great bubbles of the 20th century have followed the bubbles, not the other way around. You try and justify why you have an enormously high price, and the arguments of a new economy that were so prevalent in 1929, the mid-1960s and again now, follow.
I've got to read you Andrew Smithers from the Evening Standard (Mar. 13): "It's not easy to make a rational case for buying shares that have gone up a lot unless there is some new information to justify the price rise. But all too often the only new information is that the share price has risen. If fund managers don't buy shares that have already shot up, they fear they will underperform. If they do and the market crashes, they fear they will be blamed for recklessness. There is thus a huge new demand for excuses. The fund manager's biggest need today is for reasons to justify the unreasonable. Supply has risen to meet this demand. The number of irrational arguments around must be approaching a world record. The moral is simple: If you want to invest, don't be rational, and if you want to be rational, don't invest."
Blodget: I think it's important to remember with stocks like Yahoo and AOL that have been recently added to the S&P 500, the benchmark for a lot of professional money managers, that they have the potential to go up 100% or 200% in a given period. AOL was up 300% two years ago--100% last year--and Yahoo had pretty much the same performance.
You have extraordinary risk if you do not buy them and are benchmarked [to the S&P 500]. So, we can't look at each of these stocks in a total vacuum on a pure discounted cash-flow basis. Because relative performance is important, and a lot of money managers unfortunately underperform the benchmark because they missed the Internet.
In terms of declaring it a bubble and saying it's insanity to put money in, you have to bear in mind where we are. Because in 1996, 1997 and 1998 that was the wrong argument. You missed multibagger stocks--in the case of Yahoo, a hundred times.
You can buy a lot of stocks that go to zero if you get one that goes up a hundred times. So I just think it's important to have a sense of where we are in the development of the whole medium when you make the judgment that a stock just looks too expensive.
Grantham: I've got to admit it's very dangerous not to buy AOL and Yahoo and so on in a benchmark world. But that has nothing to do with the prudence of the investment. That's just the craziness of benchmarking returns.
I'll quote another favorite, [John Maynard] Keynes. He was a sophisticated money manager. He ran money for his college. And he had no illusions about how hard value investing is as opposed to getting a jump on the gun: "He who tries to pick long-term value stocks must surely lead much more laborious days and run greater risks to his career than he who tries to guess better than the crowd, how the crowd will behave. Human nature desires quick results. There is a peculiar zest in making money quickly. It is the long-term investor who will, in practice, come in for the most criticism. If he is successful, that will only confirm the general belief in his rashness and, if in the short-run he is unsuccessful--which, of course, is very likely--he will not receive much mercy."
There is no mercy shown to people who don't buy Yahoo and AOL. But that is no rationale for [buying them]. It is, in fact, a justification for running along with the crowd and paying 30 times earnings. The trouble with the Internet is fallacy of composition. It is used as an excuse to justify 30 times earnings for the entire S&P 500. When you ask people why are they doing that, they start talking about Yahoo and AOL. But, of course, in total the S&P is approximately a claim on the entire U.S. economy. And it's 30 times earnings.
Blodget: I'd gladly buy Yahoo for 30 times earnings. I wish I could. [It sells at 340 times earnings.]
Is the Nasdaq crash the beginning of a real bear market?
Blodget: The pull-back and the speed with which it's happened has been brutal. However, the Nasdaq is still up 40% over [the past] year, an extraordinary performance. In 1999 it was up 83%. Unfortunately, if investors expect that is somehow an average annual performance for a major market index, they have not looked back at history.
The Nasdaq has been a very strong performer for several years, but last year was wildly out of balance. So you have to look at a sector this volatile from a distance, and expect the volatility to be there. My guess is that things have changed a bit; we are in much more of a rising interest rate environment. The economy is steaming along and the Federal Reserve seems as though it is not willing to save the market. It's willing to slow the economy down. The fundamentals of the technology sector are still very strong, but the Internet sector is maturing.
Grantham: The week before the crash, our model on the Nasdaq showed it trading at half price for decades. So the model has no dramatic understatement. It didn't hit fair price until 1995 on that model. Then it proceeded to rise steadily and blew off in a classic bubble to 3.5 times, at which point we concluded it needed a 70% decline to get to fair value. Of course, if it stops at fair value it'll be the first time in history. And that's for the 88% of the Nasdaq that has earnings we can get our teeth into.
We basically believe that, from their highs, the S&P 500 will decline 50%; the Nasdaq, 70%; and the nonearnings Nasdaq, 80%. The safest thing to say is sooner or later. The great bear markets do not hurry. They have often had precipitous decline phases. But basically the 1929 peak didn't really bottom until 1945. The 1972 peak didn't bottom until 1982. And, incidentally, in those ten years, the S&P was down close to 40% in real terms.
