Paying for Perfection Won't End Well

A 'stone cold' business genius... Why I doubt his latest venture is a good investment right now... Investors have rarely been this bullish... It looks like the end of the AI bubble is in sight... Investors' lack of imagination...

Brad Jacobs is a 'stone cold' business genius...

Back in 1989, Jacobs saw an opportunity in the waste-management business. He noticed that most waste-management companies effectively had monopolies over a given area. That meant they could raise their rates in line with inflation. He also noticed that there were many small waste haulers – an industry ripe for consolidation.

So Jacobs formed a company called United Waste Systems and started buying up (or "rolling up") small waste-collection companies in rural areas. He took the company public in 1992. And in 1997, he sold it to USA Waste Services (which later acquired Waste Management) for $2.5 billion.

That same year, Jacobs saw an identical opportunity to roll up smaller companies in the industrial equipment rental market. So he founded United Rentals (URI).

Today, United Rentals is the largest equipment rental company in the world. It has a $50 billion market cap and a rental fleet of 995,000 units. Since going public shortly after Jacobs founded it in 1997, URI's stock has become a 48-bagger.

Jacobs followed his roll-up strategy again in June 2011, when he invested $150 million into freight transportation provider XPO (XPO).

To maximize shareholder value, XPO spun off logistics provider GXO Logistics (GXO) in 2021 and trucking brokerage RXO (RXO) in 2022. The three companies have a combined market cap of roughly $24 billion. When Jacobs invested in XPO, its market cap was $83 million... making his investment roughly a 156-bagger.

In short, Jacobs saw great opportunities, executed his roll-up strategy well, and created billions in new shareholder value.

Now, Jacobs sees a new opportunity...

Last December, Jacobs took over a small company called SilverSun Technologies... spun off its existing technology-services business to shareholders... and changed the name of the company to QXO (QXO). QXO is a shell with no business operations and no debt.

Jacobs has injected $5 billion in cash into the company, including $900 million of his own money. He wants to use QXO to buy building-products distributors... which he believes is a fragmented industry ripe for his trademark roll-up strategy. I don't doubt that Jacobs will succeed again. However...

I doubt that QXO is a good investment right now...

Remember, the company's one and only asset is that $5 billion in cash. Yet as we write, QXO's market cap is about $32 billion. And that's only after the stock fell by more than 30% yesterday. The stock has traded as high as $290 recently, briefly giving it a market cap of $87 billion.

Its market cap today assumes nearly sixfold growth in value. Given Jacobs' history, that's not an irrational expectation. URI's revenue has grown nearly 100-fold since Jacobs founded it in 1997. XPO's revenue has grown 50-fold since he took over in 2011.

But United Rentals' share price wasn't up sixfold until 17 years after Jacobs started the company. And the chart below shows what you would have endured to earn that return... seven declines of between 42% and 91%:

XPO took about six years to hit the sixfold milestone, and investors would have had to endure a 61% decline along the way.

Both stocks went in the right direction long term. But most folks would have had a hard time holding onto the stocks through the sell-off periods.

Most investors can't stomach holding through one steep, brutal drawdown... let alone seven. That's a big reason why multibagger gains will always elude most investors.

And expecting a sixfold increase isn't the same as paying a price that requires one...

The more you pay for a stock, the more you need to lower your expectations.

If you could buy QXO for $1 per $1 on its balance sheet (it has no debt), that would make sense because you would only be paying for the cash at that point. You'd be getting Jacobs' experience and talent for free. Even paying $2 doesn't seem crazy, since he'll likely create plenty of shareholder value within the first couple of years.

But if you're paying more than that for $1 of value in QXO, you should expect to ride out multiple extremely steep declines over the next decade before you get anywhere near the giant multibagger return you'll need to make it all worth it.

And if you pay $6 for $1 of value, you should expect all that volatility and then some. You'll probably be underwater on the stock for several years, maybe a decade or more.

The way the stock is priced now, you only break even if Jacobs and his team generate a sixfold rise in value. The risk/reward setup doesn't work. You want to get upside potential in a new venture cheaply. Paying way too much for a stock like this turns big, multibagger return potential into big downside risk.

That's what happens in bubbles.

The upside – and much more – is priced into stocks. So even if you buy the shares of a cash-gushing, well-managed, highly competitive business... you're risking a huge loss in exchange for the potential to merely break even. That's what folks did in March 2000 when they paid $80 a share for Cisco Systems (CSCO). They wound up losing 89% of their investment over the next two and a half years. The stock eventually bottomed out at $8.60 per share in October 2002.

