What are you thinking?
Scott McNealy has a question for you
My intention for this newsletter was to focus on timeless investment principles and to ignore the day-to-day noise. But given market action so far this year, I feel like I must address the AI elephant in the room.
This week NVIDIA became the sixth-largest company in the world, by market cap.
They did it by defying even the most positive forecasts, indicating that next year’s revenue would be up an astonishing 64% over last year. For a company of this size to reset expectations to such a large degree is almost unprecedented. The stock jumped by 25%, adding almost $200 billion in market cap in a single day.
The story, as it goes, is that the company has a dominant position in the chips that will be necessary for companies investing in artificial intelligence projects. Susquehanna analyst Christopher Rolland wrote, “It looks like the new gold rush is upon us, and Nvidia is selling all the picks and shovels.”
Indeed. AI, as you know, is all the rage. In fact, the hope of AI and the momentum behind large-cap tech is single-handedly keeping markets supported so far this year. The chart below tells the tale:
Among the stocks leading the market, none are obviously cheap based on traditional valuation metrics. On the contrary, one can make the argument that they are quite expensive, especially in an environment where the risk-free short-term interest rate is around 5%.
Gravity always wins
Last month I wrote about why gravity always wins when it comes to company valuations. Rest assured, those paying too high a price for future earnings stand to be disappointed in the long run if promised cash flows don’t materialize.
How confident are you in that future growth? Back in March, I explained why it’s so hard to pick the future winners, and how high growth expectations so often disappoint.
Both of these essays are highly relevant as we ponder recent market action.
As for what it means for the overall market, it’s generally acknowledged that a narrow market, being led by fewer and fewer large, dominant stocks, is not healthy. I thought this chart was very interesting. We haven’t seen market action like this since the 2000/01 tech bust.
Whatever, old man. Convince me not to buy NVIDIA and make some easy coin.
Look, I’m not here to give out investment advice. And even if I was, I’m not sure you’d want to listen to what I have to say. The NVIDIA bulls have been right so far, correct in their belief that even as demand from gaming rigs and cryptocurrency mining withered, other markets would rise to take their place. A few months ago it was Virtual Reality, today it’s Artificial Intelligence. Who knows what tomorrow will bring? The future will undoubtedly rely on the type of high-powered GPUs that NVIDIA specializes in.
But let’s draw a simplified parallel. Cisco is often held up as an example of crazy stock prices at the peak of the 1990s tech bubble.
Here’s a quote from this past Thursday’s edition of the Almost Daily Grant’s newsletter:
Kevin Duffy, co-founder of Bearing Asset Management, relays that Nvidia’s $940 billion market cap stands at 64 times gross profits over the 12 months through April. At the peak of the dot-com bubble, shares of tech darling Cisco crested at a mere 53 times trailing gross profit
For those unaware, as I write this in May 2023, Cisco has still not recovered the bubble high price it reached in March of 2000.
I’m not about to stand in the way of a freight train. This seems to be less about fundamentals than it is about a lack of AI-specific stocks for investors to buy. If the momentum keeps going long enough, you’re going to see a raft of AI-related IPOs and companies changing their name to catch a ride on the wave (“Long A-Island Iced Tea,” anyone?) It’s very rare to see a bubble form so soon after another one, especially when monetary policy is so restrictive, but in the markets, anything can happen. Right now, anyone buying NVIDIA has to be hoping that we are at the very early stages of an AI investment bubble. I’m not going to say that’s impossible, but it’s not a game I’m interested in playing.
All of this reminds me of the words of Scott McNealy, former CEO of Sun Microsystems, in the wake of the 2000 tech collapse.
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
Today, NVIDIA trades at 37x revenues, almost 4x the valuation that had Scott McNealy asking investors “What were you thinking?”
I love that quoted paragraph from Scott, it's spectacular. Great article Geoff!