Every era has them … the cult investments. Securities that everyone owns, that surge ever higher, have great narratives, backed by companies with fast and unlimited growth prospects. The 1970s had Nifty Fifty “one-decision” stocks, the 1990s had dot-coms, the 2010s had digital economy stocks. And, every era has epic collapses (which the following value metrics can help you avoid) that wipe out most of the value of the cult securities. LTV, Pets.com, Worldcom, Wayfair, cryptocurrencies and hundreds (thousands?) of others just like them.
Rising interest rates often catalyze the collapse, but what consistently wipes out these investments are crumbling earnings. Why? Usually, the hyper growth of a niche product or service trend reaches its limit and then reverses, leaving companies with slumping revenues and bloated expenses. Maybe new competition draws away customers, or pressures prices, or raises costs by creating an arms race. Sometimes a commodity cycle succumbs to the inevitable reversal. In the current cycle, many companies attained hyper growth because they sold their goods below cost, but eventually, they ran out of capital, the subsidies stopped and customers vanished.
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Lather. Rinse. Repeat. How can investors avoid getting cleaned out? Here are my top two value metrics:
Value Metrics Rule #1: Understand the fundamentals.
Learn how the company actually generates revenues. Look deeper than the trendy buzzwords on the company’s website, which are designed primarily as a sales tool to impress potential customers and to promote the company’s “mission.” While it takes a bit of digging, read the company’s annual 10-K statement – these include dull but valuable descriptions of the exact sources of revenues. Many cult stocks of the current era rely on advertising and subscriber/user fees, which requires retaining and attracting ever-growing numbers of fickle advertisers and customers.
Think about whether the product or service is profitable. This can be as simple as wondering if you would use their “free” product if you instead had to pay for it. Does the old business school joke apply: we lose a little on every sale but we make it up in volume? While industrial companies readily cut unprofitable product lines, many hyper-growth companies have only a single product that can’t be culled regardless of its profitability (or lack thereof). Also, consider whether the company can generate a profit after it pays for overhead costs like its sales force, research and development and its managers.
Review the company’s sales and earnings history. For example, Wayfair (W) has had unimpressive sales growth outside of the pandemic era and has never in its 20-year history produced a profit other than in pandemic-driven 2020. How likely is it to ever produce a profit in the future?
As a measure of Wall Street analysts’ exuberance, Wayfair was once projected to generate $22 billion of revenues and $1.6 billion in profits in 2023. However, due to aggressive competition, slowing demand and weak management, the company is now estimated to produce only $12 billion in revenues, and the expected bounty of profits has vaporized into a projected $87 million loss.
Compare this to clearly non-cult companies like Allison Transmission (ALSN), which rely on sales of tangible and hard-to-replicate, heavy-vehicle gearboxes with enduring and profitable demand that is likely to continue for decades. Revenue and profit estimates for 2023 have remained steady despite recession worries.
Value Metrics Rule #2: Pay attention to valuations.
If a stock is trading at more than 25x estimated year-ahead earnings, investors expect earnings to grow strongly well into the future. Cult stocks often trade at 50x or even 100x earnings. To justify these valuations, earnings need to grow at hyper rates for years. It would be fascinating to find research that shows how many 100x-multiple companies actually achieved the earnings growth required to justify those valuations. The result is probably fewer than 1 in 100.
Many cult companies are projected to produce negative profits for years. With no earnings as a base, investors and analysts rely on price/sales multiples. But sales have no value until they are converted into profits, so using this valuation metric requires guesses about how profitable a company might eventually become. At the market’s peak, many stocks traded for 40x revenues – but even if the company was generating a 25% profit margin right now, it would still trade at 160x earnings. Most likely, such a company could perhaps produce a 10% margin in five years, meaning investors were paying 400x estimated 2027 earnings. Investments in these stocks can border on pure speculation.
Using Allison Transmission again, its shares trade at a modest 7.3x estimated 2023 earnings. Its price/sales ratio: a humble 2.2x.
At the Cabot Undervalued Stocks Advisory and the Cabot Turnaround Letter, we help investors navigate the equity markets using a common-sense value-oriented approach that emphasizes out-of-favor stocks of companies with real value. Let us help you sort through the market to find them.
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