As I've pointed out many times, if you pay way too much for a stock, you absolutely will lose money. It's been more than 24 years and Cisco still hasn't eclipsed its March 2000 all-time high.

Investors have rarely been this bullish...

Our friend Jason Goepfert at SentimenTrader.com recently told his readers that the stock market is "nearing record persistence of risk-on behavior." In short, investors have hardly ever been this insanely bullish for this long.

I'm always concerned when stocks are egregiously expensive. Investors are always insanely bullish at those times, even if they aren't breaking records for persistent bullishness. And these investors set themselves up for years of disappointing returns... like with QXO.

But the reason folks are super bullish right now is easy to see... the introduction of so-called generative artificial intelligence ("AI") in the form of chatbots like ChatGPT, Bard, Jasper, and a few others. This AI has lit a fire under investors, causing a brand-new tech stock mania.

All the so-called Magnificent Seven companies – Apple (AAPL), Microsoft (MSFT), Nvidia (NVDA), Alphabet (GOOGL), Amazon (AMZN), Meta Platforms (META), and Tesla TSLA) – are spending plenty of money developing AI.

Nvidia has been the main beneficiary, with its stock up about 2,500% over the past five years. It's up about 150% over the past 12 months.

But it looks like the end of the AI bubble is in sight...

For one thing, nobody is making money on generative AI. And there's still no "killer app" that proves the technology is valuable.

At least two of the biggest AI players – Alphabet and Meta Platforms – have admitted that they're probably spending way too much on AI. On a recent Bloomberg podcast appearance, Meta founder and CEO Mark Zuckerberg said:

I think there's a meaningful chance that a lot of the companies are overbuilding now and that you look back and you're like, "Oh, we maybe all spent some number of billions of dollars more than we had to."

Meta has been stockpiling AI-enabling microprocessors made by Nvidia so it can train AI models.

Alphabet CEO Sundar Pichai said on the company's quarterly earnings call on Tuesday that his company might also be spending too much on AI, but that it has little choice.

Zuck and Pichai remind me a lot of former Citigroup CEO Chuck Prince. In July 2007, with the subprime mortgage bubble already beginning to unravel, Prince famously said of his bank's continuing activity in that business:

As long as the music is playing, you've got to get up and dance. We're still dancing.

Citigroup (C) shares peaked at $564 in December 2006. They lost 98% of their value, bottoming at $10 in March 2009. The stock trades around $65 today – still 88% off its all-time high. Gosh, who would have guessed that investors would lose money buying into a mania... when even the main players admit they're just spending money until the whole thing falls apart?

Zuck and Pichai are afraid of the competition getting ahead of them, so they're spending money hand over fist to keep up – even though there's a real chance that the whole thing will blow up soon.

This fear of missing out also leads folks to pay $6 for every $1 of cash, like in QXO. By the way... QXO was trading at $14 per $1 of cash when I started writing this Digest two days ago. Then it fell more than 30% yesterday.

When the market has had enough of an exorbitant valuation, things can fall apart fast. Don't fool yourself into thinking that can't also happen to the whole market. I'm willing to bet most folks can't imagine such a rapid decline in the big stock indexes. And that's the problem...

The hallmark of this moment is investors' lack of imagination...

Investors can't imagine that all this money being invested in AI is wasted.

They can't imagine that QXO's stock might not generate a huge, multibagger return over the next few years. Nobody believes that it's possible to pay way too much for a stock, even if it's a great company.

In a recent letter to his clients, investor and author Vitaliy Katsenelson wrote:

The Magnificent 7 are starting to look like the Nifty Fifty stocks from the 1970s (Kodak, Polaroid, Avon, Xerox, and others) – stocks you "had to own" or you were left behind – until all your gains were taken away or you faced a decade or two of no returns. Forty years later, it's easy to dismiss these companies as has-beens. They've all either gone bankrupt or become irrelevant. But back then, they were the stars of corporate America, just like the Magnificent 7 are today.

Nobody today can imagine the shares of Apple, Microsoft, Nvidia, Alphabet, Meta, Tesla, and Amazon doing anything but going up forever. You won't find the mainstream press or Wall Street mention the idea that any of these businesses could produce mediocre business results or investment returns for any length of time.