The Japanese market may not have even bottomed now, ten years later; from 40,000, it's now 18,000. In real terms, there's no guarantee that this is the low. This is typical. So it isn't that I fear a quick market break. What I fear is a slow reversion to more sensible pricing where stocks, in general--including the Internet thrown in--can return 6.5% real. [That implies a price of] 17 times earnings.
Incidentally, I poll professional money managers informally at conferences with the simple question: "Hands up, those who believe that the P/E on the S&P 500 will not reach 17.5 some time in the next ten years?" You know how many people put their hands up? None. I have done this now seven times, and finally I got one person out of maybe 600 to stick his hand up. Second question I ask: "How many people believe that profit margins will not retreat from their 1965 and 1998 peaks of 7.2% on sales back towards the 5% average?" Nobody.
Professionals believe that P/E will get to 17.5, against the long-term average of 14. And when you put that down and work it through, you have a major-league bear market.
Where do each of you have your own portfolios invested?
Grantham: I have mine invested exactly the way I advise my clients: REITs (including timber), 23%; emerging equity, 20%; emerging debt, 5%; and the rest in government bonds, predominantly inflation-protected ones which yield 4.3%. No credit risk. No inflation risk.
REITs are at the greatest aberration of my career--a 25% discount to the capital value of the property. The property values are about at replacement cost now. Not surprisingly, that gives them an 8.5% yield protected against inflation by rents, which tend to rise with inflation. Even a mild recession does not get to REITs.
Direct property is not quite as good because the REITs are a 25% discount. Fixed income, right across the spectrum in the U.S., looks perfectly reasonable. And emerging. If you want to take some risks, use up your risk units in emerging equity and emerging debt. We like Asia here. Emerging debt has about a 15% yield. Emerging equity has a P/E less than half of the U.S. on GNP growth rates of about double. You know, however much of a new era person you are, there's something nice about having GNPs grow at twice the rate and at half the price.
Six years ago emerging equity sold at a premium P/E to the U.S. And sooner or later, in the next ten years, it'll probably happen again. You will make modest amounts of money in a world where people are losing tons of money. This is a unique bubble. Most bubbles, like Japan, put you in a situation where you can't make money anywhere. Golf club memberships are a million bucks. Even Van Goghs are selling at $80 million. Bonds are terrible, stocks are terrible, everything's terrible. This is not like that. We have a lot of sensible asset classes.
Finally I own timber, my favorite long-term asset class. It's the only commodity that's beaten inflation in real terms for centuries. Most competent managers can get you 8% -to-10% real return in timber.
How do you buy it?
Grantham: You have to go to one or two of the timber REIT's--Plum Creek is one--or go to institutional managers who will handle $500,000 pieces.
Blodget: My portfolio also is consistent with what I am telling clients with regard to technology and the Internet sector. Less than half is in the equity markets--40% equities, 60% in stuff I hope will survive a nuclear war, or the scenario Jeremy has laid out. And 20% is in aggressive equity, which is technology related--and 5% -10% in the Internet sector.
Do you have anything in bonds?
Blodget: Some of that 60% is in bonds. But not directly.
What do you think about Amazon, the stock that made you famous? Is it a buy at 50% off its high?
Blodget: If you're a long-term investor, this is a buying opportunity. In retrospect, we were right about the revenue growth but wrong about the bottom line. We didn't think the company would have to invest as much as it did to get where it is today.
The company's focus has changed over the past six months, from hypergrowth to long-term growth--now they're going to leverage earnings and cash flow streams. Our projections get Amazon close to $1 of free cash flow in a couple of years. We think they've been built to last; they have one of the best management teams around, and they're incentivized for 10-to 20-year performance, not next year. So that is one of the companies we're comfortable owning over the long term.
What percent of your portfolio is in Amazon?
Blodget: I have about 1%, the most I have in any one stock.
We've seen such large increases in market volatility the past few years. Is it the day traders or something else, and is it here to stay?
Blodget: Day trading has certainly accelerated volatility. It's tremendously short-term investing, the most momentum-oriented: Where is the stock going to be in ten minutes? My guess is that if we go into a sustained bear market you will see a great sobering of the day trading habit. Investing is extraordinarily difficult, and that is why even few professional managers will outperform the market.
If you have a period where it's easy, and if all you've got to do to win is have the guts to pull the trigger, those don't tend to last very long. So my guess is if we have a secular change here, and the market is headed down, volatility will gradually decline.
Grantham: Volatility is a symptom that people have no idea of the underlying value--that they have stopped playing the asset game. They're not buying because it's a company with certain attributes. They're buying because the price is rising. People are playing games not related to any concept at all of what the long-term value of the enterprise is. And they know it.
Day trading has obviously exaggerated the problem. It will obviously go down if there's a drawn-out bear market. I think it will drop to 20% or 30%, still a whole lot bigger than it was years ago. The technology just allows for it. And, in a sense, it's an easy and cheap way to play that game.