Below is an excerpt from the beginning of chapter 14 from John Neff's book. He wrote this chapter in July 1999, four years after he retired from from the Vanguard Windsor Fund. He wrote this in the backdrop where the Nasdaq 100 would go on to gain 100% in the year. The TLDR is that market might be crazy but we still have to invest rationally. And he put his faith in his low P/E strategy. And he risked his reputation by stating where he found great ideas to invest in, in July 1999.
**Chapter 14: Deja Vu**
It would be nice to be able to invest yesterday, but investors don't have that option. You can spend your time regretting that you didn't buy Cisco before a tenfold rise, or you can organize for future performance. That's the nature of the daily investment challenge. You can't invest yesterday; you have to invest today. How do you rise to the occasion and still keep the odds in your favor? Stock tips don't fall within the purview of this book. But because the investment process is supposed to generate investment ideas, and also because today's market is more familiar to readers than past epochs, the market in June 1999 is a good backdrop for showcasing my low p/e principles within a framework of Measured Participation. I've stuck my neck out before. I'll do it again here, just to illustrate my way of surveying the investment horizon. Needless to say, I reserve the right to change my opinions as markets change.
At 28 times earnings and about a 1.1 percent yield, the current market is the most highly valued that I've ever experienced. It resembles two previous markets that exceeded 20 times earnings and eventually folded dramatically: in 1986-1987 and, before that in 1971-1973. High price earnings this time manifest an economy and a country that are doing unbelievably well versus the world. I readily concede that I'm a big fan of this economic boom, even though, after 100 months, it's double the duration of the longest average business expansion since World War II. The typical areas of excess-capital expenditures, inventories, and consumer debt-all look pretty good to me. Consumer debt has troubled some observers, but not me-so far. In this robust economic climate, consumers can afford to ratchet up debt levels a bit. And consumers have not been stupid; lately, according to government figures, they have moderated their appetite for debt even as lower mortgage rates have increased their disposable income. Less credit card solicitation has helped ease the overall growth in consumer debt. After distributing credit cards almost willy nilly, lenders became more cautious and took this prudent step. With no signs of excess visible in these areas, a recession seems unlikely; however, over the intermediate term, we always have to remain alert to other excesses that are not measured as acutely. The market itself suggests excess. The so-called "wealth effect" represents a question mark. It's not clear how much a high stock market prompts consumer spending, which lately has obliterated savings. With corporate America awash in cash flow from operations, savings are not needed to keep companies well oiled. But if a down or even a flat market were to influence consumers to cut spending, thereby choking cash flow, a ripple effect could gather force.
Here is how an economic assessment becomes an investment strategy. Average price-earnings ratios in the neighborhood of 28 times are justifiable only if the outlook for earnings is outstanding. But we seem to be in a part of the business cycle that favors moderate growth at best. Insofar as overall growth governs even demand for the spiffiest high-tech products and services, it seems foolish to predict that those areas will continue to expand at an exceptional pace. Along with improvements in productivity, we must weigh prospects for wage increases, which have been trending upward lately. Meantime, a hotly competitive environment across most sectors hampers price increases. All things considered, it's almost axiomatic that earnings are going to grow slowly. So, should we pay 28 times earnings for 3 to 4 percent growth? Red-hot NASDAQ stocks seem most exposed to reality checks, particularly because five stocks command almost 40 percent of the market capital of the NASDAQ 100 index. Four of these five stocks advanced more than 140 percent in 1998. This growth is quite unsustainable. Even if growth had been less than 140 percent, that's impressive, to be sure. My point is: They have enjoyed superlative growth for several straight years. Does the market believe they'll grow in excess of 30 percent for the next five years? I don't. And as we've already seen at Dell, sales growth is outpacing earnings growth, which suggests that profit margins are shrinking. If there is any classic lesson in the marketplace, it's that, at some point, reversion to the mean occurs.
Sooner or later, something happens and growth, particularly high-magnitude growth, is diminished. If these stocks are being hailed as 20 to 40 percent growers, any diminution of their growth rates will be dealt with quite severely in the marketplace. Besides those easy five, lots of others fall into the same fragile category. Still more egregious are the fledgling Internet stocks that are valued at ludicrous levels and constitute about 8 percent of the total market value of all U.S. stocks. Two factors will KO this segment. First, the Internet is not the exclusive province of Internet companies. The Fortune 1000 are going to be big on the Net, simply because the profit potential is so enormous. CEO Lou Gerstner of IBM reported, in May 1999, that nearly one-fourth of IBM's sales were Internet-related. He described all but two or three of the Internet swarm as fireflies darting about before the storm. Needless to say, his comments were aimed at promoting IBM stock, but they waved a caution flag at legions of Internet groupies. Moreover, any similarity to the Nifty Fifty ends with one very important distinction: Those companies had earnings. Exit strategies also will trip the Internet racers. The holders of Internet stocks who plan to get out as soon as possible are legion. They are venture capital firms, founders, and employees with tremendous paper fortunes. Even corporations have big stakes; expect them to cash them in when possible. Delta Airlines owns a stake in Priceline dot com worth about $2 billion.\*
Those proceeds represent a lot of airfares. All these people are near the cusp of cashing in, but the initial offerings are too recent. They have to hold on for a while, to satisfy underwriters. With so many investors poised to sell, who will be the new buyers? There are roving bands of Internet day traders, but, as day traders, they aren't likely to help sustain the stock price for more than 24 hours. Already, these stocks have begun to labor and lose momentum. Is the jig up already? Time will tell. Meantime, people who are sucked into day trading eerily suggest the investors of 1929. A dazed and confused public has been persuaded that investing is easy and that stock prices only go up.
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*The rest of the chapter goes on to describe in detail where he saw opportunities in the market in June 1999, because they were cheap: REITs, financial intermediaries, Home builders, airlines and energy markerters and refiners. Sounds familiar right ?*