While the S&P 500 reaches new highs, I’ve taken the opportunity to reread Margin of Safety by Seth Klarman. While rereading, I rediscovered the story of trading sardines. The old story goes that after sardines disappeared from traditional waters in California, commodity traders sent the price of the sardines skyrocketing. One day, a buyer of these sardines decided to indulge, so he opened up and ate a can of them. After doing so, however, he became immediately ill. The man consequently returned to the seller to complain, and was told that the sardines he had consumed were not “eating sardines”, but rather “trading sardines.”

This story goes to show how in the short-term, investors may ignore logic and bid up securities without regard for their intrinsic value; the spoiled sardines in the story should have had no value, yet were bid up anyway. In a similar way, we may now be observing software companies turning into “trading sardines”.

Buying software companies and getting the instant gratification of stock price appreciation in the form of multiple expansion has sent software revenue multiples close to 2000 levels. Short-term investors tend to not weigh the risks of either multiple contraction nor performance not living up to expectations. Similarly, these investors in high revenue multiple software companies continue to add to the flywheel of continual multiple expansion by attracting more capital (which they are able to achieve given that their multiple expansion-reliant strategy has worked well in the last 5 years). Only time and patience will reconcile trading values to intrinsic values.

– Andrew Leaf, Analyst

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