How to Spot (and Avoid) an Investment Bubble

Doc's note: If you've invested long enough, you've seen your fair share of bubbles – like the housing bubble before the 2008 financial crisis. But not all bubbles are that big, and there are ways to avoid them.

In today's issue, Whitney Tilson explains how to spot a bubble and keep it from ruining your portfolio...

I'll never forget what I saw at the annual Consumer Electronics Show ("CES") in Las Vegas back in January 2014...

It was the first CES conference I had ever been to, and it was during the peak of the 3D-printing bubble.

Back in 2013, investors couldn't get enough of the early movers in the space. At the time, I was already short all five publicly traded stocks in the sector, the largest of which were (and still are) 3D Systems (DDD) and Stratasys (SSYS).

I had come into CES extremely skeptical, having recently spoken to a friend who had met with 3D Systems then-CEO Avi Reichental, who told him during a one-on-one meeting that 3D Systems "is 50% technology, 20% innovation, and 30% awesomeness."

I knew the company's fundamentals were deteriorating and it had lowered guidance in its most recent earnings report. But that hadn't deterred the bulls... The stock had continued to march upward and was trading near its all-time highs, at more than 17 times revenues and 63 times forward earnings.

At CES, I gained even more conviction for my short thesis when I saw many Chinese competitors all selling knockoff printers at a fraction of the price. Plus, 3D Systems had just announced that it had named music artist as its chief creative officer.

It was an obvious gimmick and an even more obvious bubble...

So when I got home, I doubled down on my bet and made my views public. Here's what I wrote to my readers (which was published on ValueWalk)...

Think about the implications of this. I used to think that it's mathematically impossible for a company with a $10 billion market cap and more than 10 times sales (much less 21 times) to ever be a good investment, but a few companies have proven me wrong. They all have three characteristics:

1. They serve rapidly growing global markets,

2. They have winner-take-all (or at least most) business models, and

3. They have extremely "light" business models – meaning they can scale globally with very little capital required.

The stocks of such companies can actually be undervalued – even with big market caps and price-to-sales multiples.

Examples of stocks that have done well even after they were trading above 10 times trailing 12-month sales and had market caps in excess of $10 billion include:

  • Microsoft (MSFT) in the late 1990s
  • Biotech giants Amgen (AMGN) and Biogen (BIIB) prior to 2003
  • Adobe (ADBE) in 2000
  • Alphabet (GOOGL) in the few years after going public
  • Qualcomm (QCOM) from 2001 to 2006
  • Salesforce (CRM) at various points
  • Meta Platforms (META) for its entire existence

Every one of these falls into one of two categories: companies that don't deliver a physical product (the lightest business models imaginable), or companies with intellectual property (i.e., patented drugs) that allows them to earn supersized profits (70% to 90% gross margins and 20% to 30% net margins).

Applying this framework to 3D Systems, I'll admit that 3D printing was a rapidly growing global market.

But the company utterly failed in the other two characteristics... For one, it was in a highly competitive market with no winner-take-all characteristics. And its business model wasn't particularly light... certainly not as light as the tech companies I cited above.

At the time, 3D Systems' gross margins were hovering around 50% and net margins were falling like a rock. As I summed up in my article:

Mark my words: this will end very badly. I think DDD is maybe worth 2x revenues, so my price target is around $10 – down nearly 90% from here.

It didn't take long before I was proven right. By January 2016 – just two years later – the stock hit a low of $6.42 per share, down 93% from when I published my essay.

Anecdotally, when I visited CES in January 2020, I noticed that there wasn't a single publicly traded 3D-printing company there. This is what the aftermath of a burst bubble looks like.

The lessons here are timeless: Don't get sucked into bubbles, high growth in the absence of profits isn't worth much, and valuation matters.

Until recently, investors were focused on "exciting" new technologies like cryptos, flying taxis, fintech, artificial intelligence, space exploration, and more...

But the truth is, the businesses in many of these sectors are years away from being profitable.

Remember: Lots of emerging companies have revenue – but very few have profits.

If you want to find stocks that will become "the next Apple (AAPL)" for their respective sectors, you must distinguish between the two. If you're successful, the rewards can be massive.

For example, Meta Platforms and Alphabet scaled massively in extremely short time frames and delivered outsized returns because they were booking real profits that few investors and analysts predicted would grow so fast.

Today, there are many little-known companies with this kind of potential that haven't received nearly the same hype as 3D-printing stocks did almost a decade ago.

Better yet, this year's market turmoil has caused their stocks to become wildly decoupled from their true value – the proverbial babies thrown out with the bathwater – which is giving investors a chance to buy at prices that only come along once every decade or two.

That's why I recently sat down on camera with Louis Navellier...

Louis is an investing legend who has recommended 18 different stocks that went on to return 10,000% or more.

If you want the chance to see life-changing gains – like the 29,800% gain on Tractor Supply (TSCO), which I recommended during the dot-com crash – then you need to be greedy when others are fearful, to borrow the famous line from Warren Buffett.

Click here for the full details, including the name and ticker symbol of a stock Louis and I think is a no-brainer at today's levels.

Best regards,

Whitney Tilson
August 8, 2022