Value Library

The Nortel Factor: An Historical Precedent

With the recent price collapse of Nortel many investors remain in a profound stupor. The shock of Nortel's precipitous decline form a year 2000 high of $124 ½ to the present $20 price has still not produced the expected reality check to Nortel holders.

Surprisingly there are still a number of investors who cling to the belief that Nortel will claw its way back up to previous levels. They remain complacent and hopeful. Technology, they say, is the wave of the future and Nortel remains the new technology icon for the 21st century. This may be so. But let's face it: Nortel at its 2000 high of $124 ½ carried a PE ratio of 125 times and a book value of over 11 times. This, no matter which way you cut it, was an extraordinarily rich valuation. Furthermore, Nortel at these multiples left little room for any error or unexpected disappointment.

Nortel's price risk at $124 ½ was incredibly precarious and it was only a matter of time until its price adjusted downward in the event of any sniff of financial disappointment. This point of view, however, was a minority opinion and so any price weakness was considered temporary. New waves of buying quickly absorbed any investor selling. To make a very long story short the eventual financial disappointments did, in fact, occur. The unraveling of Nortel started to appear in the autumn of 2000 and subsequently mushroomed and grew in crescendo.

The resultant financial fallout of the Nortel price decline not only affected the TSE 300 index, which Nortel, at one point, made up 35 % of its weight, but also, the whole high technology/ bio technology growth sector. Nortel's decline was a lightning rod price depreciation catalyst to both growth and index investors. The end result of this huge wealth destruction has been all-pervasive. Many investors are still in the state of shock. Many are left struggling to understand how this all could have happened since very few investment analysts had forecasted this event. Yet the Nortel downfall is not without historical precedent throughout hundreds of years of financial history. In consequence I would like to relate a 1970's financial event that had a lot of parallels to the Nortel story.

Recently, I reread with great interest " The Tao Jones Averages by Bennett W. Goodspeed, a terrific down to earth investment interpretation written in the early 1980's. In the book Goodspeed described the early 1970's disaster of the " nifty fifty stocks " which, at that time, were the equivalent to the year 2000 Nortel situation. Not surprisingly there were many similarities to Nortel which serves to exemplify how cyclical and mistake-prone our investment industry is. The descriptions highlight the fact that investors seem to make the same investment mistakes over and over again. Investors generally neglect to review financial history, and as a result, they tend to suffer through the same cyclical consequences that their fathers or grandfathers had learned earlier.

As Bennett Goodspeed relates:

"Billions of dollars were lost in 1974 when the "nifty fifty" collapsed. The "nifty fifty" were a group of stocks that had accumulated impressive records of sustained earnings growth. These companies, as a result of their past achievements, satisfied the investment criteria of almost all-major institutions. Such "one decision" stocks could be purchased at any price, (and they certainly all had high P/E ratios) and sooner or later the company's growth factors would make you look good. Such strategy worked well for a while, and certain institutions smiled smugly each night as they slipped into a deep secure sleep. But they were blithely ignoring the fact that no sizable company could sustain fast enough growth rates to justify such ratios. In doing so these institutions proved once again the maxim that Burton Malkiel , in his book, A Random Walk down Wall Street, refers to: "Stupidity well packaged can sound like wisdom." In his book, Malkiel developed the following table to depict the final outcome of the nifty fifty loser's game."

Needless to say there are many interesting conclusions and parallels to the mid 1970’s decline of the "nifty fifty" stocks in relation to the 1999-2001 Nortel experience. While I will not delve into all the similarities I do sense that Nortel will settle into the same new valuation parameters (i.e. PE, book Value, etc.) which these six nifty fifty stocks gravitated to by 1980. Moreover the cyclical downfall of the extremely expensive 1999-2001 growth stocks and their subsequent recovery will be put to the investment back burner for at least a year or two. I believe that growth stock investing won’t reappear until growth investors recover from their recent distasteful experience.

In the meantime we expect the switch from growth, momentum and index investing back toward value, fundamental analysis and hard core research to continue. Once again the cyclicality of investment management trends has manifested itself. The ultimate challenge to us in the future, I believe, will be to pay extreme attention, as new investment trends begin to develop.

Irwin Michael, CFA