Every time you can turn a literal phrase into a beautiful metaphor, you take it. It’s likely that Buffet was being quite literal when talking about liquor and ladies, but many of his previous quotes actually reflect a lot of the same themes.
Buffet and Munger have lasted as long as they have because their ideas have stood the test of time. People complain that their edge isn’t as great as it used to be, and that’s true. Edge and success are a bit confusing when you begin to manage hundreds of billions of dollars, though.
Especially when you begin to look at the cumulative earnings dependent on overall performance:
When we decode the simple phrasing of three avoidance alerts, we begin to see what alcohol, women, and leverage really mean.
Nothing sedates rationality like large doses of effortless money.
Buffet said this in 2000 in Berkshire’s annual report. It’s actually on page 14. It’s pure gold because you don’t quite grasp it fully until you begin to think about what he’s saying.
Rationality can take sedatives. This is because the market is governed by people, no matter if they are an individual on forums like Reddit’s WallStreetBets or institutional behemoths at a regional trading shop.
When it comes to segmented, isolated niches, like technology, far and few people understand the capabilities and limitations of that technology. Most of the time, like an accordion, a technology company will reach its fair value or cross it, only to far exceed any rational valuation in the near-term. Sustainability is then thrown out of the equation, further distorting the alignment of the marketplace.
When this happens, we get a ripple effect throughout the economic sector.
Here’s a thought-experiment: Technology filters through the stock exchanges in America in the early 2000s. Many people have high hopes that the internet is a panacea for all of society’s ills. We can fix anything.
Within one year following 2000, the Nasdaq has reached an all-time high. Valuations are larger than traditional companies but are not producing profit yet. Venture capital funding runs out, and the Nasdaq loses around 80% of its valuation.
Recently, the new wave of technology has been gaining momentum. The Nasdaq has now doubled since its last all-time-high, and it doesn’t seem to be slowing down. The widening of valuations between traditional corporations and technology-based applications is growing.
Any app-based technology company, or advertising data company, or company with social media-based user growth has earned a tremendous valuation spike since 2010.
While none have seen profitability yet, their venture-backed dollars seem as refreshed as ever.
Don’t be Cinderella. Also, don’t look for Cinderella.
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
This was also on page 14 of Berkshire’s annual report in 2000. It’s been true time and time again, and will continually be true in the wake of any history lesson that goes unlearned with enough time.
The stock market parties are great — they just don’t last.
People are looking for the panacea today that they were looking for in 2000. But the tech industry of today hasn’t changed as much as we’d like to think. The technology world struck gold upon the realization that digital advertising could render a profitable business segment for many of the companies that own the highways on the internet.
Truly, Microsoft, Amazon, Facebook, and Google owe their valuations to just that: Advertising.
The entities that provide the majority of that advertising, however, are not profiting. These are companies driven by heavy venture dollars that are promising future profitability.
Airbnb and Shopify are two applications promising exactly that.
Airbnb is still a private company looking to go public soon. It has raised $5.8 billion over 16 funding rounds over the last 11 years. It recently raised another billion dollars in April of 2020. After 11 years of seeking profitability, it’s still failing. Applications, at their very nature, are seen as the same panacea that dot-coms were in 2000. But they’re just that: Applications. Airbnb is still struggling with very real issues:
- Internal valuation decline
The worst of all: Profitability.
Much of the investment dollars that Airbnb receives translates into revenue dollars for companies like Microsoft, Google, Amazon, and Facebook. Airbnb’s venture dollars goes towards advertising to help the userbase grow. In turn, these artificial growth dollars come at the expense of those sourcing the fundraisers and expose a gargantuan revenue line item at the big technology companies that is exposed and artificial. One day, if people realize that Airbnb will never be profitable, the app-based world might struggle to find supercharged venture money. On that day, those revenue lines at Microsoft, Amazon, Facebook, and Google will struggle to sustain their past heights.
