AI is Bubbly…But It’s a Buy?

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The foolishness of Sun Microsystems investors … it’s way worse today … the mindset shift needed to ride the AI boom … Luke Lango’s trading approach to the markets

 

Are you feeling AI-based FOMO (fear of missing out)?If so, you’d be well-served to remember your market history.Let’s rewind the clock to the Dot Com bubble.Older investors will remember Sun Microsystems. It was a tech stock darling that was creating overnight riches for investors in the late 1990s.From 1996 through its high in 2000, the stock rose from about $5 to $64 for gains of well-over 1,000%.Of course, when the bubble burst, so too did Sun Microsystem’s stock.By 2006, Sun had round-tripped, falling back to $5, meaning it had lost all its gains.

Chart showing the price of Sun Microsystems back in the runup to the Dot Com burst, then crashing afterward

Investors who bought Sun in its run-up in the late 90s and held onto their stock found themselves sitting on staggering losses they never recouped.Now, there’s nothing inherently new about this story. You’ve heard these “rags-to-riches-to-rags” tales plenty of times.

But what makes Sun’s story unique is the analysis from its own CEO in the wake of the stock price meltdown

And as you’ll see in a moment, his analysis is incredibly important as we analyze this current market environment.In 2002, Scott McNealy, the CEO of Sun Microsystems, looked back at the jaw-dropping climb of his company’s stock and had the following to say to investors who bought near the top and found themselves destroyed when the bubble burst:

Two years ago, we were selling at 10 times revenues when we were at $64.At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends.That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company.That assumes zero expenses, which is really hard with 39,000 employees.That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal.And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate.Now, having done that, would any of you like to buy my stock at $64?Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes.What were you thinking?

Well, investors weren’t thinking.They were wrapped up in the excitement of the transformative power of the internet… they were watching explosive gains in internet stocks… and they wanted to get rich.

You might know where I’m going with this, but you’re still about to be floored

In the same way that many investors weren’t thinking during the Dot Com bubble in 2000, they’re not thinking today either.They’re wrapped up in the excitement of the transformative power of Artificial Intelligence… they’re watching explosive gains in AI stocks… and they want to get rich.Of course, the eventual peak of the AI stock boom could be miles above where we are today…or perhaps not.Consider this…McNealy does a great job of pointing out the absurdity of buying Sun at 10X its revenues and expecting to be handsomely rewarded.Well, with that as our context, take a guess at the price tag of Nvidia, which is arguably the poster child for AI stocks today.Ready?You’re not paying 10X-sales…You’re paying 39.5X-sales.

Chart showing Nvidia's price to sales ratio at an eyewatering 39.49
Source: YCharts.com

Let’s borrow McNealy’s analysis of Sun and tweak it slightly for Nvidia.Imagine yourself seated before your computer, logged into your brokerage account. You’re considering buying Nvidia’s stock at today’s price. Behind you stands Nvidia’s CEO Jensen Huang saying…

At 40 times revenues, to give you a 40-year payback, I have to pay you 100% of revenues for 40 straight years in dividends.That assumes I have zero cost of goods sold… That assumes zero expenses… That assumes I pay no taxes… And that assumes with zero R&D for the next 40 years, I can maintain the current revenue run rate.Now, having said that, do you really want to buy my stock at 40X-revenues?Do you realize how ridiculous those basic assumptions are?What are you thinking?

Despite this absurdity, this is not a bearish Digest on AI stocks

Yes, Nvidia’s valuation is eyewatering. And yes, I’m nervous for a buy-and-hold investor who’s buying Nvidia for the first time today at these prices.But where does it say you must be a buy-and-hold investor?Our CEO, Brian Hunt, has a favorite saying: “Better learn how to trade.”A few examples…When the conversation turns to how stratospheric federal debt levels, debasement of the U.S. dollar, and long-term inflation will hurt some sectors while helping others…Better learn how to trade.When the conversation bleeds into how the biotech sector has been exploding in recent months, yet there’s no guarantee how long the gains will last…Better learn how to trade.And yes, when the conversation centers on a hot market trend that – despite nosebleed valuations – is still creating wealth for investors, but no one can say for how long…Better learn how to trade.

Buying a stock such as Nvidia at a stratospheric price today becomes less scary when your perspective changes

Rather than view it as a buy-and-hold, set-in-stone addition to your portfolio, what if it was merely a tool?What if it was just a means to generate wealth for as long as it served that purpose, and when it no longer was effective, you traded it in for a new tool?That’s the general idea behind trading.We can take this one step further by looking at Luke Lango’s trading approach in Breakout Trader.While traditional valuation metrics like the price-to-sales ratio might be important, even critical, for Luke in his various buy-and-hold investment services, in Breakout Trader , they’re irrelevant.Instead, there’s one preeminent variable that rises above all others…Price strength.From Luke:

Let’s say you found a truly atrocious company – we’re talking the opposite of a blue chip. It’s hemorrhaging cash, has awful management, and is in a dying industry.But what if its stock price had just broken out and, hypothetically, was on its way to doubling from $5 to $10? Would any of those negative characteristics matter to you?If what you care about is your personal wealth, they shouldn’t. Why would they?All that would matter is that the stock is doubling while you’re invested.This brings us to the core principle of our Breakout Trader system…When it comes to wealth-building, the only thing that truly matters is whether the share price moves in the direction you want during the period you own the stock.

When you’re a trader, it makes investing rather simple – the one and only thing that matters is “is the stock price going in the right direction?”Think about all the other questions that no longer matter…“It the stock too expensive?” … “Can the company defend itself from low-cost competitors in the quarters to come?” … “Is the business burning too much cash?” … “Will new legislation next year hurt the company’s profits?”If the stock price is climbing, the answers to those questions are irrelevant – you’re making money regardless.

Coming full circle to AI stocks and Nvidia

Two things can be true at once…One, history suggests that investors who buy Nvidia at nearly 40X-revenues will lose money in the years to come.Two, a study of stock market bubbles and investor FOMO suggests that investors who buy Nvidia at nearly 40X-revenues could make double-digit returns in the weeks to come.The way to resolve this tension is by approaching Nvidia (or any inflated-valuation stock) as a trader, not a buy-and-hold investor.You simply ride momentum as far as it takes you, then hop off when it runs out of steam (to be clear, the “hopping off” part is critical).Here’s how Luke describes his trading mindset:

Our Breakout Trader system is simple…We wait until a stock is signaling the beginning of a new bullish trend, as evidenced by a strong price breakout. We ride that momentum as long as possible. Then, we lock in profits when the uptrend appears to have run its course.To be clear, we aren’t value investors. We’re not searching for overlooked gems that will soar “one day.” We’re not even especially patient for that matter.What we are is simple…We’re returns-focused traders who view stocks merely as wealth-generating tools.As soon as one loses its value to us, we move on to another.

Bottom line: Today, tech stocks – primarily AI stocks – are the most powerful wealth-generating tools in the market. Let’s use them for that purpose.However…History tells us that valuation matters…eventually. So, holding onto a nosebleed-valuation stock for too long is a very effective way to lose money.But for now, the AI party is raging. So, as Brian likes to say…Better learn how to trade.Have a good evening,Jeff Remsburg

 


Article printed from InvestorPlace Media, https://investorplace.com/2023/05/ai-is-bubblybut-its-a-buy/.

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