Einstein’s definition of insanity

October 7, 2021

During the late 1950s, Gerald Tsai pioneered the strategy of momentum investing. He started the first publicly traded aggressive growth fund while working at Fidelity Management. The fund grew from $12.3 million in 1959 to $340 million in 1965. The term “go-go” was frequently used to describe this aggressive way of investing.

The 50s and 60s were golden years for the United States (US) economy and the stock market. During this time, we saw the rise of the professional fund manager, with the mutual fund industry managing $38.5 billion in assets and representing a quarter of all transactions on the stock market.[1] They had no idea they were creating a bubble, which would eventually burst. Since then, we have seen this pattern play out countless times, and yet, momentum investing never died out. In fact, it is back with a vengeance and will inevitably end in tears.

The Nifty Fifty

Momentum investing really took off when market commentators identified fifty stocks, which soon became the darlings of Wall Street. These companies shared strong traits, like high-quality franchises, good balance sheets, and strong topline growth. As these companies delivered higher returns, investors rewarded them with ever-increasing multiples.

Most professional investors started their careers on Wall Street in the 60s, so at this point, they had only seen the market go up.[2] They had just one rule when it came to the Nifty Fifty stocks – and the rule was buy!

Back then, valuations did not matter. Investors believed growth would continue forever. At the peak of the Nifty Fifty bubble, companies like McDonald’s, Disney, and Baxter were trading over 71 times price/earnings. Even Johnson and Johnson was trading at 57.1 times price/earnings.

The markets were so frothy that even legendary investor Warren Buffet closed his investment partnership on May 29, 1969. In the late 60s, Buffett noted in his letters that the number of attractive investment opportunities was rapidly diminishing. As a result, investors were piling onto the “winners”, regardless of price.

When the bears woke up in 1973, the Nifty Fifty stocks initially held up when compared to the rest of the market. However, it was just a matter of time before they saw severe selling pressure. As one columnist at Forbes Magazine put it, “the Nifty Fifty were taken out and shot one by one”.

The arrival of the Four Horsemen

Fast forward to the late 90s when the “information super highway” sprang forth from cyberspace, and the only companies that mattered, had something to do with the internet. Back then, Microsoft, Intel, Cisco, and Dell were referred to as the “Four Horsemen” given their total dominance in the tech world. There were times when these four represented 55-60% of the Nasdaq price movement. Not surprisingly, investors were attracted to tech due to the general adoption of the internet and sweeping investments in technology and telecom infrastructure.

The four were later joined by companies like Oracle, EMC, Sun Microsystems, AOL, eBay, and Yahoo. Eventually, the tech bubble burst, giving us yet another example of why momentum investing comes with a lot of risk.

The evolution of FAANGM

The tech bubble may have burst, but our obsession with tech giants lives on. Over the last few years, a new cohort of companies caught the eyes of momentum investors. Originally, they were called FANG stocks (Facebook, Amazon, Netflix and Alphabet). Eventually, the group evolved into FAANG (Adding Apple) and later FAANGM (adding Microsoft). These stocks are long recognized as powerful market movers. But how long will these giants rule?

Some similarities from the Nifty Fifty years

Just like in the 60s, investors and professional fund managers who joined Wall Street after the financial crisis of 2008 have only seen the market go up. While there has been some volatility from events like Brexit and the pandemic, the market has been consistently strong. The new breed of investor has only seen interest rates drop and governments eager to bail out the economy by printing money. In this environment, the only rule is to buy, buy, buy.

Robin Hood Army and WFH boredom

There is growing evidence that working from home (WFH) boredom has been driving many unsophisticated or non-professional investors to start playing the market. Historically, retail investors have not played a major role in the movement of individual stocks. However, according to research from Pipe Sandler, this has changed. Since COVID-19’s impact, we are seeing a high correlation between retail user accounts and stock price fluctuations.

The retail-investing approach unfortunately seems too simple: buy regardless of fundamentals or valuations.

Out-of-control valuations

The combined market cap of FAANGM is over $9 trillion dollars, which is greater than the MSCI World Small Cap Index, which has 4,432 constituents. The entire US stock market is worth $51 trillion dollars, meaning FAANGM stocks represent almost 18% of the market.

While it’s true these businesses are growing fast and their margins are better, a lot of the margins for companies like Google, Amazon, and Microsoft are from cloud computing, which over the long run is a commodity product and whose price has been falling. As a comparison, back in the 60s, Coke and McDonald’s were delivering hyper growth and attracting legions of investors who thought the party would never end. But eventually, the law of large numbers kicked in. That level of growth is unsustainable.

The mounting risk

Regulatory – There are numerous anti-trust lawsuits against FAANGM across the world. South Korea became the first country in the world to ban Google and Apple from requiring users to pay for apps with their own in-app purchasing systems. Facebook is fighting the Federal Trade Commission’s antitrust lawsuit while also facing a backlash from the whistleblower hearings.

Inflation and Interest rates – Looking back to the Nifty Fifty, interest rates were a lot higher, and globalization and automation were providing deflationary pressure. At the moment, interest rates are almost as low as they can get, unless we are going negative. Enormous liquidity released by the various central banks worldwide are giving rise to inflationary pressure.

Meanwhile, the debate over what is transitory and what is not continues. A higher interest rate will reduce the valuation for growth stocks. An inflationary environment will eat into the earnings power, which will lead to a lower multiple.

Portfolio impact

We do not participate in momentum investing. Our portfolio has much faster growth than the index, and is currently trading at a discount to our index. Our companies continue to deliver strong topline and bottom-line growth in their latest reported earnings. Our portfolio holdings have a strong balance sheet and a third of our companies have no debt. As money begins to move out of the various highflyers, we believe our names are ideally positioned to benefit from the reallocation.


[2] The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s, By John Brooks

Global Alpha Capital Management Ltd.
October 7th, 2021