Shopify, on the other hand, is an example of a dot-com company that has gone meta. Instead of building the service themselves, they have turned into the service that sells other people the service to build their websites and businesses.
With a valuation of over $100 billion, they still struggle to find profitability.
The lifeblood of Shopify’s existence doesn’t operate in a vacuum, either. Amazon survives almost solely through Web Services. This is another meta-service, something that sells the infrastructure to other entities to help build their businesses.
And the backbone of the entire technology industry right now is the fact that venture dollars are infinite.
Some day, if the money ends, the early investors will bounce. As Buffet says so confidently, people are dancing in a room in which the clocks have no hands. The last ones out are usually the majority — the majority who didn’t realize that the party would actually end.
“Between September 1999 and July 2000, insiders at dot-com companies cashed out to the tune of $43 billion, twice the rate they’d sold at during 1997 and 1998.” — Brian McCullough, An eye-opening look at the dot-com bubble of 2000 — and how it shapes our lives today
I got this far because I didn’t listen.
Leverage doesn’t happen if the tracks come to a halt at the other two stops. Leverage is what we look for when the money seems guaranteed and the party doesn’t look like it’s going to end.
So we place the fake money bags on our real money bags.
And that’s all great — until it’s not.
Because, if we remove all the financial jibberish, leverage is just an extension of what you already have. The problem, as with everything, is that you can leverage a lot. Brokerage services aren’t stupid. If they knew that they’d be on the hook for letting you leverage, they wouldn’t do it. It’s the same theme that revolves around home buying. Banks wouldn’t be in the industry of handing out loans if it didn’t benefit them in a big way. We tend to see a tiny interest rate and fool ourselves into believing that the banks are losing. Most of the interest, if not all of it, is paid initially.
When you leverage on a brokerage service, they’ll calculate the exact dollar amounts in real-time. This is compounded if you are borrowing their money, too.
It is important to realize that, even though companies like Robinhood and Ameritrade won’t charge fees for most equities, you will get charged for the following:
- Over-the-counter stock purchases or sales
- Options purchases or sales or repurchases (per contract, not per purchase)
- Futures purchases and futures options purchases and sales
- Pretty much anything else other than the fancy companies most people know
On top of that, understanding the margin rates for borrowing is another thing. On Ameritrade, you really have to dig to find what it costs you to borrow. Here are their rates:
For most people, 9% is a lot of money to be paying.
Not to mention, time and irrationality are the enemies of borrowing. If, let’s say, we hit a minor trough in the markets and you lose 20% of your portfolio’s liquid net worth, then a brokerage service has every right to liquidate more of your equities at your loss to cover their loan. If you reach a threshold for a capital requirement that they don’t want you to go under, you’ll be partially liquidated.
They enter what’s called a ‘margin call’, wherein you’ll be on the hook to either
- fund your account.
- or sell your equities to cover the negative balance.
They don’t care which you do, they just want their money. If you do neither, they have every right to liquidate your assets without giving you a heads up.
The concept of things appreciating for infinite lengths of time dilutes the reality of a retail trader. Nobody seems to mind that interest rates are off the chart or that options fees can easily become atrocious. Everybody understands the meme that ‘stocks only go up’. That is, until they don’t.
Or, worse, if they fall.
The reality of the situation is, if you’ve made it this far and haven’t lost yet, you should count your blessings and re-adjust while you’re ahead.
Eventually, all sedatives wear off. When they do, markets eventually become checked. When we don’t have a sense of when the money ends, or what time it’s going to end, or why the party has lasted so long, it becomes increasingly difficult to tell when reality will cast valuations to a level of normalcy.
We do know, however, that things eventually become rational. Every now and again, we find ourselves in a bubble. Some bubbles can exist for long periods of time — backed by deep pockets that misunderstand the limitations of technological advancement.
That’s when we go back to Buffet and understand why he’s lasted as long as he has.