Nortel Networks: Why Valuation Matters

The rise and fall of Nortel Networks (NT) is a classic story of why valuation matters. On December 1st 2006, management consolidated the shares at a 10:1 ratio in order to increase its share price from the $2 range – resulting in a new stock price of about $20. During the tech boom, Nortel Networks soared to over $800 USD. Today it trades around $20 USD – a whopping 97% decline in price!

Sure - It's Different This Time

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 - exalting “it’s different this time.”

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 whooping 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 a big chunk 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. With a whopping 97% decline in price, our friend lost all her savings and was forced to move home with her parents.

Vital Few and Trivial Many

When Nortel traded a bubble prices, the Trivial Many ( e.g. the herd which include Wall Street analysts, journalists, and lemming-like investors) were all on the Nortel bandwagon (much like the Google frenzy today).

What were the Vital Few doing? Warren Buffett 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." Investor genius Warren Buffett made billions by buying the right companies at the right time - when "value screamed.”

Nortel Today

Today, Nortel is a shadow of its former self with just 30,000 employees – down from 95,000 employees just six years ago. Also, its customer base has consolidated with many recent telecom mergers – giving Nortel almost no pricing power during negotiations in an almost commodity type business.

Is Nortel a good value today? A good source of information is GuruFocus, a site which tracks the holdings of 32 investment gurus like Warren Buffett and David Dreman. Currently only two gurus - Charles Brandes and George Soros - hold Nortel. From our perspective, we are staying clear of Nortel as we feel it does not have an adequate margin of safety and no economic moat ( i.e. sustainable competitive advantage).

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 and “scream value” – because valuation matters.

NT 1-yr chart

Disclosure: Author has no position in NT.