A mini bubble warning?

A mini bubble warning?

Between 1995 and 2000, the mere mention of the word ‘internet’ in your business plan, IPO or marketing material was enough to set your stock on fire. Over that five-year period, the Nasdaq climbed from under 1,000 to 5,000 despite few businesses in the index actually making any money.

In The Theory of Investment Value, John Burr Williams set forth an equation for value. He wrote that the value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.

Given the Nasdaq had such a large number of profitless or even revenue-less businesses, prices at the peak of the internet bubble bore no resemblance to the underlying economic earnings power of many individual companies. The party ended, as it always does, with a bang, and the index retreated 60 per cent from its highs.

History is replete with stock market bubbles and we are always on the lookout for pricing that reflects irrational exuberance. Indeed we think that a mini-bubble may be forming right now in Australia’s smaller capitalisation ‘digital’ stocks.

By way of example, since mid July, Mint Wireless (MNW), Smarttrans Holdings (SMA), and Mobile Embrace’s (MBE) share prices have been riding a euphoric wave of optimism, buoyed by industry buzzwords such as ‘cloud’, ‘mobile’, ‘payments’ and ‘online scale’. The share price trajectories have left us shaking our heads yet again.

Suppose we offered you the opportunity to buy a diversified digital ‘business’ for $292 million. If, upon telling you that the business generated just $16.9 million in revenue and produced a loss in 2013 of $4.1 million, you didn’t zip up your wallet and walk away you would arguably need your head read. Combine the current market capitalisation, revenue and profit for Smarttrans, Mobile Embrace and Mint Wireless and you have exactly the same scenario and yet many market participants are arguably willing to pay just that or even more, given more recent price action, for these businesses.

As John Burr Williams put it: in the long run (fads notwithstanding) it’s the earnings power of a business that ultimately drives share prices.

Given anyone could deposit $292m into an online bank account and earn over $7m in after tax profits – a level of profitability that currently appears years away for this group – such lofty market prices are, in our view, hard to justify at best and at risk of a severe correction should earnings fail to materialise at worst.

We have been helping investors discern the difference between investing and speculation for years but it remains clear there will always be market participants willing to be the “unwitting” mugs that value investors and hedge funds will be able to take advantage of.

As Warren Buffett noted in his 1975 letter to Katherine Graham at Washington Post: “…that relates to the periodic tendency of stock markets to experience excesses which cause businesses – when changing hands in small pieces through stock transactions – to sell at prices significantly above privately-determined negotiated values. At such times, holdings may be liquidated at better prices than if the whole business were owned – and, due to the impersonal nature of securities markets, no moral stigma need be attached to dealing with such unwitting buyers.”