Katsenelson went on to say:

Magnificent 7 stocks require us to draw straight lines with cash flows growing at significantly elevated rates far into the future, and even then, we get values yielding either mediocre or negative returns – forget about any margin of safety.

Their valuation demands a perfect, highly prosperous vision of the future with little competition and insatiable demand for whatever they produce. Though these are truly terrific companies, which dominate their industries, and have track records of success and growth, the financial history of markets is not on their side. Their valuation reflects only optimism and nothing else.

This optimism is compounded by passive investors mindlessly contributing to 401(k) accounts every two weeks. The Mag Seven stocks make up more than 35% of the S&P 500 Index's market cap these days. So investors are putting more than $0.35 of every $1 they invest into just seven stocks, which are priced as though their businesses won't experience a single challenging moment "far into the future," as Katsenelson put it. The stock market is assuming absolute perfection from many companies for decades, which has never occurred.

Now, there seems to be a ray of hope... in the subsequent performance of the Nifty Fifty after they peaked. Wharton professor and author Jeremy Siegel pointed out in a 1998 Barron's article that:

[A]n investor who bought the Nifty Fifty at their seemingly ridiculous highs in December 1972 and held them for 25 years did roughly as well as those who simply bought the S&P 500.

So if you have 25 years to wait, you can buy QXO, the Mag Seven, and whatever great businesses you like and could do at least as well as the S&P 500 Index.

Unfortunately, today's overvalued "must own" businesses might not dig you out of their egregious valuations like the Nifty Fifty did.

Today's market is egregiously expensive...

The cyclically adjusted price-to-earnings ("CAPE") ratio was 18.7 in December 1972. Today, it's 35.2. Stocks right now are nearly twice as expensive overall as they were at the peak of the Nifty Fifty madness.

In the short term, valuation is a lousy timing tool (which I've said many times). But in the long term, it's the force of gravity. I have to wonder how the Nifty Fifty would have performed over the subsequent decades if the CAPE ratio were at today's levels – and if interest rates hadn't peaked in 1980 and declined for decades.

Besides Cisco, Bloomberg data indicates that 21 U.S.-listed stocks with market caps of $5 billion or more still trade below their March 2000 levels today. This list includes names like Fannie Mae (FNMA), Intel (INTC), Cisco competitor Juniper Networks (JNPR), and Sirius XM (SIRI). At one point or another, all these stocks were considered "no-brainers" that would produce incredible returns for years to come.

Now, I love a good stock market mania as much as the next person...

I love to see my portfolio shooting straight up most days.

However, I also assess the risks of my investment opportunities. I can't just get excited and satisfy myself with what everyone else is doing. I have to think about the downside potential too.

And I have the "archaic" notion that if you pay too much for a future stream of cash flow, even if it outgrows your expectations, you can still lose money owning it. The Nifty Fifty and the dot-com era show that it happens.

So when I see the whole world engaging in record levels of persistent bullishness, I get worried.

But I've been bearish and wrong for a while now... so no worries, right?

New 52-week highs (as of 7/25/24): AbbVie (ABBV), Danaher (DHR), iShares U.S. Aerospace & Defense Fund (ITA), Coca-Cola (KO), Lockheed Martin (LMT), Grand Canyon Education (LOPE), Lonza (LZAGY), Altria (MO), and Tyler Technologies (TYL).

In today's mailbag, feedback on yesterday's edition, which in part highlighted a prediction our founder Porter Stansberry made about Kamala Harris many years ago... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"The July 25 Digest article [section] 'Something Doesn't Add Up' forces me once again to dig out Porter's booklet The End of America published in 2011. Oftentimes I purge some files and throw away piles of trash that I once thought important enough to save hard copies of and I run across Porter's booklet.

"By today's standards, things written about in 2011 are from the age of the dinosaur and once or twice Porter's booklet was put in the trash only to be retrieved before it made its way to the outdoor recycle bin because it speaks the truth to me each time I thumb through it. At the heart of Porter's thesis is the power of the U.S. dollar (and the importance of currencies in each sovereign nation) and how America has squandered its position as a world leader..." – Subscriber Michael U.

"I remember Porter's comments way back about Kammy and wondered... could it be true?..." – Subscriber Lee Q.

"I seem to remember sometime around the last election that somebody in the Stansberry family made the comment that Biden might step down due to illness and Harris would move into the President's chair. Not exactly what happened but close." – Subscriber John W.

Good investing,

Dan Ferris
Eagle Point, Oregon
July 26, 2024