Valuation Matters – Nortel Networks Today Versus 5 Years Ago

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The rise and fall of Nortel Networks (NT) is a classic story of why valuation matters. Just five years ago, Nortel had 95,000 employees. Today, the company has about 35,000 with plans to cut another 1,100. During the tech boom, its stock price became grossly overvalued based on every analytical measure. The madness of the crowd ignored logic and let greed take over. In the short run the market is a voting machine; in the long run it is a weighing machine. The stock price of Nortel has plummeted over 97% since its bubble peak. Valuation matters.

The rise and fall of Nortel Networks (NT) is a classic story of why valuation matters. Just five years ago, Nortel had 95,000 employees. Today, this technology company has about 35,000 with plans to cut another 1,100. During the tech boom, its stock price became grossly overvalued based on every analytical measure. In fact, it had negative earnings –which made calculating the Price Earnings ratio impossible. The madness of the crowd ignored logic and let greed take over.

Circa the turn of the millennium, the crowd was saying that the market could only go higher—and analytical measures like Price/Earnings (P/E) ratios were antiquated tools that do not apply to the new economy. The P/E ratio allows an investor to know how much they are paying for earnings – generally lower means cheaper. The S&P 500 peaked in March 2000 with a whopping P/E of 42 – an earnings yield of just 2.4%. The tech laden NASDAQ’s P/E ratio was even higher. Eventually, the stock market crashed and valuation levels returned to historical averages.

Many investors lost the majority of their retirement savings—forgetting a golden rule of investing: buy low and sell high. One friend of ours “invested” her life’s savings in Nortel. Nortel Networks soared to over $80 USD during the boom. Today it trades around $2 USD – a whopping 97% decline in price! Our friend lost all her savings and was forced to move home with her parents.

A smart investor knows that market timing is a key success factor to building and maintaining wealth. Investor genius Warren Buffett made billions by buying the right companies at the right time - when "value screamed"! He wisely avoided the recent 'tech bubble' and kept his fortune in tact. The legendary value investor Benjamin Graham said it the best, "In the short run the market is a voting machine; in the long run it is a weighing machine."

From a valuation perspective, the Price Earnings ratio of the S&P 500 is currently close to its long-run historical average of 16. In our opinion, now is a rational time to buy value stocks with a margin of safety. Recently, guru Warren Buffett has been buying equities such as Lexmark International (LXK), United Parcel Services (UPS), General Electric (GE), and ConocoPhillips (COP) —a validation of our analysis that the S&P 500 is now rationally priced.

The Nortel Networks story contains a few important lessons. Don’t follow the crowd and let greed cloud your judgment. Only buy stocks that can be rationally valued – because valuation matters.

Disclosure: The Contrarian Investing Association currently advises its members to study Lexmark International.

About Contrarian Investing Association:

The Contrarian Investing Association looks for companies that are undervalued by the market for the wrong reasons, believing that the market will come to appreciate their true value over time. Our investing approach can be described as Contrarian, since such stocks are purchased when most investors believe that they are unattractive.

The Association has over 10,000 members across Canada, United States, United Kingdom and Japan.

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Mark Schlotzhauer, President