Wednesday, March 10, 2021

With high flying stocks, most buy arguments are actually sell arguments

I've been meaning to write for a while. Now Jamie Powell of FT Alphaville has done most of the work for me.

In the annals of investing literature, there are a few lessons which stick out. But perhaps none more so than the adage that at the right price, every asset is potentially a good investment. Even subprime CDOs. The flip side of this axiom is, of course, that if you pay too much the experience can be a painful one.

At the turn of the new millennium, the IT hardware, software and networking equipment company was one of the hottest stocks in the US equity market. From the beginning of 1999 to March 2000 the shares rose 236 per cent to a market capitalisation of $555bn, or $80.06 per share, backed by a crazed-enthusiasm for the technological shifts bought about by the internet. The thesis was solid: as a provider of networking equipment for both telecom players and other businesses, Cisco was the shovel-seller in a dot com gold rush. What could go wrong?

And, some might argue, it had the numbers to back it up. In the 2000 financial year, Cisco posted revenue growth of 55 per cent, gross margins of 66 per cent and had a return-on-equity of 14 per cent. Sure, top-line growth had slowed from 1994 when revenue had doubled, but as one of the few players sitting at the intersection of several technological trends, it surely was going to be one of the big winners of the new millennium.

Well yes and no. In one way, investors were right. Cisco was a big winner. Over the next 21 years, Cisco’s revenues grew four fold to $49bn, with profits quintupling to $11bn. Return-on-equity even improved, with the figure averaging 17 per cent over the next two decades, 3 percentage points above its 2000 number.

The problem was the share price. It was, simply, too damn high. At the March 2000 peak, Cisco’s price-to-earnings ratio stood at 201 times, its enterprise value to sales at 31 times and its price-to-free cash flow at 176 times. By anyone’s standards, the valuation was over-egged.

And, suddenly, everyone cottoned on. Over the next two years, Cisco’s share price collapsed 80 per cent, a total market capitalisation loss of $431bn, as the dot com bubble deflated and telecom capital expenditure with it. Twenty-odd years later at pixel time, Cisco’s shares are at $46.25, still 42 per cent below their dot com peak.

Imagine a stock analyst in 2000 who sat down with Louis Rukeyser and laid out a scenario for Cisco that was completely prescient. The case would sound spectacularly bullish. The company really did have a long and profitable future ahead of it. In the context of Cisco's peak price, however, this would have been anything but a case for going all in. When a stock is flying that high, what would normally be a buy argument more often than not becomes a sell argument.

You probably expect me to talk about a certain car company now, but that's not the only example in 2021. It might not even be the most egregious one.

Alex Wilhelm writing for TechCrunch:

Using normal accounting rules, Uber lost $6.77 billion in 2020, an improvement from its 2019 loss of $8.51 billion. However, if you lean on Uber’s definition of adjusted EBITDA, its 2019 and 2020 losses fall to $2.73 billion and $2.53 billion, respectively.

And as Wilhelm notes later in the piece, it takes a hell of a lot of adjusting to get the loss down to two and a half billion.

Despite this, Uber has a market cap of over $100 billion. Its spokespeople and shills will argue that the company is about to become profitable but even if it does go into the real black (and not just the creative accounting black), no one is offering a convincing scenario where the stock is worth more than a fraction of its current price;
There are plenty of other examples where that came from.

A lot of investors, particularly retail investors, operate under the assumption that if you like a company and have faith in it, you should buy. They ignore Powell's basic lesson that any investment is a bad investment beyond a certain price and, as he points out, sooner or later someone is in for a painful experience.

1 comment:

  1. One calculation that I find helpful is looking at how much profit the company would need to make in order to justify the market cap. At $100 billion one rather assumes that a 2% profit would be a minimum (not necessarily 2% dividends but at least 2% net profit). Going from minus seven to plus two billion dollars is a large jump.

    Now you might see future potential for growth, beyond what is priced in, but there is also risk, including regulatory risk.

    Look at this, for example:

    Hard to see how this is a base from which future huge gains will be made, even should the company have a long and profitable future.