I've been on hiatus from writing articles, and I'll admit that the reasoning is a little embarrassing. Despite claiming to be a big fan of Warren Buffett, I'd never read Benjamin Graham's book, The Intelligent Investor. Several months ago I made the $12.81 investment. While I'm not yet finished with it, I was amazed to find that some of the easiest pitfalls to avoid (highlighted in the first chapter no less!) are being reiterated right now, despite decades of examples.
Before venturing into the specifics, I'll be making an assumption, which the reader must go along with in order to find meaning in this article; Benjamin Graham was a better investor than you and what he says is correct.
This shouldn't be too much of a stretch, given his track record, along with that of his most well known protege, Warren Buffett. If you can acknowledge that much, let me continue with some of his crazy ideas. According to Graham in The Intelligent Investor, one of the methods that the enterprising investor uses to get better than average results is through long-term selectivity:
Here the usual emphasis is on an excellent record of past growth, which is considered likely to continue in the future. In some cases also the "investor" may choose companies which have not yet shown impressive results, but are expected to establish a high earning power later. (Such companies belong frequently in some technological area - e.g., computers, drugs, electronics - and they often are developing new processes or products that are deemed to be especially promising.)
Several companies come to mind, as they should, since there is always new technology looking for investors. In the late 1990s, this list would have consisted of AOL (NYSE:AOL), Amazon (NASDAQ:AMZN), eBay (NASDAQ:EBAY), Cisco (NASDAQ:CSCO), etc. This is the better side of the Dot-Com Bubble. We can't forget Geocities (yes, they were publicly listed!), Pets.com, WorldCom, Freeinternet.com, etc. Just because a company has a good product however (or good industry, such as the then-new e-commerce), does not make it a good investment. And in the cases when it is a good company with good future prospects, an investor would be wise to listen to the warning of Benjamin Graham, "He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating." The message here is clear; do not buy stock in a company at value or overvalued, when it will only be profitable years from now.
This seems the opportune moment to mention Twitter (NYSE:TWTR), since it's the elephant in the article. With an IPO priced at $26 per share, it was given a valuation of $14.2 billion. Given the speculative nature of recent tech IPOs, it was unsurprising that by the end of the first trading day, it was priced at $44.90 per share, with a valuation of $21.22 billion. This for a company that has yet to generate an operating income! Yes, as the graph below indicates, that operating margin has been quickly closing in on positive.
Despite this, who's to say that when Twitter finally does generate an income, it'll justify the market value? Who's to say that the company won't be replaced by the "latest and greatest" just as it's turning profitable? Of course these are the risks that an investor faces with all new technology stocks. The foolish thing is inflating the price so much that not only does it need to become profitable to equal it's share price, it needs to grow profitability by leaps and bounds for several years following.
This is a digression. What I really want to focus on is the auto industry, and more specifically, this:
I have a decent size holding in Ford Motor Company (NYSE:F). In analyzing that holding, I put together a simple chart comparing operating margin over the industry. This isn't all inclusive, but it does show Ford in the middle of the pack, a little lower than I was hoping to see. Now there are a few liberties that I took:
- The Japanese automakers use a fiscal year spanning from March to March, versus December to December for their US and European counterparts however I didn't bother to correct the timeline to account for that.
- Three quarters of the current fiscal years' results are in but instead of estimating Q4 to give 2013 results, I left the year out entirely.
- The revenues that were used to calculate operating margin include total profitability, such as automotive and finance for Ford, and the additions of motorcycles and power generation for Honda (HMC).
- Any non-recurring costs which lowered the operating income were included, so that this might not paint the most accurate picture of how efficient each company is.
Perhaps I'll eventually get around to making a more representative operating margin plot. The reason I stopped at this point however, was because of the addition of one more automotive company:
This is the same chart, scaled for the addition of Tesla Motors (NASDAQ:TSLA). This and the following chart were generated using financial data from the close of business, November 8, 2013, and a share price of $137.95. Let me preface my discussion by stating that I think Tesla has lots of great potential. A lot more than Twitter, for sure. When the Tesla Model E becomes available, I would like to buy one (well maybe after a year when they've smoothed over the kinks). If I had the income to afford it and a garage not filled with power tools, I'd buy a Model S in a second. There are so many advantages of an electric vehicle over a gas vehicle, that it seems crazy to not want to own one.
On the other hand there are many risks (supply and reliability of lithium ion batteries comes to mind). I think that for the most part, the benefits outweigh the risks. I also think that most people agree with this sentiment, hence the high valuation. This is in fact the issue. Let me accompany that previous chart with a new one:
It's hard to put a worthy valuation on Tesla, since it's not yet profitable, but I'll just go with Goldman Sachs' analysis since they're the experts, and peg it at $104/share. Before this week, when the company commanded a share price in the $170 range, Goldman had a $95 price target. That would give the company a valuation of $11.53 billion. The chart above shows Tesla at the current valuation of $16.75 billion. As you can see, it's not nearly as obvious as the prior chart that Tesla is overvalued. It's easy to point the finger at hindsight for this week's drop, but the reality is that only looking at valuation can be tricky. You'd expect Tesla to be below the valuation of it closest competitors, and in fact it is.
To venture beyond hindsight, the price should continue to drop since the company is still quite overvalued. Going back to the lesson of Graham, the market price already reflected what was anticipated, back in May/June 2013. Buying shares for any price higher means having to wait more years for profitability to catch up, and with that, higher risk of competitors catching up. In the meantime, investing in Ford, Toyota (NYSE:TM), Volkswagen (OTCPK:VLKAF), Daimler (OTCPK:DDAIF) or any of the other gas vehicle competitors would not only net you growth at less risk, but you'd earn a dividend for your patience. Finally, the more years you have to wait for your investment to become profitable is more years for the competition to come up with an answer.
The real problem with Tesla then relates directly to the goal of your investment. If you buy at $170/share and plan on holding the stock for the long run so that the company can become profitable, you have to accept that you'll be holding till at least the year 2020 (as some have estimated). In doing so, you're incurring an opportunity cost through the price increase of any other stock (but specifically other automakers) and the associated dividends, which Tesla is many years away from offering. On the other hand, if you're not planning on buying Tesla for the long run, then you're speculating based on momentum. You'll face similar odds and faster results if you take a trip to Las Vegas.
Twitter may show signs of future profitability, but if you follow the path that Tesla investors followed, you'll face the same sudden drops as well. Let this be a lesson. As Benjamin Graham puts perfectly:
Even if one or two can be found that can pass severe tests of quality and value, it is probably bad policy to get mixed up in this sort of business. Of course the salesman will point to many such issues which have had good-sized market advances - including some that go up spectacularly the very day they are sold. But all this is part of the speculative atmosphere. It is easy money. For every dollar you make in this way you will be lucky if you end up by losing only two.
Tesla might be a good company. Twitter, too. But $16.75 and $21.22 billion valuations after 10 and 7 years since founding (2003 and 2006 respectively) and no profits to date? Don't be surprised to see your investments shrinking. As a final chart to put things in perspective, let me add Twitter to that valuation chart so you can compare an overvalued tech stock undergoing a large correction, with a brand new tech stock, fresh off of an IPO.
Thanks for taking the time to read my article. If you haven't realized it by now, the purpose wasn't to persuade or dissuade from any purchases, but rather to reiterate an investing lesson that is often repeated and quickly forgotten. Please leave comments below, and I'll respond when I can!