In his latest memo titled – On Bubble Watch, Howard Marks discusses how bubbles, while often grounded in a kernel of truth, lead to excessive valuations fueled by optimism, FOMO, and a belief that prices can’t fall.
He reflects on past bubbles, such as the late ’90s internet mania and the TMT bubble, where enthusiasm for “new” ideas like clicks and eyeballs led to unsustainable valuations.
Investors often overestimate potential, award excessive valuations, and adopt a “lottery ticket mentality.” Marks warns that speculative fervor, especially for new innovations, risks major corrections when reality sets in, emphasizing the importance of rationality, historical context, and pricing discipline in investment decisions.
Here’s an excerpt from the memo:
There’s usually a grain of truth that underlies every mania and bubble. It just gets taken too far. It’s clear that the internet absolutely did change the world – in fact, we can’t imagine a world without it. But the vast majority of internet and e-commerce companies that soared in the late ’90s bubble ended up worthless. When a bubble burst in my early investing days, The Wall Street Journal would run a box on the front page listing stocks that were down by 90%. In the aftermath of the TMT Bubble, they’d lost 99%.
When something is on the pedestal of popularity, the risk of a decline is high. When people assume – and price in – an expectation that things can only get better, the damage done by negative surprises is profound. When something is new, the competitors and disruptive technologies have yet to arrive. The merit may be there, but if it’s overestimated it can be overpriced, only to evaporate when reality sets in. In the real world, trees don’t grow to the sky.
The foregoing discussion centered on the risk of overestimating fundamental strength. But optimism surrounding the power and potential of the new thing often causes the error to be compounded through the assignment of too high a stock price.
- As mentioned above, for something new, there by definition is no historical indicator of what an appropriate valuation might be.
- Further, the companies’ potential hasn’t yet been turned into steady-state profits, meaning the thing that’s being valued is conjectural. In the TMT Bubble, the companies didn’t have earnings, so p/e ratios were out. And as startups, they often didn’t have revenues to value. As a result, new metrics were invented, and trusting investors ended up paying a multiple of “clicks” or “eyeballs,” regardless of whether these measurables could be turned into revenues and profits.
Since bubble participants can’t imagine there being any downside, they tend to award valuations that assume success.
In fact, it’s not infrequent for investors to treat all contenders in a new field as likely to succeed, whereas in reality only a few may thrive, or perhaps even survive.
Ultimately, with a really hot new thing, investors can adopt what I call “a lottery ticket mentality.” If a successful startup in a hot field can return 200x, it’s mathematically worth investing in even if it’s only 1% likely to succeed. And what doesn’t have a 1% likelihood of success? When investors think this way, there are few limits on what they’ll support or the prices they’ll pay.
Obviously, investors can get caught up in the race to buy the new, new thing. That’s where the bubble comes in.
You can find the entire memo here:
Howard Marks Memo – On Bubble Watch
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